April 20, 2010

Strategic Investments in Medtech: Three Deal Terms Companies Should Consider

Strategic investments are very common in the medtech industry. For a variety of reasons, numerous strategic investors, typically large companies with pools of venture investment cash, are focused on emerging medtech companies.

Unlike traditional venture investors that are primarily looking for a significant economic return, strategic investors are focused on the product development advantages emerging medtech companies can offer. In addition, strategic investors often make a small investment in a risky company, finding this preferable to developing the necessary technology in-house.

While such arrangements can be advantageous for both parties, current market and industry pressures give strategic investors an advantage in negotiating deal terms. It is therefore essential that medtech companies understand the implications of strategic investments in their company. The following article provides an overview of what strategic investors may ask for—and what medtech companies should consider before agreeing to any provisions.

Strategic Investor Resources Assist Product Development

Generally, companies developing medical technology are not expected to be cash-flow positive for years. Despite this, strategic investors see a variety of reasons to invest in medtech companies that are developing new technologies. These may include:

  • Filling a hole in the strategic investor's business
  • Assisting companies in developing next-generation technologies for the strategic investor's existing technology
  • Providing a platform for growth in the strategic investor's business by investing in adjacent technologies
  • Exploring high-growth business development opportunities

Strategic investors, in turn, bring resources—such as expertise in FDA approval, reimbursement, business planning, and market analysis—that can assist an emerging company seeking to develop a product.

Companies Should Be Aware of Investor-Related Risk

While strategic investors bring many benefits through their resources and expertise, such arrangements can also decrease a company's value. A relationship with a strategic investor, for example, could chill a deal with strategic buyers who are not interested in letting a competitor know of their interest in a technology or who are not willing to serve as a stalking horse for a competitor. A strategic investor might also require onerous deal terms that could hinder a sale or investment process.

Deal Terms Companies Should Consider

Once a company decides to bring on a strategic investor, however, they must think critically about the rights they grant to the strategic investor. There are three main areas of rights that often pop up with strategic investments: (1) expanded information rights; (2) a right of first negotiation (also called a right of first offer); and (3) a right of first refusal.

Expanded Information Rights

As an investor, the strategic investor will likely already have certain rights to financial information, as well as inspection rights and other rights as provided in the investors' rights agreement or other agreement.

However, strategic investors often ask for expanded information rights not available to basic investors. These often include a board seat or board observer rights permitting a representative to observe all board and committee meetings in a nonvoting capacity and to receive the same materials as board members.

In granting these rights, companies will likely want some input into who is chosen to observe and when the observer can be excluded from a meeting. They may decide, therefore, to require that the observer to be approved by them. In addition, companies should consider retaining the right to exclude the observer in situations where there could be attorney–client privilege issues, conflict of interest, discussion of another strategic investor or buyer, or an executive session.

Right of First Negotiation

A right of first negotiation requires a company to negotiate in good faith with a strategic investor before entering into a specific type of transaction. As long as both sides negotiate in good faith there will never be an obligation to enter into a transaction. Timing and scope are the two biggest issues for companies to consider before granting this right to a strategic investor.

Scope determines what types of transactions trigger the obligation to negotiate with the strategic investor. Companies may attempt to narrowly define the scope in order to avoid an obligation to negotiate in every transaction. The strategic investor's motives for investing will likely drive the scope they request. For example, if a strategic investor invests in a company because of a new technology it has been unable to develop in-house, it will likely request a right of first offer that prevents the company from licensing that technology to a different company.

As to timing, the right of first negotiation lasts for a specified period of time, beyond which no obligation to negotiate exists. Strategic investors may request the right of negotiation last for a lengthy period, but companies may try to limit the time period. Within the specified period of time, a potential transaction within the scope of the right triggers a period for negotiations between the parties. This negotiation time is typically limited to one to three months. After this period of good faith negotiations, the company is able to enter the contemplated transaction with a third party.

Right of First Refusal

A right of first refusal gives the strategic investor the option to enter into a specified business transaction with the company before the company can enter into the same transaction with a third party. In many ways it is a stronger version of the right of first negotiation. This is because a right of first refusal obligates the company to give the strategic investor the option to enter into a certain transaction before the company can enter into the same transaction with a third party. In contrast, as long as both parties negotiate in good faith there is never an obligation to deal under a right of first negotiation.

As is the case with the first negotiation provision, companies should focus on the scope and timing of a right of first refusal. Even more so than other rights granted to strategic investors, a right of refusal can chill deals with third parties. Because a third party knows the company must first offer a proposed deal to a strategic investor, that third party will be less likely to approach the company in the first place. Also, the time to complete a deal can be substantial when complying with these rights, which can decrease a company's value as markets change or a company runs low on cash.

A variant of this right requires a company to make an offer to a strategic investor first—and the company is not permitted to offer any other party better terms without first submitting the improved terms to the strategic investor. This has the same chilling effects as a more traditional right of first refusal; however, it can also lead to an even more extended timeline for closing a transaction.

Understanding Potential Tradeoffs Is Key to Successful Deal

While there are many potential benefits in working with strategic investors, medtech companies should carefully consider the rights they grant in return for the resources and expertise they receive. To ensure they understand the full array of potential tradeoffs associated with such investments, companies may wish to enlist the help of counsel.

Considering the implications of expanded information rights, rights of first negotiation, and rights of first refusal—and limiting these rights where they could be detrimental to the company—will help ensure a satisfactory arrangement that supports the shared goal of developing new technology.

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