Raising Capital for Your Startup: It’s About More Than Money

Most of the time for most entrepreneurs, raising money for a startup is not a lot of fun. Absent some combination of a hot deal and a hot market, fundraising is a real chore, too often full of demoralizing turndowns and even more demoralizing walls of silence. Still, as bad as it can be, the process almost always includes some important opportunities that good entrepreneurs will seize and use to their advantage.

The first opportunity the capital chasing process offers is self-reflection. Asking other folks for risk capital forces you (at least if you expect any success) to think about your business objectively, from the perspective of an outsider. And not just any outsider, but a jaded professional investor. Vision and passion are certainly appreciated by most of these folks, but as table stakes, not closing arguments. To seal a deal, you will need to get back to the cold hard realities of your value proposition, your business model, your evolving competition, your financing plan, and your exit strategy. Mission critical stuff that can get lost in the fire drill of day-to-day startup life.

Another opportunity worth grabbing on to in the fundraising process is the learning opportunity. If you have been at all careful about qualifying your investors, you will be talking to folks who very likely know a lot about the environment – technology, competitive, financing, exit, etc. – your startup is living in. If you listen carefully, and ask good questions (you should, in all events, be vetting potential investors as much as they are vetting you), you will almost certainly learn a lot of valuable information from the fundraising process, as much or even more so from investors who turn you down.

Finally, the fundraising process will give you valuable feedback on your teams’ capabilities, collectively and independently, in an area – raising capital – that will only become more important as your capital needs grow on the road to your exit. Raising capital is a skill in its own right – indeed as mission critical a skill as there is. Getting a periodic handle on where your team measures up in that regard may not be worth the trouble in and of itself, but when you need the money you might as well get as much besides money as you can out of the process.

Approaching the fundraising process as a learning opportunity, as well as a way to generate needed capital, may not make the effort any more fun. But it can make it a lot more rewarding.


Building Your Startup Team: Complementarity and Chemistry

Most professional venture investors believe the best predictor of startup success is the quality of the team. Good teams can and do fail, but as team quality drops below “awesome,” the chances for success drop very fast. Thus the cliché that most investors will gravitate to an “A” team with a “B” opportunity over a “B” team with an “A” opportunity.

There are a lot of reasons team quality is so critical to startup success. The incredibly stressful startup environment is the biggest. Startup teams need to accomplish difficult goals with minimal resources in terms of time, capital, and people. Additional stress accrues as outside forces – competitors, markets, technologies, etc. – evolve and force teams to make significant adjustments, often including basic “pivots” (business model, for example) on the fly.

If the extraordinary stresses of the startup environment explain the importance of getting the team right, they also offer a clue to what makes a superior startup team. At the foundational level, what separates the superior startup team from the merely good startup team is complementarity and chemistry.

Complementarity is pretty straightforward in concept, if not always in execution. Within the confines of available resources (financial) and the constraints of team chemistry (more later), you need to make sure the team includes top-tier players at the mission critical startup tasks (i.e. the tasks that need accomplishing in the current round of funding), as well as the flexibility to successfully “wing it” with respect to important ancillary functions.

The trick to building a complimentary team lies in recognition of, and dealing with, the well-established HR principle that when people get to choose who they work with – or who works for them – they tend to choose people like themselves. Now, if you are a founder, and thus most likely very confident of your own near-perfection, that might not seem like a problem. If you’ve got perfection, why not clone it if you can?

Consider if Apple had been founded not by Jobs and Woz, but by Jobs and … Jobs. If you know the Apple story, you know what a catastrophe a Jobs/Jobs founding Apple team would likely have been.

The bottom line is that however perfectly suited you may be for leading your startup to fame and fortune, building a team of clones is seldom the best way to go about it. Instead, look for people with different skill sets. And as much or even more so, different personalities and perspectives on business, technology, and life. The most successful startups – even those like Apple in the years after Jobs returned from exile that were dominated by a leading personality – build leadership teams with diverse skills, experiences, perspectives, and personalities. Just ask Tim Cook.

And that leads to the second, and harder to execute, aspect of assembling a superior startup team: chemistry.

It’s not enough to assemble a team that “covers the waterfront” in terms of skills, experience and personality. You need to make sure those folks can also form very strong bonds with each other (thus the “chemistry” analogy). Because in the constantly changing world of the startup, relationships between key players on the team are going to be under almost constant stress as company circumstances evolve and people have to adjust to changing opportunities and challenges. As anyone who studies morale in the military will tell you, folks in foxholes are motivated more by their loyalty to the folks around them than to “the cause” as such.

On that last point, one of my favorite quotes from an entrepreneur came when he was asked what he would tell his team at the beginning of his next startup journey. He replied: “Folks, we are going on a very long and difficult journey. On this journey, we will carry our wounded – and shoot the deserters.”

The quality of the team has long been the most important factor for most venture capital investors, for good reasons. As you think about assembling your team, particularly in the early days, don’t make the mistake of hiring folks because they look like you, or because they are a perfect skills fit. Look more for folks who compliment your skills and personality – and that look like the kind of people you want on your side when the going gets very tough. Because it almost certainly will, likely many times.

Things Entrepreneurs Should Know (About Venture Capitalists)

If ever there was a prototypical “love-hate” relationship, there is a good chance it was between an entrepreneur and a venture capitalist. It’s the perfect kind of relationship for the love-hate dynamic: lots of pressure; big egos; mutual dependence; and over-lapping but different and evolving relationship objectives and constraints. Unfortunate as it may be when things get ugly: surprising it isn’t.

While ugly entrepreneur/VC relationships are inevitable, there are more of them than there should be. As both a VC and a VC-backed entrepreneur I’ve seen a lot of entrepreneur/VC relationships get ugly that shouldn’t have; or at least shouldn’t have as soon as they did. Many times, entrepreneur/VC relationships break down when one side – and it is more often the entrepreneur side – doesn’t appreciate some of the realities that shape the attitudes and requirements of the other side.

And so this brief review of some of the realities of the world venture capitalists inhabit, and how those realities impact their relationships with entrepreneurs. Some are deeply ingrained in the nature of the venture investing business; some seemingly arbitrary rules of thumb. And yes, in almost every case subject to the occasional exception that most often proves the rule.

  1. Venture Capitalists are Fiduciaries. Venture capitalists manage money entrusted to them by their own investors (commonly referred to as “Limiteds”). That makes them fiduciaries, and that, in turn, means they are legally bound to act solely in the best interests of their Limiteds. Thus, as much as they may like and respect their portfolio entrepreneurs, their Limiteds have first call on their loyalty. A VC with any integrity at all (and you surely would not want to work with a VC lacking integrity, right?) will, when faced with a choice of doing the best thing for her Limiteds or doing the best thing for her portfolio company, pick the Limiteds every time.

    The fiduciary character of the VC/Limited relationship manifests itself in all sorts of ways beyond the obvious “should I invest more capital to save this company that I want so much to succeed, or would that be a bad move for my Limiteds” sort of situation. For example, entrepreneurs are often bemused by the emphasis VCs put on dotting every “i” and crossing every “t” in the deal documents. Well, that’s because while they personally might think a particular “t” does not need to be crossed, they have to think of their Limiteds – more specifically, what their Limiteds might think if not crossing that particular “t” turned out to be costly.

    More generally, being a fiduciary makes VCs very sensitive to making and managing deals within the real if not always well-defined parameters of the then current market. So, for example, I once knew a very prominent VC who thought that the whole idea of anti-dilution price protection was silly (I actually agree with him on that). That said, he got it in every deal he did for his fund. Why? Because if he didn’t his Limiteds would want to know why every other VC got it for their Limiteds, and he didn’t get it for them.

    The bottom line here is that entrepreneurs are well-advised to remember that as much as they may think of their VC as their VC, she is in fact first and foremost her Limiteds’ VC. And if she is any good at all, as much as she may like and respect you, in terms of her priorities her Limiteds are at the top of the list.

  2. Venture Capitalists are … Entrepreneurs. You heard that right. VCs are entrepreneurs just (well mostly) like you. They put together a business plan and take it on the road to raise money from mostly very sophisticated institutions. If they deliver the goods, they will likely find it easier to raise capital for their next fund. If they don’t they will probably find themselves in another line of work.

    Beyond just generally helping you have some empathy for VCs, realizing how their life and yours have so much in common should tell you something about their nature. Look in the mirror. Do you have a big ego? Are you often wrong but never in doubt? Are you a tenacious bulldog when it comes to building your business? Do you have at least one serious personality … quirk?

    Well, so does your VC. Which is to say, as difficult as you may find them to work with at times, you can be pretty sure they feel the same way about you.

  3. Venture Capital Funds Pivot, Too. If there ever was a startup that evolved exactly according to plan – from the first money in to the exit – you can be sure it was one of those exceptions that proves the rule. The same goes for venture funds. VCs leave funds unexpectedly. Markets evolve, and investment strategies evolve with them. Unexpected opportunities and challenges come up, and with them changes in resource (capital and people) allocation. Stuff happens and funds change, just like startups.

    When stuff happens at a VC fund, portfolio companies can suffer. One of the saddest VC/entrepreneur stories I know involved a company where I was an angel investor and director. The entrepreneur was really good, and really wary of brining a VC into the business. He bootstrapped and invested most of what he had made in a prior deal. Finally, with a good product, cash-flow positive operations on $5 million revenue, and great press, he concluded (rightly, in my opinion) that to come out as a leader in the market and really scale the business he needed to bring in some capital.

    So, he took $10 million from a very reputable venture fund at a good price, working with a partner who had followed the company and made noises about wanting to invest for several years. The first three months post-close were fantastic. And then .., the VC left the fund for greener pastures. The fund assigned a junior associate to the deal, and started looking at how to get out sooner rather than later. The company ultimately failed, largely, I believe, because what looked like such a sweet entrepreneur/VC pairing turned sour.

    Ok, the general point is that your relationship with your VC and her fund will evolve. Sometimes for the better. Sometimes for the worse. It pays to stay attuned to what is going on in your VC’s life, and her fund’s life. Is her star – and the funds’ – rising or falling? How much dry powder does the fund have? How much of that is for your deal? How is the rest of your VC’s and her fund’s portfolio doing? Knowing all of this, of course, doesn’t mean you have a lot of influence on it. But it can give you some inkling about how your relationship with your investors is going to evolve, for better or worse.

  4. Venture Capitalists are Business Partners not just Investors. Entrepreneurs are all over the map on the notion that VCs bring more value than just cash to the table. In my view, good ones do. But that really is not the issue here. The issue is that whether or not you think your VC has anything to offer besides money, you can be sure your VC believes she does, and in any event she is going to have some serious things to say about how you manage your business. And it doesn’t really matter how much of your company she owns: as folks who have run afoul of a bank loan covenant can attest, you don’t need to have an ownership interest to have a controlling interest.

    The point here is that you should be very careful, as you put together your deal with a VC, not to get so focused on the economics that you miss the management implications of the deal terms. Make sure you talk with your lawyer about control issues like class voting rights; Board seats and observer rights; fiduciary obligations (which can cut different ways in different circumstances); any voting agreements or side letters with investors; and most of all the extent and nature of the “Protective Provisions” in the deal documents. You’ll almost certainly find that there will be things you will not like in these areas, some of which you will likely not be able to change. But you can often change some of them at the margins at least, and even when you can’t it is better to know about the realities of control before your VC asserts them at a crucial moment.

  5. Venture Capitalists Don’t Do NDAs. Having been a serial entrepreneur I get why entrepreneurs think VCs should sign Non-Disclosure Agreements. Having been a VC as well, I get why VCs don’t do NDAs. And, well, the VCs are right. If they signed an NDA with every entrepreneur they took a business plan or pitch from, you can be sure they would spend most of their lives in court defending claims that they “borrowed” some entrepreneur’s idea and used it in another deal. (And that does – very rarely, I think – happen).

    Now, the VCs don’t do NDAs shtick would be a really big problem if it did not have such an easy solution: don’t tell a VC, until a term sheet is signed and final due diligence is in process (if then), anything that is really proprietary. If that seems impractical, consider this: You can sample my secret sauce without me sharing the recipe. For example, I can show you data demonstrating how my device detects metal fatigue, and likely even tell you some of the concepts about how it works, without telling you anything that would allow you to recreate my device.

    Seriously, there is no reason to share real, valuable proprietary information in your business plan or pitch to VCs. You can have a “black box” at the heart of your value proposition if you have sufficient indications of credibility (team, data, etc.) surrounding it. How strong those indicators need to be depends on how extravagant your claims are for your black box. If you have a device for sampling someone’s breath and diagnosing an infection, put a credible scientist beside it with some relevant literature and some early data and you’ve told me more than enough to get my due diligence going. If your telling me that your black box violates the second law of thermodynamics (I’ve seen plans like that a couple of times), you’ll likely have to show me a lot more: perhaps, say, that Stephen Hawking is your CSO.

  6. The 20-50% and 10x Rules. Valuation is what most entrepreneurs focus on in negotiations with VCs (often to the detriment of equally important issues like control and exit provisions). Entrepreneurs, of course, want higher valuations (thus less dilution), and can be very creative coming up with fancy spreadsheet forecasts and financial analysis.

    I must say I have seen some very slick spreadsheets supporting valuations for startups. Most of them, though, confuse precision with accuracy, and fail to deal with two fundamental realities of how VCs look at valuation. And in the process, provide a plethora of trivial details for folks to pick apart.

    The first valuation reality, and probably the best known, is that a Series A investor’s approach to valuation is very practical and simple: show me a model, from my investment to the exit, that I can believe in and that gets me at least $10 back for every $1 I invest. What they want to see is a list of likely buyers; the metrics for the likely sale; and some sense of how much additional dilution they will suffer to get there.

    That is a “big picture” kind of analysis that just doesn’t require a very detailed spreadsheet. It’s an analysis that places a lot more importance on the accuracy of assumptions than their precision, and limits the number of cells in the sheet to debate about. So why not save the time and expense of the finely detailed and precise spreadsheet model that reaches a conclusion only loosely correlated with what the investor thinks is important?

    The more overlooked valuation rule is the 20/50 rule. Most VC investors want to see an A round where the investors acquire at least 20% of the company, but no more than 50%. VCs want some minimum stake that reflects their centrality to the business. Most of them think that minimum is 20%. That may be arbitrary and capricious, but it is what it is.

    On the other hand, most VCs don’t want to see the founders and their team give up more than 50% of the equity in the A round because they want the founders and the team to have sufficient incentives to maximize the valuation of the company well past the A round. Again, 50% may be just a number, but it is pretty commonly “the” number in terms of maximum dilution at the A round.

    The trick with the 20/50 rule is how it can impact valuation when the size of the VC Fund is mismatched with the size of the needed A round investment.

    Most venture funds have a rule that limits how much of their capital can be deployed in any one company. That number is commonly 10%. So a $30 million fund is usually thinking that it can invest up to $3 million in any one company. Further, most VCs, given $X to invest in one portfolio company, will want to make sure some minimum fraction of X – let’s say 1/3 for an example – is available for the round after they first get in the deal.

    Ok, so let’s assume our VC’s Fund is $30 million. They want to put $2 million into you’re a round, and they have another $1 million lined up from another investor that will follow them into the A round. So they have $3 million for the A round.

    If you apply the 20/50 rule, you’ll find that to get the minimum 20% ownership for the A round investors, the maximum pre-money valuation is $12 million. If you want a significantly higher pre-money than that, you are probably better off looking for another lead investor with a deeper pocket; perhaps the smaller fund will follow in the higher priced deal.

Now, as I noted at the outset, the various rules and such noted above are, like most rules not found in physics or mathematics books, subject to exceptions. Maybe your deal should be one of those exceptions. But even if your deal should be an exception, the chances it will be an exception will be maximized if you know the whats and whys of the rules before you start trying to convince a VC to break them.

To Be or Not to Be: The Entrepreneur as Hamlet

Watching promising new companies fail – and a good chunk of even the most promising startups ultimately do – is not a lot of fun. It can be instructive, though. While many startup deaths are beyond the control of the startup itself – e.g. the technology doesn’t pan out, or someone else gets there first – others are variously the result of entrepreneurial mistakes. And like the rest of us, good entrepreneurs can and often do learn and ultimately profit from their mistakes.

Today, my subject is one of the most painful of entrepreneurial mistakes to watch, a mistake that is too common and (to make matters worse) by its nature tends to play out like a train wreck in slow motion. It’s what I call Hamlet syndrome. The startup that fails not on account of poor execution, but rather on account of not executing at all.

What makes Hamlet syndrome so frustrating is that after it happens you are left with the sense that the afflicted entrepreneur never even gave himself a chance to succeed. In most startup failures, even those that can be laid squarely at the feet of the entrepreneurial team, a dispassionate observer can at least come away thinking that the entrepreneur went down swinging.

Observing Hamlet syndrome, on the other hand, is like watching a batter, in the big moment of the big game, spend a lot of time fiddling with his glove, looking for signs, stretching, and stepping in and out of the box – interspersed with staring blankly at three called strikes before walking back to the dugout.

Ok, a couple of real (but disguised) examples.

Our first victim is a brilliant scientist with a long track record of good ideas, many of which have been turned into successful products. More recently, she developed some really interesting imaging technology with a broad range of potential applications, across a variety of industries from metallurgy to medical imaging to 3D printing. (Entrepreneurs with target rich ideas are particularly susceptible to Hamlet syndrome.)

A threshold question for this entrepreneur, was obvious: what application in what industry should I go after first? Obvious though the question may have been, the answer was much less so. And so … the entrepreneur did a little research. And then did a little more research. And then did a lot of research. And then … well, let’s just say after several years of waiting on a decision, I just walked away. That was two plus years ago, and I haven’t seen anything in the news to suggest that the entrepreneur ever did pick an application or a market.

Startup two had developed a really fascinating set of algorithms for manipulating data that dramatically improved the accuracy of all kinds of forecasting models. Startup two’s entrepreneur had some of the target rich marketing challenges of startup one, but even more than that could not settle on a business model. Was the business about enabling customers to make better predictions, or about making better predictions? After two plus years of debating the point, and increasingly complex analysis of the pros and cons of each approach, I am beginning to doubt there will be an answer before the window for this entrepreneurial idea closes.

I am not unsympathetic to either of the entrepreneurs in these two examples. Given all of the known, and unknown, unknowns inherent in any worthwhile startup opportunity, the possibility of making a critical mistake is a near constant source of stress. And surely picking the wrong application or market or business model is as fraught with risk and implications as any.

But as big as decisions about applications and markets and business models are, in almost every case the only decision that is certain to be wrong about any of these things is not to make any decision at all about these things. It is axiomatic that you can’t miss a target you never shoot at – but perhaps more to the point, neither can you hit a target you never shoot at either. In the startup competition, if you wait until your aim is certain, someone is almost certainly going to claim the kill before you pull the trigger.

Don’t be another victim of Hamlet syndrome. Pick a target market; spec an MVB with a compelling value proposition; decide on a business model; and pull the trigger. You may be wrong, but if you haven’t taken too much time and money to figure that out, chances are you’ll likely get at least one more shot.

Back to the Future? Venture Investing in Flyover Country

The term “Venture Capital” covers a lot of ground, even when confined to the traditional institutional funds at the heart of the industry. Funds come in many flavors based on factors including stage of investment, industry focus, geography, and propensity to lead or follow in deals.

I’d like to suggest another basis for classifying venture investors, one that I think is absolutely critical when considering the unique opportunities – and challenges – of investing in places outside of the major established centers of venture capital investing. Places like where I grew up, and after twenty years in Silicon Valley and North Carolina, returned to some years back: Wisconsin.

My classification is based on two alternative paradigms for investing capital and managing investments: Nurturing and Managing.

The Manager Venture Investing Paradigm

The Manager paradigm dominates the venture business today (certainly in terms of capital deployed and public mindshare). It is characterized by large funds, many in the billions of dollars (see Softbank’s $100 Billion fund for the current outer limits of the industry) with multiple levels of investment professionals, many of which do not have early stage operating experience or even STEM educational credentials. The “value add” Manager investors provide is largely in terms of the later stages of expansion and exit planning and execution.

The Manager paradigm is ideally-suited to the contemporary Silicon Valley venture capital scene and in terms of number of deals and capital deployed the large majority of Manager paradigm investing occurs in Silicon Valley and a handful of other major venture capital hubs. Today’s large funds simply can’t efficiently make and manage smaller deals. Even those that operate affiliated “seed” funds typically make larger initial investments than their traditional seed fund peers, and limit those investments to deals that they perceive as having mega deal potential (and capital needs) going forward. As a result, the Manager paradigm funds are much less likely to invest in raw entrepreneurs who need a lot of hand-holding on basic operational blocking and tackling. Their deep pockets also make them more likely to focus on capital intensive growth/brand-driven exit metrics than profitability.

Now, the Manager paradigm may get all the headlines, and skew the statistics such that Silicon Valley round deal sizes and valuations or as much as an order of magnitude or even more than the comparable figures in flyover country markets, but it is not the only venture investing paradigm. In fact, it was preceded by a very different and still important, if no longer as publicly prominent, paradigm.

The Nurture Venture Investing Paradigm

The modern venture capital era began in the late 1940s and hit its stride in the 1970s.  Throughout that period, and into the 1980s, even the largest venture capital funds seldom exceeded $100 million and most were only a fraction of that. The prototypical Nurture VC was someone with industry operating experience as well as a STEM education. Further, these smaller funds had minimal junior staff compared to the layers of analysts, directors, junior partners, etc. that make up the bulk of the investment professionals at today’s larger venture funds.

The early decades of the venture business were characterized by something else, besides smaller funds: less experienced entrepreneurial teams. With the industry’s small size, and even with fairly rapid growth in the 1970s, it took awhile for the “serial” entrepreneur to emerge as a regular part of the deal flow. It was probably not until well into the 1990s that most venture-backed Silicon Valley startups included founders and senior managers well-versed in the art of building a high impact company from experience at prior venture backed emerging companies.

When you put all of these factors into a pot and stirred them up, you came up with the Nurture venture investing paradigm. An investment model based on VCs focusing on startups where they could add a lot of value to the deal in terms of the basic nuts and bolts of defining and building the business. Indeed it was a time where the venture investor was often involved – as for example Brook Byers and Genentech – in the actual conception of the business, recruitment of the founding team and formulation of the business plan. Sometimes well before it was even clear there would be any resulting investable deal.

The industry’s structure during the ascendancy of the Nurture paradigm had other implications, among the most prominent of which was the emphasis on profitability as an exit metric. This was not because Nurture investors were any smarter than today’s Manager investors, who by comparison are far less concerned with early profitability. Profitability was part of the Nurture paradigm simply because the typical Nurture fund – even when factoring in syndication of investments – simply did not have sufficient capital to support a portfolio company burning tens or hundreds of millions (or as per Uber recently billions) of dollars of capital a quarter.

The Nurture paradigm led to venture capital’s first golden age in the 1980s. It also sowed the seeds of the Manager paradigm which arrived on the scene in the later half of that decade. The Manager paradigm was launched, ironically enough, when some of the great Nurture firms started raising the first wave of mega funds with hundreds of millions of dollars and, before long, even billions of dollars to deploy.

Implications for Flyover Country Venture Investing

If there is still a meaningful role for Nurture funds in Silicon Valley, there is very little room – today – for Manager-modeled funds outside of Silicon Valley and a handful of other of the larger venture investing centers. And that is something that too many folks in flyover country just don’t understand. And something that is making it even more challenging than it needs to be to foster the emergence of a meaningful high impact entrepreneurship and investing sector in still nascent and emerging flyover markets.

I saw the problem in North Carolina circa 1990, and I see the problem in Wisconsin, today. Regional folks who want to foster a vibrant high impact entrepreneurship and investing community look to Silicon Valley and, seeing how the Manager venture investing model dominates the headlines, conclude that we should be doing the same thing here. That we should invest as if our entrepreneurs had the same kind of “been there, done that” startup experience and networks that their Silicon Valley counterparts enjoy.

Well, they don’t. The opportunities and challenges of venture investing in Wisconsin in 2017 are indeed comparable to the opportunities and challenges of venture investing in Silicon Valley. But Silicon Valley circa 1975, not 2017.

What places like Wisconsin need, in terms of venture investors, is Nurture VCs, not Manager VCs. We need small funds, run by hands-on partners who bring their own “been there, done that” high impact startup operating and investing experience to the game. People who are willing to get down in the trenches with entrepreneurs to help shape raw talent and ideas into fundable deals; and who are willing and able to start doing that even before making an investment. Venture investors who can proactively help their portfolio entrepreneurs achieve profitable operations supporting attractive exit opportunities with lifetime risk capital needs that don’t exceed even the average A round in today’s Silicon Valley.

Unfortunately, instead of Nurture funds led by experienced startup entrepreneurs and hands-on investing professionals helping raw entrepreneurs with good ideas build modest companies that offer solid investment returns with limited capital, what I’ve seen here in Wisconsin is mostly investors with little or no venture backed startup operational or seed/early stage risk capital investing experience casting about for the kind of startup teams and capital-ready deals that fit the Manager venture investing paradigm.  Teams and deals that we just don’t yet have enough of in Wisconsin to support a sustainable high impact venture-driven startup community.

Don’t get me wrong. I think – know – that Wisconsin and places like it have the raw entrepreneurial talent and capital to become small but important and sustainable centers of high impact entrepreneurship and investing. But getting there is not going to happen unless and until the folks who want that to happen understand that right now we need Nurture venture investors, the kind that built Silicon Valley, not Manager venture investors in the mold of those who get the headlines in Silicon Valley today.

Consumer Product or Medical Device? (Or Maybe Toy?)

By Paul A. Jones and Joel E. Henry, Ph.D. (Managing Partner, Michael Best’s Missoula Office)

So when is a consumer product – say a little matchbook-sized box you wear on your wrist that keeps track of your pulse over the course of the day –a medical device?

“What difference does it make?” you might ask. Well, if you are developing that little box for market, quite possibly tens of millions of dollars of added development and testing expenses, a couple of years more development and testing time, and millions of dollars of legal fees, regulatory expenses, insurance premiums, and misc. other costs both before market introduction and after. Not to mention likely a different distribution model, a higher price point, and lower volumes.

Alas, having perused FDA Guidance on distinguishing consumer products from medical devices (including some recent draft Guidance), and talking about the matter with some of my colleagues who spend substantial time practicing in the medical device regulation space, my take is that there is a lot of gray area around this question. Which is to say, there are a lot of current and soon-to-appear products out there for which good arguments could be made that they are consumer products – and good arguments could be made that they are medical devices. And that in some cases, the answer might even hinge on whether the manufacturer labels the product a toy. And that’s a problem.

While it takes pages and pages of regulation and guidance to get there, basically the distinction between a consumer product and a medical device – according to the FDA, which is to say the people that matter here – is pretty simple: the application of the distinction, less so.

First, the distinction. If the purpose of a product is to process inputs which are collected by the product from a person (a substance, for example sweat or blood, or data, for example a pulse) and use that to diagnose or suggest treatment for a medical condition, you have a medical device. Thus, for example, a personal ECG consumers can purchase without a prescription for the purpose of determining if they should see a doctor about an arrhythmia is a medical device, and is regulated as such. And that is true regardless of the intended use (well, I think so: more later).

Now, on the above logic, you would think that a product you wear on your wrist that keeps track of your pulse would be a medical device. I mean, the only real reason to have such a device – beyond a gee whiz sort of curiosity – is to monitor your physical activity for purposes of improving (or at least monitoring) your health. Clearly a medical device, right?

Well, no. The FDA has said, in its guidance on medical devices, that it will not deem a product a medical device if it’s only intended use is to encourage or maintain a general state of health or healthy activity, and the use of the product does not entail any significant risk to the user or third parties. Thus, your smartphone app for keeping track of your pulse isn’t in fact a medical device according to the FDA. This class of products would include (among many others) things that monitor calories burned or suggest healthy menus to control weight.

On the other hand, if your exercise monitor claims it can help you manage your Type II Diabetes, you’ve got something that is a medical device and that the FDA will consider to be a medical device. (You can see, I think, how this could get confusing.)

It gets more confusing. Our exercise monitor that is marketed as a tool for helping manage Type II Diabetes is in fact a medical device according to the FDA, and thus subject to regulation as such by the FDA. But the FDA, as a matter of policy, has indicated that it will not enforce those regulations with respect to such a medical device. That’s not a regulation but a policy. Which means it can be changed pretty much any time for pretty much any reason, without going through any rule making process or seeking industry or consumer input.

The thinking, here, is not to enforce the medical device regulations in the case of medical devices that present a low risk and are aimed at helping the consumer better manage a particular medical condition where the use of the device conforms to a generally accepted medical consensus. In this case, getting more exercise is a generally accepted mechanism for managing Type II diabetes. Another example of this kind of medical device would be a device that “coaches breathing techniques and relaxation skills, which, as part of a healthy lifestyle, may help living well with migraine headaches.” But, then again, FDA guidance says that it would regulate a medical device that listened to someone’s breathing to diagnose bronchitis (and yes, there is technology that does just that).

You can see, I think, how all of this can get pretty confusing. And we have not even talked about what “low risk” means (basically, if a product is invasive – that is it involves puncturing the skin or otherwise inserting something in the body as opposed to on it, or if it involves applying something (a laser, for example) to the body that could harm the user or a third party if not used correctly, you have a product that is not low risk).

If you think you can figure all this out on your own, here is a final twist; admittedly a pretty strange twist, but I think a valid one for purposes of illustrating how much uncertainty there is as the FDA struggles to adapt to a rapidly changing technological environment.

If you’ve ever had kids, you know that you can buy toy stethoscopes. These products, at least some of which are as functional as low end “real” stethoscopes, are not regulated as medical devices. They are marketed and intended to be used as toys, and include labels that they are not to be used for medical purposes.

On the other hand, traditional stethoscopes intended for medical use are medical devices (albeit regulated with a light touch). And “smart” stethoscopes – devices that enhance, manipulate, or interpret information generated by the stethoscope – are in fact regulated as medical devices (which, given the initial example of the personal ECG product, isn’t surprising).

So, what about a “toy” smart stethoscope? Before you say that labeling it a toy doesn’t work because it is clearly capable of performing a medical function, remember that so can a dumb toy stethoscope.

The answer? I am not sure. But there is, in fact, a “business card toy ECG” on the market. At least there is as this blog goes to press. You figure it out. And if you are smart, talk to your lawyer about your thinking before you run too far with it.

gener8tor: The Gift That Keeps on Giving

It’s been a few years now since I wrote my first appreciation for the folks at gener8tor.  Back then, they had just launched, and yours truly was surprised (albeit very pleasantly) that they had gotten not just off the ground but had achieved some sort of seemingly stable orbit.  Which surprised a bunch of people, I think.  I know it surprised me.

Well, here we are in November 2017 and they have flown well beyond Madison and Milwaukee to places as far afield as Minnesota, Illinois and even my own neck of the woods up here in Packerland.  Recently, it was my good fortune that a scheduled speaker for a OpenBETA Lunch program in Oshkosh had a last minute scheduling conflict.  My good fortune in that I was offered an opportunity to substitute as the headliner for the event.

The Oshkosh event was a lot like my first time at gener8tor way back when in Milwaukee.  Quirky space, a roomful (well, ok, maybe a half-dozen plus) of raw but passionate and very early-in-the-process entrepreneurs.  Who asked good questions, and shared some good ideas.

What was most interesting about the event, for me, was in fact how it took me back to those early gener8tor classes, where the entrepreneurs were rawer than raw, and the ideas sketchier than sketchy.  And, in fact, what amazed me about gener8tor then – and caused me to write my initial blog about the program and team – was how over the couple of months after I saw that cohort of newbies the gener8tor folks had somehow worked some magic to turn them into that rarest of commodities hereabouts, fundable high impact entrepreneurs.  (And, yes, they all got funded.)

Since those times, gener8tor’s flagship program has expanded to new places and moved a bit downstream in terms of appealing to less raw, even semi-polished entrepreneurs (often hailing from well beyond Wisconsin).  And I’ll admit, I had (and to a limited extent still have) some doubts about whether they can sustain their success across multiple markets and with later stage entrepreneurs.  But the results continue to speak for themselves, and if we – that is those of us who are serious about growing the high impact entrepreneurship and investing community in our little corner of flyover country – are lucky gener8tor has a lot of fuel left in the tank.

All of that said, what really made my day at the OpenBETA event was seeing gener8tor staying true to its “rawest of the raw” roots, and doing it in the New North.  In Oshkosh even.  (They also have a new gBeta program in Green Bay.)   That means, I think, that it won’t be long until entrepreneurs and investors in Madison and Milwaukee start  realizing there are deals to be done in Wisconsin in places other than Madison (mostly) and Milwaukee.

And so congratulations to all of us in the high impact entrepreneurship and investing community across Wisconsin.  We are the lucky benefactors of the gener8tor program – the gift that keeps on giving.