ESP Newsletter: Issue 5
Special Focus: Michigan Investing
In this issue of the Early Stage Partners newsletter, we wanted to give you a closer look at how we enter a new market and how we have conducted our business in Michigan. As you know, in 2009 we received a significant capital commitment from the Venture Michigan Fund and the 21st Century Jobs Fund, both managed by Credit Suisse First Boston. At that time, ESP agreed to open a Michigan office and to invest in Michigan companies. We have honored both commitments, by taking an office in Ann Arbor, by hiring Andrew McColm to staff it, and by investing in three Michigan companies previewed below.
In Defense of Regional Investing
The question venture capital firms are confronted with when they agree to invest in a particular state is: Are you going to be making bad investments by honoring that commitment? Another flavor of this question is: Won’t you be passing up better investment opportunities elsewhere? A third way this objection is stated comes from LPs who won’t invest in a fund that is committed to geographic investing.
These are legitimate concerns and we are acutely aware of the ramifications of taking LP capital intended to be invested in one state. After all, Early Stage Partners began, with ESP Fund I, as an Ohio-based fund with backing from Ohio LPs to invest in Ohio companies, before expanding into Michigan with ESP Fund II.
After a dozen years in business, we’re here to say that regional investing, done well, can generate nationally competitive returns to LPs, be a sustainable business model for an early stage venture capital fund, and also have corollary benefits to LPs who are partially motivated by supporting robust regional economies. It’s hard work, to be honest about it, but so are most things that are worth doing. We have profiled three of our Michigan investments below, and drawn lessons from those investments later in this newsletter. We hope that you will read on.
What Kinds of Deals Does ESP Do?
Early Stage Partners divides its activities into three practice areas: Information Technology (IT), Healthcare Technologies (HT), and Advanced Manufacturing and Industrial Technologies (AMIT). A fourth area of focus, the tech transfer (TT) practice, layers horizontally across all three vertical sectors. Each area has its own profile and its own Managing Director—Jonathan Murray for IT; Mike Bunker for HT; Richard Stuebi for AMIT; and Andrew McColm for tech transfer—with senior transactor Jim Petras serving as an experienced hand in all transactions and across all sectors. Usually we are the first institutional investors, or among the first group of institutional investors. We typically invest in the Series A Convertible Preferred stock of Delaware “C” corporations and hold sufficient reserves to participate in subsequent rounds. We often take a board seat, and are active board members. Most companies in which we invest are in early revenue, but we do also invest in pre-revenue companies.
Here are three of our Michigan investments.
HT and TT Portfolio Company Profile: Histosonics
HistoSonics first came to the attention of ESP Managing Director Jonathan Murray at the 2008 MichBio Expo. ESP had not yet opened a Michigan office or received LP commitments in the state, but was exploring the potential to pioneer a new market. The firm had conducted a market entry study and determined that Michigan was underserved by venture capital but had good deal flow, particularly university-based medical technologies. With the receipt of Michigan LP commitments, the hiring of Andrew McColm, and the opening of an Ann Arbor office in 2009, Michigan-based investment opportunities became a priority for ESP. HistoSonics caught the eye of Mike Bunker, added to the ESP team in 2008 to lead the healthcare technologies practice. The company quickly emerged as a strong candidate for investment.
HistoSonics is developing a non-invasive robotic micro-surgery platform using histotripsy—the creation of micro-bubbles by sound waves that, on implosion, provide the force necessary to dissolve tissue—without the thermal side effects of other surgical technologies.
The HistoSonics technology was developed and spun out from the University of Michigan, where it had been under development for a decade. Mr. McColm was familiar with the Company from his tenure at the University of Michigan Office of Technology Transfer, where he was involved in helping with grant funding and company formation. Coincidentally, Mr. McColm was sharing office space in Ann Arbor with Venture Investors, which was leading the development of a term sheet and syndicate for an investment in HistoSonics. He and Mr. Bunker reaffirmed ESP’s interest in the investment opportunity and joined the due diligence process.
The first application of the HistoSonics platform is for treatment of benign prostatic hyperplasia—enlargement of the prostate gland. Enlarged prostates press on the urinary tract, causing discomfort and urinary frequency. By age 50, half of men have evidence of enlarged prostates; by age 80, 75% of men are affected. The prostate gland is embedded in surrounding tissue and criss-crossed with delicate nerves. A safe, effective, and non-invasive surgical approach would address a large market. A prototype had been demonstrated in dogs. The company had three issued patents and 12 additional patent filings.
To get to market, Histosonics would require an extensive clinical trial to demonstrate safety and efficacy, followed by FDA clearance. In companies of this type, the clinical trial is usually the riskiest and most expensive component of the business plan. Mitigating the risk through careful trial design and syndicate formation is critical to being able to see a company through the inevitable bumps in the road. This is where the ESP team spent much of its time.
The term sheet envisioned multiple venture capital firms each contributing equivalent units of capital. On reflection, and considering the clinical trial risk and the size of ESP Fund II, Mr. Bunker concluded that it would be prudent for ESP to commit to half of a unit and keep more capital in reserve—which is what he advised the partnership to do. To compensate for ESP’s decreased contribution, he and Mr. McColm also identified an additional venture capital firm to participate in the syndicate at the same investment level as ESP.
The $11 million Series A investment in Histosonics closed in January 2010 and was ESP’s first investment in Michigan. Since then the Company has refined its product, attracted to its board former FDA commissioner and specialist in urology and cancer treatment Andrew von Eschenbach, and completed safety trials in dogs. A pilot clinical trial to achieve “first in man” has been designed and has been submitted to both U.S. and Canadian regulatory agencies. There have been bumps in the road, as is common in early stage investments, but the prudent formation of a large investment syndicate is ensuring that the company has access to capital to complete its path to commercialization.
IT Portfolio Company Profile: Amplifinity
Amplifinity initially came to the attention of ESP Managing Director Jonathan Murray in 2008 through an introduction from founder and serial entrepreneur Dick Beedon. The Company, initially named uRefer, was founded to provide a software-as-a-service (SaaS) platform to enable companies to manage customer and employee referrals. Mr. Beedon’s career in enterprise sales had convinced him that referrals from satisfied customers and employees were the most effective way for businesses to acquire new customers.
ESP followed the company for several years, liked its progress, and decided to consider an investment. An early due diligence step was to map out the competitive marketplace. In doing so, it became clear that, with the shift of commerce on-line, the marketing function in enterprises was moving from an arts-and-crafts environment to an automated, numbers-oriented discipline driven by return on investment—but that the shift was early and uneven. Some market segments, such as e-mail marketing and on-line advertising, were well served. Others, like referrals, were nascent or underserved.
Due diligence confirmed that uRefer had identified a big market opportunity. Phone interviews with large companies revealed that they were striving for revenue growth in a weak economy, were committed to customer acquisition through word-of-mouth referrals, and were managing non-scalable, labor-intensive solutions that had been patched together internally over time. These companies needed a platform to automate word-of-mouth marketing programs but, not finding a commercially available product, had decided to custom-build their own solutions and had received bids in the millions of dollars. Once they heard about uRefer, companies like DirectTV decided to abandon these expensive custom efforts in favor of a commercial platform. uRefer was the only scalable enterprise-level solution they could find.
Companies that had installed the referral platform reported that it was generating phenomenal results—high conversion rates, significant customer acquisition at a lower cost than other alternatives, and substantial incremental revenue. ROI was immediate.
Coincident with these calls, several research studies were published by respected consultants, such as McKinsey & Company, which confirmed that referrals from trusted social contacts were the best way for companies to acquire new customers. These studies noted that there were few products in the market and that budgets for purchasing marketing platforms were expected to grow significantly.
Another key factor supporting an investment decision was the quality of the investors and board. The Company was backed by a strong group of Michigan angels who agreed to participate in the Series A round and to continue supporting the company in subsequent investment rounds. The board included experienced entrepreneurs and investors with connections to Chicago and national markets.
These and other factors convinced ESP to lead the Company’s Series A round in September of 2011.
Since that time, the Company has focused its activities on the enterprise SaaS market, built a robust pipeline of Fortune 1000 companies, added significant customers like ADP and MetroPCS, and enhanced the management team with a talented group of up-and-coming young executives. Customer feedback has pointed the team towards a more expansive platform that includes additional functionality: the ability for advocates to post positive reviews and comments throughout popular social media; contests and games that companies can regularly update to activate brand advocates and keep them engaged; and rewards programs. These additions, which enable advocates to broadcast their satisfaction through social media, also led to the name change to Amplifinity—the ability to “amplify” the activities of advocates who have “affinity” for a company and its brands.
Software companies evolve—good ones do—as they engage with their customers and learn more about customer needs. Stay tuned for future developments.
HT and TT Portfolio Company Profile: CytoPherx
As CytoPherx CEO Jim Danehy describes it, two of ESP’s managing directors approached him following a presentation at the 2009 Michigan Growth Capital Symposium and “867 days later, with ESP’s leadership, we had a financing completed.” CytoPherx is based on a promising cytophoretic (filtering) technology developed by University of Michigan nephrologist David Humes, M.D. and had initially been funded, when the Company was called Nephrion, to explore applications in both acute and chronic kidney failure. The clinical trials for kidney failure were not successful. However, the data suggested that the technology would lead to reduced mortality among patients with sepsis, a systemic inflammatory response to Infection that is often untreatable and may lead to multiple organ failure and death. The Company had decided to conduct a pilot trial and was seeking investment to finance it.
ESP approached the deal as a team, with Mike Bunker in the lead, given his considerable experience evaluating filtering and infection control technologies from his prior work at CR Bard. Andrew McColm knew the history of the company, having been involved in its formation by the University of Michigan Office of Technology Transfer. Jonathan Murray participated in evaluating the opportunity because he had spent nearly a decade in the kidney dialysis market, and was familiar with the technologies, science, and competitors in that segment. Senior transactor Jim Petras brought perspective on how to structure restarts with complex capitalization tables.
A couple of initial concerns arose. ESP thought that the FDA would want the company to provide a detailed explanation of the biomolecular mechanism by which sepsis was reduced. A second concern was the use of a standard, off-the-shelf kidney dialyzer made by another company. There was also a question about whether the clinical trial was large enough (and the targeted capital raise sufficient) to prove efficacy. Consequently, ESP passed on the opportunity initially but asked the Company to stay in touch.
A year later the CytoPherx management team returned. Existing investors had provided additional financing to replace the off-the-shelf dialyzer with a proprietary product, characterize the biomolecular mechanism of action, and conduct a successful pilot trial. Thirty-five patients with life-threatening kidney injuries from a variety of causes had been treated in six hospitals. Mortality, expected to be 50%, was lowered to 31.4%--a statistically significant difference. None of the survivors required long-term dialysis, compared with 10-20% typically. The Company used these results to convince the FDA to approve a larger clinical trial.
CytoPherx was now seeking funding to perform a pivotal clinical trial and gain regulatory clearance. If the Company was successful, the market opportunity was immense. In the U.S. alone, 160,000 patients annually present in intensive care units with severe sepsis and septic shock. Reducing mortality from 50% to 35% would save 24,000 lives annually. With 70 issued and pending patents, CytoPherx had a strong intellectual property position. ESP decided to take another look.
Tapping into his national network of resources, Mr. Bunker led a renewed due diligence effort. A central focus was the clinical trial design. The consensus was that a larger clinical trial and capital raise would be required than CytoPherx was contemplating. After a series of iterative conversations with clinical experts, the Company, and existing and new investors, ESP took the lead position in negotiating a term sheet with the Company to raise $34 million. A study protocol was submitted to the FDA and approved.
The challenge for ESP, as a small regional fund, was to find the required $34 million in capital. Working closely with management and existing investors, Mr. Bunker spent the next nine months leading the fund-raising effort. To solidify its lead position, ESP formed a special purpose LLC and augmented ESP Fund II’s $1 million investment with $6 million of commitments from ESP’s network of high net worth individuals. Existing investors committed additional capital. Finally, Onset Ventures and Kaiser Permanente agreed to participate—validating the clinical and economic theses of the investment. The investment closed in January 2012 and was recently recognized by the Michigan Venture Capital Association as the 2012 “Deal of the Year,” due in large part to the extraordinary effort by ESP in assembling the necessary capital syndicate.
Since that time the Company has enrolled about 25% of the required patients in the clinical trial. Preliminary results are promising in showing a benefit for patients with sepsis. Stay tuned for future developments.
Lessons in Regional Investing
There are actions a regional venture capital firm can take to ensure that, by focusing regionally, it isn’t making bad investments, or missing better opportunities. As illustrated in the prior stories, these include:
• Investing nationally. Early Stage Partners has made significant investments around the country in both Funds I & II, and intends to continue the practice in Fund III—while still accessing overlooked regional opportunities that provide proprietary deal flow, favorable terms, and the opportunity for extraordinary returns;
• Developing national networks. Investing nationally provides access to networks that provide critical perspective on the competitive dynamics for regional portfolio companies. These networks also provide resources like co-investors, management, and board talent. Each ESP practice manager has built a national network of co-investors, due diligence resources, recruiters, and investment bankers to provide context for understanding regional investment opportunities and to bring resources to the company;
• Taking transactional leadership. ESP leads or co-leads 75% of its investments. This means taking an active role in identifying opportunities, working with management teams to come to terms, leading thorough due diligence, and attracting sufficient co-investors to ensure that a regional deal is nationally competitive and several rounds of capital are covered from the beginning to minimize financing risk;
• Being integrally involved in regional networks that support entrepreneurial companies. Many Midwestern states are focusing significant resources on building entrepreneurial economies based on university tech transfer, incubator and accelerator programs, angel investing networks, grants and loans, matching capital, and other types of support. These networks draw on national experience, and also bring national partners into regional economies. Early Stage Partners is deeply involved in these initiatives in Ohio and Michigan in many ways. This provides proprietary access to deal flow and resources that help portfolio companies to be successful.
These steps, and others, provide a repeatable process that supports quality investment decision-making. Through this investment discipline, ESP has built a substantial portfolio. We expect that both Early Stage Partners funds will generate competitive—and potentially superior—returns compared to national peers.
In this issue, we are pleased to profile Andrew McColm, who leads our technology transfer (TT) practice.
Andrew, you spent five years in technology transfer at the University of Michigan before deciding to become a VC. What lessons did you learn about how to start companies from university technologies?
University spinouts offer a firm like Early Stage Partners the opportunity to get in on deals at the earliest stage and to have a hand in refining the business concept and building the management team. This provides access to deals, many of which may be otherwise unnoticed by venture capital firms, on a low cost basis with high upside potential. Universities are among the most fertile sources of innovation in the U.S. economy, particularly in fields such as healthcare technologies.
How are university spinouts different from other VC investments?
In several ways. For one, they are often driven more by a patented technology than by a market opportunity so early market validation is critical. Second, the inventor/founder typically doesn’t want to be—or often isn’t best suited to be—an entrepreneur, so an experienced executive has to be found to raise money and run the company. This requires helping the inventor find an appropriate continuing role with the company. Third, a key piece of the company’s value is derived from the IP license with the university, which is a specialized and sometimes tricky negotiation.
What special skill sets are needed to invest in university spinouts?
Great question. Knowing how to find and team with other investment partners is important. So is deep knowledge of how universities work, and how a VC and portfolio company should interact with a university. It helps to have longstanding networks into research institutions to see and track the best projects. You have to be patient in tracking these opportunities; the time from scientific discovery to when a project is fundable as a startup can be several years. To get the best deals, you have to maintain regular contact with both the tech transfer office and the inventors. That’s a lot of meetings to manage.
What are the unique challenges on investing in university spinouts?
I’m not sure that these are unique to university spinouts, but you have to understand the scope, scale, and funding that is appropriate for technical and market development, and then put together a sufficient capital syndicate to ensure that the available capital matches the business plan. Knowing when to have this in place—at the time of spinout, or when the additional risk of less capital will be rewarded with a greater ownership stake and higher future returns—is a judgment call of some nuance for an investor. Finally, as with any startup, early commercial and market validation are critical to success.
What opportunities does the Midwest offer to an investor?
Midwest research institutions receive over $6 billion in research funding annually—this is what finances inventions—but generate less than 10% of spinout companies nationally. To us, this almost ensures that there are a number of promising opportunities that are incubating under the radar at universities. These institutions are generally underserved by venture capital, and often don’t have robust entrepreneurial ecosystems into which they can spin out companies. VCs that call on these universities can significantly expand their deal footprint and, as with ESP portfolio company LineStream, gain proprietary access to extraordinary opportunities.
Thank you, Andrew.