Build-to-Buy and Option Structures

23:50You think about it, all the effort that goes into an hour-long update can take weeks. And when we're innovating in this manner, that's valuable time. On the other side, what happens if the startup blows through all their money and they don't get out to market? That does happen. Not necessarily with investments we've made, but it does happen with structures like this. So there's a couple of things. One, we do our best to stress test the budgets going into this. So again, I meant the point that the option premium, the investments that we make in whatever form that additional investment comes in.

24:20Ideally, it carries the company to that milestone or value inflection point where we're ready to make a decision. But let's imagine we're not. A couple of different ways that could play out. Maybe the company has done their best and they just haven't delivered on the technology and the criteria that we agreed to. We need more money. How does that look? Certainly is going to be a negotiation. Probably a negotiation to us. They come with us and say, would you help us? Would you bridge us? Depends how long the bridge is. You may have to go to their existing investors and say, hey, we just need a little more time.

24:50Would you put more money into the company to carry us? There are lots of different levers you could pull, but it's almost always a negotiation. You could also imagine a scenario where, for whatever reason, the option holder, the strategic, just wants more time for a decision. You could also put more money into the company and say, hey, we want to see a little more of this. We want to see this. But that's a negotiation. It's changing the deal. And then the company has the right to say, do we want to do that or not? Do we want to extend out the option further? I think, again, if you're partners with these companies and you're in it, you've been going on this journey together, you're pretty incented to find solutions there.

25:22But if it's a complete bust and hopefully we don't find ourselves in that situation, one does not find themselves in that situation very often, then I think you got to have hard decisions around whether you want to keep financing or not. It sounds like it's a pretty big variable. There's that if you have interest, because then you may back up and see if they have somebody else pick it up. No, exactly. And sometimes they do. Again, it depends on how successful the company's been, what the opportunity is. and why we decided not to exercise. It's not like we're doing 30, 40 of these, but we're doing them selectively and strategically for the right investments and for the right opportunities where it makes sense and we want to go on this journey together.

25:58How do you think about risks on these deals? And I think of traditional M &A where you're modeling out synergies and how well you can execute to capture those synergies. What's your view on risk on these type of deals? It's very different than what I did before. So I'm thinking back on time in both in investment banking and working corporate development at 3M. We spent a ton of time in the synergy models, costs, sales, all that. It's interesting. That was probably the lion's share of where we spent our time deal modeling. I remember sessions when Jerry and I were working on those and we'd spend hours going through the detail on the cost side and the sales synergy side.

26:39Much easier to capture the cost side than the sales side. I would say we spend less time doing that now. Where we spend a lot of time on my transactions now are understanding the patient opportunity. So we'll be digging through clinical and healthcare data, understanding what's the incidence and prevalence of certain conditions and what is the population of patients who could benefit? What are their alternatives? How do those alternatives work? It's like the time I used to spend on cost energy and sales energy is now understanding patient populations. Just different. And we have these really big multi-tab Excel models going through and figuring out what the opportunity is for patients to treat.

27:20It's amazing. There's all these different classifications of patients and patients that respond to this and not that and patients that have this comorbidity and patients, before you know it, they're just like 100 rows in Excel just to understand at a very granular level who are we going to be treating and what their benefit is going to be. So it's just different. There isn't a bunch of infrastructure to take out in a cost deal. Like it used to be really simple to go through and say, what's the redundant functions of this business? Here, it's maybe 10 people, maybe five people working on something.

27:48Yeah, it is interesting. You don't have the control. It's like what you described, your diligence like a venture capital. Yeah. Yeah, very much. And again, I think it's great, but it was a change for me when I came here to Edwards. It was energizing. It forced me to develop a whole new muscle because I thought of M &A as one thing. I thought of it as you got a company and it generates EBITDA and we get to look at the cost structure and figure out where the value points are. How are we going to take their sales, run it through our channels, where are the leverage points in international and are in the matrix, all that.

28:20And back in banking, nothing against my former colleagues in banking, but it was an assumption. The synergy was just a percentage assumption. It was like, what's the sales acceleration? Put in X percent sales acceleration. Cost is X percent. Now it's very much like when you're going this early, you have to really believe in the opportunity. And we're not talking about capturing little shares. We're like, if we're the leader in this really big opportunity, how does it change patient lives? Just a different conversation. And it's one that energizes us. It energizes the companies we invest in. And I think they respond to it.

28:53And that's why they get excited. A lot of those people, that's what gets them going. So they'd rather not spend all their time raising money and doing all that work that calling venture capitalists. They're like, let us focus on the innovation. And if you can help us, great. And we're willing to go on that journey with you and partner with you. They're the ones for whom this structure makes a lot of sense. If it's someone who believes that they want to have a really big public company and they want to maximize their exit. And by the way, nothing wrong with that. There are folks for whom that's the right kind of business they're building.

29:22They want to probably just go on the traditional journey, raise VC money in subsequent rounds and do all that. Maybe an IPO, maybe an exit. But if you have a really cool breakthrough technology that's focused and you want to work with us and we can help, that's where the natural fit is. Yeah, really good points around that. Just very different in how you got to think about this. It's very different. I had to learn a whole new way of thinking about it. I was more traditional later stage M &A. What's neat about this is it's sort of in many ways, the benefits bridge traditional venture capital investing or traditional equity investing and later stage M &A.

29:55It's like the hybrid between the two. Can you tell me about when it comes time to exercise your option? Are you still doing some of those mechanics or are you just going straight to sign and close? Traditionally, the way it works is let's imagine that we've set, we call it, sometimes call it like milestone delivery points. So there's a time at which a milestone is achieved and the option begins to expire. So again, there's different ways these can be structured. So I'm going to try to generalize for simplicity. Sometimes the option is live the entire time and we can exercise at any point. Sometimes the option becomes live, but let's just generalize a little bit.

30:28At some point, the option has to begin expiring. So one way this could work is you set a milestone and say, let's imagine it's some clinical data from a pivotal trial, the big, large trial that they're doing to get approval to market and sell this product. And we say, once you get the results of that trial, give us the results and we have a window to decide. So there is a diligence window that would open up and it's basically triggered off the time it takes for us to make a decision. It could be 90 days, it could be a few months where we do final diligence and make our decision. And if not, there's some period of time and then the option would expire.

31:02Our right to buy would go away. So you do get to do confirmatory diligence of some kind. And again, everything's negotiated. There are times where the company is like, you shouldn't need that much time. They want a tight window. Other times, we always say we want time to process whatever it is that you've delivered to us, whether that's data or things. Other times you just say, listen, the trigger is approval. And once the FDA approves the product, that's when we'll make our decision. Depends. And sometimes again, it's very early. Sometimes it could be like, we'll just see the results of an early feasibility study.

31:31Whatever it is, it has to be something where we get conviction, we have to get conviction that it's going to be efficacious and make a difference to patients. That's really what we have to get conviction around. And whatever it is that gives us that, that's where you make the decision. If we walk, the option has to expire. It can't just persist forever. Companies don't let us do that because then, of course, their strategic value is diminished. It's a finite instrument. There's a time at which it ceases to exist. And there's risk for us in that because we pay money to acquire that right. That option has value.

31:58If we don't exercise it, there's a charge that goes along with that for us. So there There is downside risk for us. The risk is that the company doesn't meet the criteria we want. And then we have to just eat that investment and it expires worthless. So that money that we gave, it was non-dilutive. It didn't result in ownership of the company. There wasn't a return on that at that point. A hard time wrapped my head around that. But I get it. If the whole intention is down the road, it would be an acquisition for your portfolio. And it would make sense. And essentially, you're making similar bets through your own organic R &D function.

32:30And listen, we do a lot of diligence in the upfront. It isn't something where you say, well, technology is, the concept is interesting. Therefore, let's just buy a bunch of options. Let's just option everything that's interesting out there. You can probably tell, given that we've, the players in the space don't, we're very judicious about how we think about these. And so you do diligence going in, but you can't diligence everything like you would in a normal acquisition because it's not all there. Company probably doesn't have a built-out HR department, for example. They don't have a giant manufacturing infrastructure, for example.

33:00So your diligence looks different, but you diligence the investments before you make them. And then you diligence again before you exercise the option. Yeah, you're running a lot of the same components you would in a typical M &A deal, at least the confirmatory diligence. Yeah, and it's done very similarly to what you typically see. So you'd have functional experts that do diligence for a living by function that do these on a number of deals. And they go through and look at their respective areas and report back on what they find. So that's the confirmatory looks. There's just much less of it before you make an option investment or a bill to buy option because not all that's built out yet.

33:38You put a fair amount of money at risk based on the conviction you have from being so focused in the space and knowing what might work. Can you give me the reasons why you ultimately wouldn't end up doing the M &A deal? One of them is probably the most obvious is through these bill to buys, you usually agree on the criteria you want to see the company develop. So whatever it is, we'd say, listen, we want the company to look like this. We want to have this manufacturing capability by the time we exercise. We want it to have this sort of impact. If they don't develop a technology that looks like that, we may not exercise.

34:14The market could never develop. There are technologies that are really interesting. So let's imagine that it's a new disruptive breakthrough technology, but it has competitors in the market already. maybe that market is just not ever developing. It wasn't as impactful as we thought it would be. So we just say, you know what? That makes sense. There can be a range of strategic reasons. We might make the decision that for whatever reason, we're not going to play in a certain segment anymore. And the last one, people often ask us about it. We hear a lot from founders about this. I know that you're convicted, meaning I know that this leadership team at Edwards really believes in this strategy.

34:47But what if you're not in your roles when you go to exercise the option? And why this matters is sometimes these are long-term agreements. It could be three, four, five years out before we're going to exercise the option. So it's a long journey. What happens if the C-suite turns over and the new people in those seats don't care about this deal or they don't care about it? So they're like, yeah, I get it. I believe you. You can look me in the eyes and tell me you think this is really amazing, but how do I get comfort that the next administration will? So what we try to tell them is, again, if you have your North Star and that's patient-focused innovation making a difference to these patients in this particular population, whoever is occupying the roles in Edwards is likely to feel pretty similarly.

35:30Okay. So it could come on both sides. They could have change in leadership or they don't deliver what you expected or they go in a different direction. Right. We try to protect against that, right? We have all kinds of things in the agreements that say, if you set off to be a company that's going to develop something really interesting for mitral valve repair or replacement. You can't take all our money and decide, actually, you want to develop an ice cream company in Austin. I'm joking, but there's a lot of protections in there. But you negotiate over what the protections are and the degrees of freedom.

36:00And we negotiate around how much of the money goes to certain things versus other things. Because again, we do want our money to go to developing the technology we want. But you're right. They can take it in a very practical way. They can squander it in efforts to advance for, in my hypothetical like an example, a mitral replacement product, they could still squander it, not invest it wisely. Once they have the money, they have the money. There's factors on your end where you may change your appetite for that segment or just general strategy? It can happen. In our case, we are very clear on what our strategy is.

36:29So when we enter into these, we've thoroughly vetted it. But certainly that's the case. And I know that if we looked at the universe of option deals that have been done, it's absolutely certain that companies changed their strategy and didn't exercise these. If you go through all this, and you don't ultimately exercise your option to acquire the company, is everything a total wash at that point? No, it's not. But it depends a little bit on how it's structured. Like I said, if you give some money that's non-dilutive to acquire the option, you have to give consideration for the option. The option has value.

36:59So you're paying money for that option. Yes, if it expires worthless and we don't do anything, there's a charge you'd have to take. And so that's like, you reacted earlier and went, wow, you can throw out all that money and get nothing out of it if you don't exercise. Yeah, the portion of the money tied to the option, yes. because the option had value along the way. That would just expire and you take a charge for it. If a component of your investment was in equity or maybe convertible debt, it would convert into the next financing or a subsequent IPO, then we still have something for our investment.

37:28These get structured different ways. Sometimes there's a piece that's option premium. That's the part that is tied to the option, to buying the option. There's a convertible debt component. Maybe there's an equity investment. It just depends on the individual needs. Other times as well, you can bring in a venture capital partner. So imagine a really long development timeline. So let's pick, for example, like four or five years to get to that value inflection point. Maybe the amount of capital that we need to raise is sufficient that we will want to go approach a venture capital firm or a private equity firm that would consider these types of investments and say, would you like to invest alongside us?

38:05And they get interested in that for similar but different reasons than maybe the company does. The return is relatively fixed. they can look at it and say, okay, if everything goes according to plan, I can put in this much money and I'll get this return in this many years. So we partner with a venture capital firm. So then you have like a three-way negotiation where it's us partnering a venture capital fund to put a big investment into the company that finances them through their development timeline. We get to partner with the VCs. I think all of us that look at these types of deals consider those structures as well.

38:34And there are various reasons why bringing those partners makes sense. Sometimes they add a lot of value. Sometimes those VCs have operating partners that are really good at this and you want their expertise. There's a range of reasons why it can make sense to do that. A lot of variables in the structure, my friend. No one said this stuff was simple, but you've been doing this a long time. I mean, M &A, the reason we love doing this stuff is it's constantly challenging, right? It's like you can spend your whole career in these areas and you're constantly learning new stuff. And when you think you know it, there's innovation in the way things get structured and the way risk is allocated.

39:05These have been around for a while. It's just, I think in the last eight years or so, it feels like they're picking up in terms of med tech utilizing them. I'm curious, is that innovation in the way we're structuring deals or is the market competitive that's driving you to do this? It's definitely both. If there's a bit of a race to form relationships with these truly innovative companies, it necessarily forces you to engage earlier. If all you did was just acquire early stage technologies, you'd probably have a lot write-offs. And if all you do is invest and then go on a long journey, then you potentially miss the relationship to help guide influence, we would say, where the company goes.

39:42We get the early engagement with them. You get the influence. You give them some benefits. And we preserve that optionality, which I think is very valuable. Yeah, your space. You guys really play the long game. That's good. I want to ask you, how do you bring this up? When you approach a company, what's your approach? What's that conversation like and how you bring up this kind of structure? because I can imagine it being fairly foreign to somebody that's a founder of a startup. You're right. You see all different levels of sophistication in these startups. And a lot of times founders may be very clinically minded, but less familiar with all the deal options that are out there.

40:18A lot of them go to healthcare conferences now. I'm hearing more from the podiums about these types of structures, which is why I think it's a good topic for us to be talking about. So I think they're getting more used to hearing about them. But a lot of times it's just about listening to them and saying, hearing them describe the technology and then saying, hey, this is something that feels very strategic to us. It feels like you're aligned with our direction and explaining to them the options that exist. I think it makes sense for some technologies, we may say to them, we want to go on the journey with you.

40:49We want to learn. And it's more about staying close. There are others that feel to us to be so on target, on strategic target and also demonstrating something already that we see that looks unique. Something. Whether it's an early patient experience, whether it's something in animal data, or just a novel, unique way to treat a condition. And in that case, we may say, we want to learn, but we want to influence meaningfully. And that's where I think you go. And you say, would you be open to something like that? Are you familiar with these types of structures? And yeah, sometimes they are not. Increasingly, they are.

41:26But I think you have a candid conversation that's not dissimilar to the one we're having right now, where a lot of the questions you're asking are the exact ones that we get. If you're honest with the companies, they'll also tell you if it's right for them. And sometimes the investor base, not all, but many of the companies that you'd be kind of considering for these types of investments have some pretty sophisticated VCs in the cap table frequently already who have experience with these. So the founder may go to their board members, go to their VCs and say, hey, Edwards is interested in a deal like this and they're going to have their view of it too.

41:58Some have had successful exits through these types of arrangements. Others maybe have a different view. So you have to incorporate that a little bit as well. But there's a moment where you have to think about as a founder that one of my colleagues I work with in corporate development always says it this way. He said, I don't know if his numbers are right, but he said 80 to 90 % of these really amazing breakthrough technologies will fail. His number's not mine. I don't mean 80 to 90 % of the investments we make. I mean, just people pursuing this type of innovation, it has a very low success rate because the challenges we're trying to solve are so hard.

42:31So if you look at that as a founder and say, this is going to be a long journey, I have to be really committed to it. If you had the opportunity to de-risk that process by working with someone who goes through, like Edwards, who goes through this, it's all we do is this type of really long, committed innovation to de-risk it and then also allow you to focus, that's what gets them excited. They definitely give up the uncapped potential of a giant IPO and all that. But I think sometimes it's worth it, given the journey they're going to go on, given the risk that's inherent in this type of work. You got to decide.

43:07Interesting. Build to buy. Build to buy option deals. We think it's an elegant solution. But again, it's one tool. It's one lever we have and we can structure lots of different things. So what's the craziest thing you've seen in M &A? I have seen multiple times in my life, and this was a lesson I had to learn. When you're in a corporate development role and a big strategic, you have to be on guard for this tendency to kind of go to smaller companies or go to targets and tell them how to do things. Like we know everything. We're the ones who know everything. And I've seen multiple times. I think this is crazy, but it's maybe crazy, but also very principled.

43:44I've seen multiple founders over the years who have been so offended by the way big companies come in and do diligence and treat them and do all this, that they've sold to other entities, other companies for tens of millions of dollars less. I saw one founder sell for 50 million less on a deal of 400 million. And I've seen that happen many times over the years. And when you see that, you go, wow. But what you realize is a lot of the people in this space that start these companies, a lot of them already have a ton of money to begin with. And they're doing it on principle. They're doing it because they are doing it for pride, all sorts of other things too.

44:18And if you come in with this like arrogant attitude and like tell these like, you have to bend to our will as the big acquirer, these people will put you in your place. And so I've seen this happen time and time again, where people are like, you know what? I'm doing to take an inferior deal and forego tens of millions of dollars. Now there's supposed to be fiduciary responsibilities that prevent that, but I'm telling you, I've seen it multiple times. So it's like this reminder to me, I have a degree of humility. This industry attracts people that are very self-confident, very type A, all this.

44:43You have to have a degree of humility in this industry and do genuinely care about the targets you work with. Because if you go in there with that attitude, it's not going to work. So I think that's definitely one of the things that's amazing to me is that it's not always about maximizing profit. And if you forget that there's a relationship business at the end of the day, you will get reminded in pretty tough lessons you'll get taught. Absolutely. It's so much better relationships. Isn't it? Becoming our core theme of M &A science here. But I think what you guys are doing is exactly that. It's bringing the human element to it.

45:13I love watching and listening to the podcasts you have because it's people that you know, but you get a little sense for what they're like as people. It's in many ways, not as big a network of folks. You're showing this, but it's great to get to know these people. And it's not like this is all math. It's not like it's all just legal agreements and things. It's also people and relationships. And that's true even of the companies that we work with. There was this old school way of doing thing, which is like, we're just tough negotiators. and you send in the team and you pummel the other side into submission and you just say no a bunch in the legal agreement says, no, you'll take this term.

45:45You'll take that term. And no, the escrow needs to be bigger. And what we're finding is like, it doesn't work. Long-term, it doesn't work. It's not good for your reputation. It's not good for the relationships. And certainly when we're talking about option deals, can you imagine pummeling a target on every deal term and then having to work with them for four years? It doesn't work. So it's like you have to work together and genuinely care. I'm obviously a big fan of what you're trying to do, but I think the more we humanize this, the more we make it about people and less about this idea of negotiating for the best terms possible.

46:15I think you've picked really good people too to talk to that are, again, show that side of it. The more we know each other, the less it's going to be about that and more it's going to be about, let's come up with things that are a win-win. That's what makes it fun. Nothing but the best here on M &A Science. I totally agree with you. Oh, this has been a great thing. I appreciate taking the time helping me become a better M &A scientist here. And I was flattered for the opportunity. I'm grateful that you made it to our campus. You're welcome back anytime. Well, I'll do it again. Maybe a little grouping out here.

46:42Those of you still with us, thank you. Until next time, here's to the deal.

46:57Thank you for taking the time to explore the world of M &A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com. Or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter.

47:42Again, that's mascience.com. Here's to the deal.

47:55views and opinions expressed on M &A science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual this podcast is purely educational and is not intended