by Willem Broekaert
The classical funding journey is familiar enough. Seed funds and early-stage venture capital kickstart the company. Then, as it matures and its capital needs grow, later-stage investors join across successive financing rounds.
For startup companies developing drugs, an exit typically occurs long before the product is ready for commercial launch, with the acquirer taking charge of the final leap towards commercialization. Financial planning in these companies is focused almost entirely on controllable parameters, both for cash-outflow and inflow, where equity remains the principal fuel.
For startup companies in medtech, diagnostics, digital tools, or ag & food, the situation is fundamentally different. In these sectors, the business plan assumes a cross-over into commercialization from a certain stage in the company’ development cycle. Therefore, the financial plan of the last pre-profitability financing round must account for cash inflows from product sales, in addition to newly raised equity. This is the period where the risk profile of the company changes dramatically — a challenging shift that is regularly underestimated by management teams and investors alike.
Management teams making this transition to commercialization face a genuine dilemma. Revenue projections need to be bold enough to attract new investors into the company, yet conservative enough to leave room for delays, teething problems, and go-to-market misjudgments. At the time of fundraising, the line between ambitious and over-optimistic is easily overstepped, and the consequences of missing projected revenues are rarely thought through carefully enough.
One reason for this oversight is that management teams naturally remain conditioned by their experience and strategies of the R&D years. In early-stage companies, development milestones are regularly delayed without harsh consequences. Investors may be disappointed, but if the underlying technology remains promising and the technical hurdles are eventually overcome, they often waive the milestone and continue supporting the company. Revenue-based milestones are an entirely different kind of beast.
Missing a revenue-based milestone delivers a blow that lands twice.
First, lower-than-expected revenues means that the company will need more financing than initially anticipated, and unfortunately, the company’s financial requirements increase precisely when management had hoped that dependence on external capital would start declining. Second, the missed milestone provides tangible evidence that the company’s valuation in past financing rounds was too generous and will likely need downward adjustment going forwards.
Management teams need to be aware that as soon as revenues enter an investor’s set of expectations, valuation gets measured with a very specific, different set of criteria: multiples on revenues, earnings, or equivalent financial markers. The comfortable ambiguity of the R&D phase, where value rests on scientific promise and narrative, simply disappears when objective financials come into sight.
Failing to deliver on financial milestones can lead a company into a danger zone where events can quickly spiral out of control. If management is able to maintain investor confidence, and its shareholder base is willing and able to provide bridge financing, then the company may get back on its feet and move on. Otherwise, management may find themselves on a tightrope: the cash-out date looming large, and the company urgently needing extra money while the negotiation position is very weak.
At that point, management can pull one of two unattractive levers — or both simultaneously. The company can cut costs dramatically, which often means abruptly downsizing much of the team it has built. Or it can try raising money from investors at whatever terms available, thus facing the prospect of a significantly reduced share price.
Neither path is painless. Management, employees, and existing investors are all hit hard, with job losses, share dilution, and worthless stock options that simply have to be stomached if the company is to survive. So what can management teams and investors do to avoid such a brutal scenario?
There is no magic remedy to avoid this cash trap, but there is one general protective element: foresight. The transition from an R&D-based to a commercial-stage company is an organizational change as much as a financial shift, and it needs to be planned years (rather than months) in advance.
Existing investors should reflect — in plenty of time — on whether the leadership team has the right skills and motivation to execute this transition. Particularly bearing in mind that changing management in the middle of a difficult fundraising period is highly prone to miscasting or failure. Where there are doubts about the ability of the company to reach break-even with the proceeds of the current round, it may be in the investor’s interest to provide a convertible loan rather than equity, offering better protection from dilution in the event of a future down round.
Management, for its part, should proactively reflect on ways to adapt its cost base — considering that the sooner it is initiated, the larger the effect it will have. R&D expenses may have to be downsized to compensate for rising pre-commercialization costs.
Above all, management should actively build funding optionality. Equity may remain the main source of capital, but it should not become the only conceivable lifeline for the company. Partnering revenue, licensing income, grants, or proceeds from the sale of a non-core part of the business rarely close a funding gap on their own. But together, they can help to strengthen the negotiation position of the company substantially.
Building a transformative tech company doesn’t just require flawless execution, quick progression, and seizing opportunities when the financial tailwinds are favorable. Equally important to success is the ability to anticipate and weather the storms that will undoubtedly appear along the journey.
The companies that make the crossing from the R&D to revenue stage intact are those that treated their first sales forecast with the same rigor as their technical development trajectory — and that built their shelter well before the weather turned bad.
