Beware the Perils of Oversized Series A Rounds in Digital Health

Editor’s Note: The author of this article, Skip Fleshman, is an investor at Asset Management Ventures and serves as an advisor to Stanford’s StartX, Rock Health, and Boston Children’s Hospital. Fleshman focuses on investments in digital health, mobile networks, and big data. His current portfolio includes HealthTap, Reify Health, Evidation Health, 1DocWay, Lark, Arterys, and Welkin Health. Recently, he authored an article expressing concerns about the current fundraising landscape for digital health companies.

Skip Fleshman

Recently, I have observed significant activity in Series A financing within the internet healthcare sector. Clover secured $100 million in equity and debt financing, Color Genomics raised $15 million, Cure Forward also raised $15 million, Honor secured $20 million, and Lyra Health raised as much as $35 million.

Some might argue that a $100 million Series A financing round is hardly substantial for a data-driven insurer like Clover; on the other hand, I believe it is rather risky to entrust $35 million to a brand-new company like Lyra, which focuses on behavioral health solutions.

The surge in mega-financing rounds exceeding $1 billion has led many venture capitalists to seemingly question the value of small Series A investments. However, I disagree; this skepticism is justified for both venture capital firms and startups. An excess of capital creates distorted incentives, which is detrimental to a company’s long-term development.

After a large Series A financing round concludes, entrepreneurs often struggle to resist the strong temptation to spend the substantial influx of capital lavishly and rapidly, leading to inefficiency and waste. This spending pressure may stem from internal sources or from investors, who expect the funds to be utilized to generate returns on their investment.

Based on my experience, most companies do not need to spend a lot of money in the early stages of entrepreneurship, because their core technical products are often developed by a small but highly intelligent team; they can iterate products quickly and with extremely high efficiency. Startups that attempt to shorten this process choose to skip market research, proceed directly to pilot customer testing, and carefully evaluate product-market fit.

For cash-rich companies, another common mistake is scaling up production capacity before establishing a repeatable and scalable sales process along with viable sales channels. Although sales personnel are often compensated based on performance, maintaining a large sales force remains highly costly.In the early stages of a startup, spending money on non-productive sales personnel is nothing short of a waste.

Whether aiming to expand their sales teams, add business development talent, or recruit developers, startups eager to hire often fail to find the right candidates.; they believe that rather than waiting indefinitely for the perfect candidate, it is better to simply hire someone who can start immediately. New employees hired hastily often fail to integrate into the team, even slowing down overall efficiency, and are frequently dismissed due to incompetence. This process results in significant direct and indirect waste of time and money.

Large Series A financing rounds are typically associated with high valuations, which can lead to other issues. First, this drives up the exercise price of early-stage stock options. One of the benefits for early employees of startups is that they can purchase options at a few cents rather than several dollars per share. When the Series A valuation is exceptionally high, this advantage disappears. High valuations also raise expectations for exit values, causing investors to forgo early-stage, small-scale mergers and acquisitions. At higher valuations, investors still expect to achieve outsized returns.

How Can This Issue Be Better Addressed? Historically, the venture capital community has relied on a “milestone-based” investment approach, whereby funded companies secure sufficient capital (plus reserves) to achieve specific, value-creating milestones. These smaller-scale financing rounds set different expectations for companies, enabling them to progressively attain a series of manageable milestones in an efficient manner, while continuously increasing their valuation with each subsequent round of financing, thereby repeating this cycle to drive growth. This creates an achievable incentive mechanism that keeps teams focused on concrete objectives, while also fostering an appropriate sense of urgency to compel them to deliver substantial value.

Nevertheless, large-scale financing offers distinct advantages. The additional capital should extend the company’s runway and free up the CEO’s time previously devoted to fundraising, allowing them to focus on building the business. If the company is already generating sales, robust cash flow will also be highly beneficial. This is advantageous for all enterprises, particularly in the healthcare sector.

Nevertheless,Historical experience tells us that large-scale Series A financing rounds can lead to disastrous consequences.Such examples are numerous in the technology industry. Some former fundraising hotspots, such as Quirky (crowdsourced invention) and Clinkle (next-generation payments), have caused significant losses for investors. Among all the failures, Color Labs is perhaps the most notorious. In its 2011 seed round, the company raised $41 million from some of Silicon Valley’s top venture capitalists and became a media darling. It rose rapidly, aggressively recruiting talent, only to collapse just as quickly. In 2012, Color Labs sold its assets to Apple Inc. for $7 million.

Let us not repeat the same mistakes in the field of internet healthcare. It is hoped that emerging companies, such as Color Genomics, which have reaped substantial rewards in their Series A financing rounds, will not suffer the same lamentable fate as their peer, Color Labs.

Compiled by Chen Xin
Editor: Mo Renying