Industry: A couple of large firms with high profits and stable returns on capital and cash flows dominate

the health care sector. Although the average margins are relatively high in this industry, strong barriers make the entrance of new companies particularly difficult. Good examples of such barriers are the huge amounts of time and funds necessary for the drug development (see appendix). As was mentioned in the case, cardio surgeons form a category that adopts new technologies really fast because of low shifting costs, and due to this product lifecycle tend to be really short which forces firms to spent a lot of time and money in R&D to keep the pace of development. Companys overview: Conor Medsystems specializes in developing a non-surface-coated stent with vascular drug delivery capabilities. Its stent platform allows for the programmed and controlled delivery of multiple drugs with different elution profiles1. The main competitive advantage of the product is that there are many small tanks built into the stent, which gives you the possibility to pack them with different drugs instead of one drug mix as in competitors. In addition company decided to use cobalt chromium alloy for production of stent, which makes them thinner and at the same time stronger. Because of this there are no expected rivals for Connor in this business for another 2-3 years. The most important question that management need to answer now is what amount of funds they need to finance future activities and in what way they should raise that money. One possibility is to get $10 million (12 month of funding at current burn rate) so they could finish trials in Europe and use those results as a signal to be able to raise cheaper financing for US trials. Although, despite the fact that trials and product launch in Europe are faster and cheaper than in USA, the stents prices there are also around two times lower than in American market because of the government-funded health care that European countries provide and hence the company faces a risk of having a funds shortage which could force it to raising money once again. Thats why the second investment alternative ($30 million, gives the company funds for 2 years at high burn rate) looks much more attractive as it provides money enough to complete trials in Europe as well as USA and even enough to file the product with FDA. In addition, Conor has to find leading investing company, which gives better possibility to sell the firm to a big pharmaceutical like J&J or Medtronic in the future at the highest valuation point. This adds the constraint in the choice of final financing composition as it strongly influences the companys ultimate valuation and exit options. Other important constraints are that new financing shouldnt dilute the value of existing shares and the fact that it is only 3 months left before the company runs out of cash.
1

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Corporate Venture Capital (CVC): possibility to raise between $5 mln and $10 mln. There are five potential contributions made by corporate venture capital in addition to the funds provided (D. Z. Knyphausen-Aufse , 2005): 1) reputation effects resulting from the co-operation with an established player(corporate certification); 2) support of R&D s; 3) arrangement of (national and international) industry relationships; 4) stimulation of business by initial order; 5) access to distribution channels. Among inherent risks of CVC financing one can mention the possibility of secrets loss as a result of a high level of information disclosure and adverse selection problem as a result of severe information asymmetries that CVC investors often suffer from. However, influence of these downsides can be reduced (and companys intellectual property protected) by using different safeguards, which could be: declining to give a corporate investor right of first refusal and board seat, restricting its ownership share etc. In addition, Gompers & Lerner (1999) show in their research that the pre-money evaluation of start-ups with a CVC investment is higher during the different investment rounds than with an independent VC investment, which fits perfectly with the CEOs final goal to be acquired at the highest valuation point. Conclusion. Even though a CVC financing pose some threats, company can reduce their influence by using safeguards, thats why we believe that this source of funds should be used in Conors case. However, its not possible to raise all $30 millions needed with CVC, so we should also look for another sources as well as for a leading investor, since CVCs usually dont want to take this role. Venture capital (VC): the possibility to raise $35 million (two VC firms are ready to provide $16 million and help to raise $19 million from other sources) in two stages: 1) $20 million after signing a contract; 2) $15 million in case of success with European trials, results from which the company do not expect at least for the next 10 months. Potential upsides are the fact that entire needed sum ($30 mln) could be raised with VC financing and company also gets the opportunity of having a cash slack (extra $5mln) in case of unexpected expenses, VC can also take the roll of leading investor and perform the ultimate valuation for Connor, in addition VCs always assist the firms management with expertise and strategic planning. On the downside, due to the high risk, VCs often constraint firms they invest in with different measures like: stage structure of financing when the possibility of getting additional money strongly depends on the previous stages results, VCs reliance on providing economic returns rather than focusing on some strategic targets usually causes difference in opinions and arguments between investor and firms management. Conclusion. Considering the risks of stage structure of financing and the fact that possible negotiation about its removal will take too much time which Connor do not posses, in addition to

the fact that company already has a VC so possible advantages of inviting new one are under doubt, we dont think that venture capital should be used as financing source at this stage. Hedge Funds: possibility to raise at least $7 million. Advantage of hedge funds financing is the fact that this source is comparatively flexible, it doesnt require a position in managing the company and in addition hedge funds are not that sensitive to possible negative swings of R&D process, so Conor can be sure that these investors wont call their money back in case something goes wrong with the European trials. On the downside, again this source cannot cover all $30 million needed and should be combined with other types of financing. Furthermore, it is a one-time investment, so in case company runs out of cash it wont be able to raise additional money from hedge funds. Conclusion. While it is a not bad source of funds for Conor, it still wont be able to cover the entire needed sum of funds hence it can only serve as a part of final financing composition. Wealthy individuals (Angels): possibility to raise around $7 million of series D financing. Among the advantages one can mention angels experience in entrepreneurship, their industry relationships as well as high tolerance to risk; in addition they tend to focus more on the opportunity rather than valuation which is a benefit in comparison with say venture capitalists. However because of the high risks associated with such investments angels usually require high returns and prefer to secure themselves with the partnership interests or ownership shares, they also tend to be more impatient in comparison to other types of financing, which is not good in Conors case. Conclusion. All in all angels do not seem as a reliable source of financing for Conor LLC. Royalties Scheme: possibility to raise $5 million if we sell 4-6% of future product sales for royalties to distributors of medical devices. The main advantage of this source of financing is that it doesnt dilute existing shareholders value. Potential downsides could be as follows: its not easy to find risky distributors for such kind of investment as trials are not finished yet, further its hard to estimate adequate royalties for possible future revenues (risk of royalties undervaluation), in addition such type of financing can cause lower value of the company at the exit scheme (because profits will be 4 to 6% lower). Conclusion. Due to the fact that Conor has a good chance of becoming monopolist in this industry with its new unique stent, we consider this source of financing not reasonable, as the company can lose much more while sharing abnormal profits with distributors than those $5 mln that it can get now. Sale of side patents scheme: possibility to raise $4 million plus royalties on future sales (4-6%). According to efficient redeployment hypothesis Conors patents for application of scents in oncology and ophthalmology dont represent value for the company because of the following

reasons: due to the fact that company focuses on cardiology now, it doesnt have additional resources to develop potential side applications of its product, and also even if Conor will leave patents as an option for future research, they wont increase value of the firm at the exit scheme and therefore should be sold: Conclusion: As the patents do not increase considerably neither current nor future value of the company they should be sold, although this source should be used after raising main financing.

Also, we do not that debt financing is possible in Conors case, due to the fact that firm doesnt yet generate any cash flows (doesnt not sell product yet) and doesnt have a credit history, when both those things are usually necessary for private or public debt.

Final composition of financing: Having previously discussed the upsides and downsides for each financing alternative we considered the following structure as the most reasonable according to the given facts: Corporate Venture Capitals: $ 5-10 M, Existing shareholders: $ 15M, Sell patents: $ 4M, Hedge Funds: $1-6 M (depending on the amount raised from CVC). At this stage Conor owns 25% of the shares and Highland Capital Partners, which are reliable partners with the same vision of the companys future as Conors and have been a leading investor in the series B funding, owns 30% of the shares. This results in control ownership of 55% and according to the case Conor wants to avoid dilution and keep control (blocking package). Therefore we suggest non dilutional instrument such as preferred stocks. However, this may not be possible depending on the negotiations and the fact if other parts accept the terms included. In the case they do not accept, another option is convertible stocks. With the preferred stocks we will have to pay a dividend that we assume would be around 7% (at cumulative basis) and transaction costs at 7-10%. There is also a possibility of a hostile take-over in Conors case because of the amount of cash they will have and no debt on their balance sheet as well as a ready product within 10 months. From this point of view convertibility can serve as an antitakeover mechanism. We propose Highland Partners to be the leading investor and do the valuation of the company and place issued stocks. The companys final goal is to be acquired by one of the major players of the market (J&J, Medtronic or other). Suggested capital structure helps to negotiate exit terms because current management retains control over the company.

References:

Dodo Zu Knyphausen-Aufse (2005) Corporate Venture Capital: Who Adds Value? Venture Capital, 7(1), p.25. Gompers, P. & Lerner, J. (1999) The Venture Capital Cycle (Cambridge, MA & London: MIT Press).

Appendix A Exhibit 1 Drug Development: Time Invested and Success Rates2

http://faculty.london.edu/ppuranam/Practice/AURIGENE_case-1.pdf