In this episode we begin to analyze the Internal Risks of a company – Technology, Regulatory and IP risks are covered in this episode. Join us as we define each of the risks, and discuss the key considerations for each.
This is Propel(x) podcast, discussion on investing in all things startups. Startup investing is highly risky. Please listen carefully to the disclosures at the end of this podcast.
Andy Reed: This is Andy, and this is the Propel(x) podcast I’m joined today by Swati Chaturvedi, CEO of Propel(x). Hi Swati
Swati Chaturvedi: Hi, Andy, how are you?
Andy Reed: I’m good, thanks. Today I’m excited to be talking about risk as part of our series about evaluations. We’ll be looking at some of the internal risks of a company. So I want to take a step back before we dive in and just talk about where we are in our road map of company evaluations. We’ve spent some time talking about some of the broad external factors such as the market dynamics and the competitors. We also had a sidebar related to team. That was especially interesting because it’s often a point of fascination, I would say, by a lot of investors going through diligence, kind of a magic box, if you will. Today we’re really going to look inside of the company. I think we can talk a little bit about technology risk, regulatory risk, IP risks, and execution, and that kind of really rounds up the framework for internal risks for the companies. And the last one that we may address today is financing risk. So let’s get into it if you’re ready to go.
Swati Chaturvedi: Yes, let’s do it.
Andy Reed: Alright. So, first of all, I think– let’s define each of these risks. In our valuation, we have a technology risk. What does that actually mean?
Swati Chaturvedi: So in deep technology startups—which really is our expertise- one of the major, major risks is technology risks. So let’s take the example of let’s say a new medical device, which let’s say it’s going to replace a heart pump for you. Now that carries major risks. Well, does it work outside of the body? But hey, will it work inside of the box? Will it perform appropriately? Will the battery technology, how’s it going to be powered? Or what is going to be the size of the signal? Is it going to last, is it going to be durable, and most importantly is there a precedent for this? Will the FDA approve with that comes to regulatory risk? The point is, will this work? In short, will this work, will this work at scale, and will this work in the market? That’s what technology risk really is about.
Andy Reed: That’s interesting. I actually think of it kind of in a different way and I’m curious to hear your perspective on it. I guess I think about it from an investor perspective, which is: What is the unique asset that this company is building. That, and where is the source of value that they’re creating? And so if it’s located in—they could be in a really hot market, like it’s great to be in that market—what differentiates them is the intellectual assets that they’ve built over time. And it could come in a lot of different ways. But really..going back to that heart valve pump or whatever the example; it’s really the blood, sweat, and tears they’ve poured into that technology that has the potential to differentiate them. And then because of that potential, the value is therefore the other side that is risk. So if they do not, they’re not able to deliver on that risk, then the company has proportionally less value.
Swati Chaturvedi: So what you’re saying is—not the way I think of it—the risk is: Does the technology work or does it not work? But what you’re saying is, does it differentiate you enough? I think that falls under that different category, which is IP, intellectual property. Is that intellectual property valuable enough or not? What is the risk? Only because we like to have a very MECE framework: Mutually Exhaustive, Collectively Exhaustive, so it’s important to separate out and piece out these different elements and understand, this is where this falls. And we don’t have to be kind of pedantic about it. We can..we can..It’s just a word. Ultimately, you do want to assess; does the technology work? Will it work at scale and will it work in production? It’s okay to work in the lab. Will it work in the human body for example? Will it work in the conditions of the Arctic? Let’s say it’s a battery technology designed for a hole or whatever. So those are the key risks that I perceive as technology. Is the technology going to be developed enough? There is this other aspect that you are mentioning: will this provide a moat? Is it differentiated enough? And you can plug that into technology risks. You can plug that into IP risk, but yes, I think those are both aspects of addressing technology risks.
Andy Reed: Yeah. I understand now that you’re talking about it. That sounds cool. Turns out that I don’t have a Ph.D. in each one of the subjects that every deep tech startup is fundraising around. So, I mean I’m essentially flying blind if I’m going to go in and make an investment on, let’s say, a cardiovascular company unless there’s a way to do some sort of validation from an investor perspective. What are your thoughts on how to actually evaluate technology risk?
Swati Chaturvedi: Yes, of course. That is our purpose here; right to demystify investing in deep tech startups, and Andy you’re quite an expert on this. But let’s discuss: So how can… Mark has a Ph.D. of course, on our team, but the others don’t have a Ph.D. in anything and so the question is, how are we able to understand what this company is talking about? Right..We certainly don’t know enough about aerospace as well as medical technologies, as well as some kind of biotechnology. So how are we able to invest? And we have a fund also, Newton Fund which invests. So how do we make these decisions? Well, I think common sense comes in useful. Yeah..Diligence is really all about asking good questions. And when evaluating technology risk, it’s very helpful to ask about data. So that’s the number one question we should ask; what is the data that you have? What is the evidence that this works? Is this just a science project? Have you..Is just theory yet? Have you done lab experiments? Is there a prototype? Is there a customer prototype? So there are these different stages. So actually, the government has come up with a categorization which is called Technology Readiness Levels (TRLs.) And they go from TRL 1 to TRL 7, which basically goes through these phases. Is it theory? Is it in the lab? Is it a prototype which is a non-customer-ready, customer-ready prototype? And so on. So there are those TRL levels and I suggest people should educate themselves on that. But essentially what those levels really indicate is at what readiness is this company? What is the testing that has gone into it? And that’s why we must ask for data. Ask for data. What are the tests that you have run? How did this perform on the stress testing? If you’re talking about some medical technologies, do you have animal data for it? And when they show you that animal data, they’ll show you graphs, and those animal studies tend to be small, initially..especially if you’re just doing toxicology studies, they tend to be very small which is 8 mice, 12 mice. And so you have to ask these questions. What does this mean? Don’t just show me this graph. What is on the x-axis, what’s on the y-axis? Why is it relevant? If only one mouse survived as a result of your experiment, why is it relevant? Is it statistically significant? In other words, what happened to this sample of mice, is it going to happen to the larger population? Those questions are important. Ask for data. That’s the number one thing in evaluating technology risk. And the reason I emphasize this so much is because most people do not ask for any data. They just look at the pitch deck and they listen to the startup. So it’s very important to ask for data. The second is to ask for published papers. If the company has any results then they must have published some papers and whether or not they’re peer-reviewed, ask for the papers. Of course, if they’re peer-reviewed, they’re even more valuable because other people have looked at them. The third is to talk to customers and industry experts. They will tell you what is right, what is not so much, what they look for in a potential solution, and so on. So that’s kind of a lot, so I’ll just stop there.
Andy Reed: Yeah, I think that’s helpful. I think one of the experiences that I’ve had in joining Propel(x) and riding shotgun on all these deals is, over time you get a sense of what’s right with a given area. And I think the other part—that is not so much on it but on a unique individual deal, but I think it’s a kind of broader thing—is you get to know what’s relevant by asking these questions a lot over time and co-investing with other people who ask these questions. So you have a point that you made around customers and industry experts. It takes time to build a network and one of the things that can help with things like platforms is you have these built-in network features. So we have an incredible pool of experts that we’ve built up over the years that we can refer to their either corporate leaders or academic leaders or even other startup founders and other investors. So something like that. And on a case-by-case basis, it gets better over time. That’s another way to kind of think about how you make this evaluation as you plumb your network for insight.
Swati Chaturvedi: This also takes us back to one of our earliest episodes, which was how to get started, right? And we said, “Oh, listen, don’t be in a hurry. Look at least 15 startups, narrow them down to 4 and then invest in one or something.” I think we gave those numbers. But that also goes to what you’re saying, that over time if you look at enough companies, you start understanding what’s relevant and what’s not. Be in no hurry. I think it’s time for us to reiterate that.
Andy Reed: Yeah. Totally…and I do want to say, we have a weekly call that we’re running right now for accredited investors and people can sign up and join that. That’s a really easy way to do it. But you can essentially probably spend every day signing up and joining a free call that’s happening somewhere and especially now when everyone’s working from home. There’s a lot of access through digital technologies to see new technology presentations. So there’s a lot of opportunities. And I think once again, I’ll plug the weekly call, which is open to anyone who’s an accredited investor who registers on Propel(x). So with that, I do want to transition and talk about some of the other things like technology is meaningful in terms of risk, but especially with deep tech, there are also industry-specific risk and as I think about it they are really around regulatory issues. This can be a little bit confusing from the outside, especially at first. But I’m curious to know, how do you think about regulatory risk in general?
Swati Chaturvedi: I think regulatory risk is about operational efficiency. Do you have..Have you been able to kind of… because it’s really about checking the boxes for the most part, right?
Andy Reed: Let’s define regulatory risks first. What does that actually mean?
Swati Chaturvedi: So whether or not..depending on the industry, especially in a medical device, for example, all medical technologies, all of life sciences, whether they are drugs, devices, and diagnostics—they are regulated by a government agency called the FDA. There might be other regulatory authorities like the EPA, (Environmental Protection Agency), which might regulate energy-related startups or chemicals related startups. There might be other regulatory authorities like FINRA, which is the Financial Regulatory Authority. So there are regulated industries and these three are definitely regulated industries, which is healthcare, financial services, as well as anything to do with the environment. And so it behooves investors to understand if the startup that they’re investing in is regulated or not: Which is, it has to adhere to certain government specified guidelines. In the case of FinTech, it’s not government specified, its self-regulated organizations. The point being the startups have to adhere to specific guidelines. And if they do not do so, they will be penalized and in extreme cases may not be allowed to operate. So that’s what I mean by regulation. Does that make sense?
Andy Reed: Yeah, it does. And just to kind of.. expand on the list, I think transportation is another one. Anyone who’s selling into aerospace, transportation, defense, energy, you obviously named – essentially each of the categories of industry on some level a company’s going to run into some regulatory issue. And I think that from my experience of looking through deep tech fields, especially in the biotech space, one of the key aspects in mapping out regulatory risk, is just understanding: What are the hurdles that a company has to get through to bring their product to market? So for a biotech company, for example, there are studies that have to be done and they cost a certain amount of money and no company can sell a drug unless they accomplish those things. So that just really frames the path to sales. And there are exceptions too. I mean, we work with companies that get special designations in biotech, for an orphan disease for example. So knowing what those things are, and understanding the landscape of how a company is bringing a product to market, I think that’s an aspect of regulatory risk. Is there anything else on regulatory risks that you think is really important to highlight for people going through the evaluation process?
Swati Chaturvedi: Well, I think the thing that you said, which is understanding the landscape, that’s like super important. And how does one understand the landscape? The easiest way to understand the landscape is to talk to people, ask the company. In fact, part of the startup’s job often is to sell right, to sell investors and to help educate investors, and to help them understand. And the reason that startups spend time educating investors is that’s part of their…part of their pitch. It’s one way to persuade investors by getting to know them better, by explaining things to them, and so on. Obviously, every startup wants educated investors on board. So ask the startup and do not be shy about it. Ask the startup: What are the steps to getting approved? Lay it out for me and then ask for timelines. How long does this take? How long does that take? Where are you at? So develop a roadmap kind of thing. And we will be putting our roadmaps in life sciences and in some of these regulated industries. But ask the startups and don’t be shy about it. Similarly, ask the experts and don’t be shy about it. You can get into these conversations. And like you said, Andy, we have a network of 1200 plus experts at this point in various industries and we try to enable that on our part, but investors should do that too like you said: Plumb into your network and find out. So that is one. The other thing that I think is very relevant is to look for precedent. So whether or not a medical device is going to be approved, one easy indicator is, is there a precedent device or a similar thing that was approved for similar purposes? It may not be solving the exact problem. For example a device was approved as a ventilator. Okay, at least we know that ventilator devices have been approved and have a chance of being approved in the future. Then you look for further similarities or differences. And so….that is important. So precedent-based understanding of what has been approved or what is likely to be approved, especially in medical devices is kind of important. But other than that it varies so much that it is important to understand: What is that roadmap, how long is it going to take? What are the steps to it? Just develop that roadmap and kind of check, check, understand where the company is at and what the risks are in the future.
Andy Reed: Yeah, totally. I see this as an eyes wide open type of issue, where if you’re going to make an investment, understanding—you don’t want to be surprised by something that’s actually pretty obvious if you’d taken the time to do your homework about the industry, that later down the line that there’s going to be potentially a challenge with the company, even if it’s a challenge, the company is really well equipped to handle. I mean every successful biotech company, to be successful, gets through the regulatory hurdles. So it’s not like they’re dead ends. It just requires time, money, and expertise. So it’s really an issue of saying: How much is the team aware of these issues? How well-spoken are they, what’s their strategy, and what do I think about that relative to everything else i know? One of the things that we had mentioned is IP earlier. I want to move on to IP if that’s okay with you.
Swati Chaturvedi: Yes, absolutely. Let’s do that.
Andy Reed: So, we talked about technology risk as a distinct thing from regulatory risks, as a distinct thing from IP risk. Again, let’s just start with a definition. What do you mean by IP risk?
Swati Chaturvedi: Yeah. So intellectual property: Typically people translate that as patents, but I feel intellectual property is much wider than patents alone. It could include trade secrets, it could know-how and it could include patents, right? Trade secrets and know-how are not things that are written on paper. Know-how especially is just kind of some.. I know it. I know the process that connects my electrolytes together or I know how I do that. I’m not going to write it on paper. I’m not going to share it. Trade secrets can be specific formula, for example, a formula for an electrolyte. We are giving real examples here, right? That’s trade secrets. Know-how and patent can be the design of a battery. For example how are the different containers structured and how the electrolytes move from one to the other? And not just that, but a wider; kind of all alkaline batteries. You can put patent over that. I mean, that’s too broad, but the point being, you can have a patent over specific formulas. You can have patent over other things; methods and compositions of materials and whatnot. So those are different things that constitute intellectual property; trade secrets, know-how, and patents, and those three need to be understood differently.
Andy Reed: And so when you say risk– I mean, if a patent exists, this is a really dumb question, but I still don’t really understand. Like a patent exists, how does that patent define risk?
Swati Chaturvedi: Yes. Well, it’s an asset and an asset, as you keep saying Andy, is risk.
Andy Reed: So it really is the absence of IP that would be risk that you’re evaluating or is it really not so much risk in the kind of risk of failure, but really in the kind of risk award…
Swati Chaturvedi: There’s definitely a risk of failure. So for example, what if your patent is just a provisional patent? You’re banking on this idea that you’re going to get this patent and you don’t? That’s the risk, right? So how does one evaluate whether or not you’re going to get this patent? First and foremost, ask what stage are they at? You first have a provisional patent where you write up your application and so. And then you get interviewed about it, and then you eventually get award and the patent examiner determines whether or not to award you this.
Andy Reed: That’s exactly what I meant though because a lot of times we’ll talk to startups and they’ll say I have 45 patents and I am like, that’s awesome. Tell me about them. And they are like, “Well, I have 40 that I submitted and five that were awarded 10 years ago on a different topic. But it was related to the research that I did in my Ph.D.” and I am like Oh, okay. Well, that’s cool. 45 sounds great. Digging into the details, it’s not that these technology companies don’t have value. But the important thing that I’m trying to stress and while we’re asking these basic questions is particularly the distinction between a patent being an initial provisional patent and a patent being awarded. That’s something I see a lot of it. And there’s no certainty around that process.
Swati Chaturvedi: Yes, absolutely. But there are other risks also. For example, how easy is it to get around a patent? So there are multiple companies…That also goes through how valuable that patent might be. So that’s the risk that we’re assessing or the reward that you’re assessing. How valuable is this part? Let’s assume it exists. It has been awarded. Okay. Is it really valuable? The broader, the pattern, and the more valuable it is. Why? So for example, if I were to say that, “Oh, I have a patent over all alkaline batteries.” Well, that’s extremely valuable because now you’re covering a very wide range of chemistries. On the other hand, I say, I have patent over a lithium-ion battery. Okay. That’s more narrow because you’re specifically covering lithium batteries. And then you could have a narrower pattern, which further defines that. So broad patent are more valuable. Coming back to that, but I think the key thing that people miss in all these numbers that are thrown out about patents; we have 50 patents, 30 patents, whatever—are patents really valuable? Is IP the single most valuable thing in a company? In some cases that is true, especially for example bio-pharma, where a lot depends on the actual composition of the chemistries. But in many cases, IP alone is not the most valuable. So I do want to stress that, especially if you look at various software-related technologies, it’s very easy to get around that. There may be multiple companies solving the exact same problem through different methods. And so just because you have a patent on a specific method, does not preclude other companies from going after your market by a different method. And for that reason, I think one should keep in perspective that all of these things within a startup are important. IP is useful, important. The more important thing is to execute, right? I mean, that’s my perspective. In some cases though, I do want to clarify, especially in biopharma, companies get bought for their IP. It’s really those patents alone in some cases that help them get an exit. So I think people need to understand in their specific industry that they are diligencing, how valuable is intellectual property in general? And then go look at that specific intellectual property and try to assess if it’s valuable, not so much and so on.
Andy Reed: Yeah, that makes sense. I guess one of the things that I’ve always thought about—and this is more on the side—is that IP is valuable but it really becomes more valuable as the company grows over time. So kind of.. it is like an option in a certain way. It distinguishes a company because it allows them to do whatever they’re doing. But if they’re not really selling products, then it’s not really important that they have a unique way of making those products. And similarly, if they had to defend it they don’t really have the resources in the first year or two of the business to get into a patent lawsuit. We’ve seen examples of well-funded companies. There was an electric motorcycle company from the Bay Area a few years ago that got into, I think, a patent dispute with Harley Davidson and they ended up having to forgo the company because they just didn’t have the resources to both build electric motorcycles, which is pretty capital intensive and find a patent. So I think it is important, but it also has to be taken into context.
Swati Chaturvedi: But Andy, on that point, I do want to raise this important point. So the example that you gave is important, why? Because it illustrates the importance of something called FTO- Freedom to Operate: Which means that in many cases, a company may unknowingly infringe on someone else’s patent, right. And that’s when they get sued for it. And of course, there are different differing opinions on this. But it’s very helpful if the startup has already had an FTO analysis done, which is a lawyer, for example, has conducted a search of patent and determined that this company has the freedom to operate using the technology that it is using and is not infringing on other people’s patents. That’s why an FTO analysis is quite valuable. It does take money to conduct but many companies do that. So investors might want to ask, “Have you done an FTO analysis?” and that would mean that do you have the freedom to operate analysis in place and that’s valuable.
Andy Reed: All right..Yeah, I think that’s a really good point and I think that that’s something- especially in markets where technology is at the center of what they’re doing, so many of these deep tech companies- it is actually important to understand what the runway is for this company and are there going to be issues down the line? And of course, you can’t anticipate those. But hopefully, this framework provides investors a good start with how to think about the different types of risks. I think we wrapped up a lot of the key internal risks, or at least we started the conversation about them there. But each time we go through an evaluation, I think we think about how we refine these aspects of the framework. And I think we want to talk about or I’d like to talk about execution risk and financing risk in another episode. With that, I think we can wrap it up. Thank you so much for your insights today.
Swati Chaturvedi: Thank you so much, Andy. It was a good conversation.
Andy Reed: Yeah, it was interesting. I’d love to hear from listeners about their perspective on these internal risks in the company especially around technology. So any comments that you want to leave on the blog, we’ll check them out. So with that, this is Andy.
Swati Chaturvedi: This is Swati
Andy Reed: And this is Propel(x) Podcast. Thanks so much.
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