INVENTION TO STARTUP SOURCES OF FUNDING

INVENTION TO STARTUPSOURCES OF FUNDING Trevor Moody – Frazier Healthcare Ventures Jens U. Quistgaard – LipoSonix, Inc.

Overview • Observations on the current financial climate • Sources of funding • Exercise – potential sources and their attributes • Quick case study: SonoSite, Inc. • Quick case study: LipoSonix, Inc. • Venture funding in depth • What is a venture capitalist? • Venture capital funding criteria • What has changed recently?

World Market Conditions • “Fear” is high • Global credit crunch/recession • Uncertainty about size and extent of problem • Companies most affected have: • Operational leverage to GDP or • Balance sheet debt VSX Volatility Index Sept 2000- Sept 2008 Data courtesy of SV Life Sciences LLP

Effect on Private Companies • Relatively limited impact on healthcare companies • Reduced access to public markets for exit or financing • Reduced availability of credit and increased financing costs • Potentially longer time period to exit and lower exit valuations

Performance of Healthcare Indices • Health sector is driven by non-discretionary spending and therefore traditionally a safe haven at times of economic turmoil • U.S. healthcare indices have all outperformed the S&P500 over the last 12 months • S&P 500 down 30% • Medical device (DJUSMC) down 11% and biotech (NBI) down 10% • Healthcare services (IHI) down 17% due to HMOs’ reduced rates of growth, credit contraction and fears about reimbursement

Performance of Healthcare Indices 12 month performance of US Healthcare indices to 5 October 2008 Data courtesy of SV Life Sciences LLP

Healthcare Fundamentals Strong • Recession resistant characteristics: • Rapidly ageing population • ~10% of world population is over 65 • Rising incidence of chronic disease • Rising healthcare costs • US healthcare spending $2.3 trillion in 2007, $7000 per person • Healthcare spending outpaces overall economic growth and inflation • Regulation creates high barriers to entry • Globalization and new markets • Innovation creates new markets Forecast rise in chronic disease 2003-2023 Predicted population growth 19% Data courtesy of SV Life Sciences LLP

Healthcare Investing (USA) Equity into US VC-backed healthcare companies Pro-forma Data courtesy of SV Life Sciences LLP

So… • Financial markets are a mess • Healthcare is a great place to be in these times • Funding is still available, but… • Bar is raised for new investments • Valuations are down • Each type of funding is affected differently

Sources of Funding • What are they? • Self • Friends & Family • Debt • Grants, contracts – NIH, SBA, DARPA, etc. • Angels • Venture funds • Crossover funds • Strategic (other companies) • Public markets

Quick Case – SonoSite, Inc. • ATL Ultrasound – parent • Digital ultrasound pioneer • Core competence in ASIC implementation • The hand-carried ultrasound vision • The internal funding reality • DARPA dual-use program • ATL Ultrasound • University of Washington • VLSI Technology • Harris Semiconductor

SonoSite – Getting Off the Ground • Basic development 1996-1997 • $12.6MM DARPA matching grant • Handheld Systems Business Group 1997 • Spin-out as SonoSite, Inc. - April 1998 • $17MM cash (+$13MM later) • Technology license • NASDAQ listed – distributed to ATL shareholders • First working prototype – September 1998 • First follow-on financing – April 1999 ($33.8MM)

SonoSite – Lessons Learned • Government grants are a wonderful thing • But… • You need an impressive consortium to get large $ • There are some complications • Government technology rights • Consortium member’s technology rights • Reporting requirements • Etc… • Being a pre-revenue public company, in my humble opinion, is not a wonderful thing

Quick Case – LipoSonix, Inc. • Originally pitched to investors by two individuals • Not successful • Picked up by a medical technology “incubator” • LipoSonix, Inc. founded in late 1999 • Initial venture funding, January 2001 (1.4MM) • IP licensing • Exploratory work • Series-B, tranche #1, November 2001 ($4MM) • More exploratory work

LipoSonix – The Bothell Story • First full-time employee and dedicated facility, August – October 2002 • Series-B, tranche #2, September 2002 ($5.9MM) • First human study, July 2003 • The joy of venture debt • Series-C, July 2004 ($27.0MM) • More debt… • Initial customer shipment • More debt… • Acquired by Medicis Pharmaceutical Corp., July 2008

LipoSonix – Lessons Learned • Top-drawer investors really help! • Be aware of capital structure issues associated with incubators • Be aware of capital structure and terms issues associated with venture financing • Multiples requirements • Liquidation preferences (!) • Etc… • Venture debt is a wonderful thing • If you can get it, and use it appropriately

Different money sources are likely to be involved as the company grows

100% 60% 45% 25% 15% 10% 5% Funding needs increase significantly as the start-up moves towards commercialization Typical Funding Requirements Through a Company Lifecycle Confidential

Sources of Funding – Venture Capital • What is a Venture Capitalist? • What criteria do VCs use to decide what to invest in? • What has changed recently?

What is a Venture Capitalist? Follow the Money Investments in US Healthcare Portfolio Companies The General Partner And the Fund Sources of Capital • Retirement funds • University endowments • Families / high net worth individuals • General partners Update!

What is a Venture Capitalist? • Typically small partnerships made up of a few General Partners (2-10) and other staff • General partners collect a percentage of the profits • Payouts over several years • Lucrative but high risk • Manage one or more funds raised sequentially over several years • Fund sizes range from <$5MM to >$2B • Some firms have been around for >50 years but vast majority have emerged in the last 15 years

Medical Device VCs are looking for the most exciting new technologies A typical large healthcare VC may see 1000-2000 plans per year and invest in only 10 • Opportunities of great interest to medical device companies • Innovations that will be rapidly adopted by physicians • Incremental improvements • “Products, not companies”

The Medical Device Investor’s checklist • Management / Founder Teams • Big Markets / Rapid Adoption • Regulatory/Reimbursement pathway • Early Clinical Proof-of-Principle • Patents

Management/Founder teams • Most startups won’t have a CEO who has taken 3 companies public • Experience in other successful ventures • Have recruited top-tier mentors, board members and advisors • Open to adding other great executives to the team • Deep understanding of the target market and technology • Just want money, don’t want a partner • Unrealistic expectations of how hard it will be • Looking for a quick win

Big markets/Rapid adoption • A very large existing or potential market is critical for generating investor interest • Physician specialty has demonstrated that they will rapidly adopt new technologies • $1B + potential market • Targeting procedurally oriented specialties e.g. cardiologists, orthopedic surgeons, etc • Challenging physician referral patterns • Requirement for large upfront capital outlays

Regulatory/Reimbursement • FDA and CMS challenges are often underestimated by founders • Clear FDA approval requirements • Compelling economic argument to key decision makers e.g. physicians, hospitals • Physician community excited enough about technology to lobby for reimbursement • Trials requiring long follow-up • Great macro-economic argument but no-one incented to adopt

Early Clinical Proof-of-Principle • A rapid path to clinical proof-of-principle greatly increases the fundability of a company • Rapid, ethical path to early clinical feasibility testing • Early clinical data that is highly suggestive of likely success of the pivotal trial • Need to run large, lengthy clinical trial to see if it works • Mediocre efficacy results

Patents • Strong patent protection is essential in a technology-driven venture • Very strong protection around key innovation • Building a “patent thicket” to cover other related inventions • Broad early patents (an added bonus) • Sloppy patent strategy / disclosures that have limited patentability • Freedom to operate concerns

What is the impact of the economic crisis on venture capital? • Limited impact in the short term – in 95% of cases, funds will continue • Quality VCs raise money from quality, long-term Limited Partners (LPs) • VCs have not typically used debt … fortunately • Potentially dramatic impact in the long term • Exits – Definitely delayed significantly • LP appetite for VC investments will decline over time • VC investment criteria will be more conservative • Early-stage VCs will still invest in early-stage companies but hurdles will increase • More sensitive on capital needs, time to market etc.

Wrap-Up • Healthcare - Perhaps no better place to be driving innovation • Buyers less affected by acute economic turmoil • Insatiable demand • Demographics • Lot’s of money still out there … the bar is much higher but great opportunities and great teams will get funded • Take a strategic approach to fund raising. Target the best sources of money given your opportunity and stage of development • Expect to spend a lot of time raising money

INVENTION TO STARTUP SOURCES OF FUNDING