By Cary Zimmerman & Kate Hickner
This article was originally published in the Winter 2020 issue of Communique.
At some point in their careers, physicians find themselves contemplating a private investment opportunity. Sometimes physicians are approached by friends or family to support a new start-up. Other times, physicians proactively search out opportunities. Perhaps they desire to feel the pride and excitement of being a business owner, to pursue a passion outside of medicine or to utilize their healthcare knowledge to advance the field. Physicians invest in not only their own practices and ancillary businesses, such as hospital co-management companies, ambulatory surgical centers and accountable care organizations, but also other businesses ranging from convenience stores, breweries, restaurants and art galleries to medical device and other healthcare technology companies, as well as pooled investment funds focusing on certain sectors or securities.
Here are some practical tips for physicians who are considering whether to invest:
1. Be Aware of Applicable Healthcare Regulations. Certain investments and other financial relationships that are permitted in any other industry are prohibited in healthcare. Before investing in any healthcare business, whether it’s a direct provider of professional services or a business that indirectly serves the industry, physicians need to consider the state and federal healthcare regulations. When implicated, the federal Stark Law and Anti-Kickback Law set forth specific parameters regarding the permissibility of various investments. State laws, such as state fraud and abuse, licensure and medical marijuana program requirements, also impose certain investment constraints upon physicians. Lastly, consider that investments in certain businesses can also trigger certain requirements under conflict of interest policies and result in transparency requirements. It’s imperative that physicians consult with a healthcare attorney before investing in any business touching the healthcare industry.
2. Check If You’re an Accredited Investor. Many investment opportunities (offerings) require the buyer to be an “accredited investor.” This means, if you’ll be investing as a “natural person” (i.e., not through an entity) your net worth must be over $1 million (not including the value of your principal residence) or you must have annual income for the past two years and a reasonable expectation of income in the current year of at least $200,000 (note: if you’re including your spouse’s income, this threshold is increased to $300,000). If you’ll be investing through an entity, a different accredited investor test will apply. Check whether the offering requires you to be an accredited investor, and if so, make sure you qualify—because you’re probably going to be required to certify that you do.
3. Know What You’re Buying. In exchange for your contribution of capital, what will you own—equity, debt or contract rights? Equity is a fractional ownership interest in the company; if the entity is a limited liability company (LLC), you will receive a “membership interest” or “unit” but if the entity is a corporation, you will receive “shares” or “stock.” Owning debt issued by a company makes you a creditor of the business, entitling you to the repayment of your promissory note plus interest. Some debt is convertible, meaning that upon the occurrence of certain triggers (the passage of a given amount of time, a subsequent equity raise, or an acquisition of the company, for example), your debt will become equity of the company at a specified, usually discounted, price. The biggest difference between equity and debt is that if the company is liquidated, a debt holder will stand in front of equity holders in line to get a distribution of the company’s assets. One example of a contract right you may purchase is a “SAFE,” which stands for “Simple Agreement for Future Equity.” SAFEs give the investor the right to receive equity in the company at a future point in time, when a priced investment round or liquidation event occurs. These are popular with early-stage start-ups that want to raise money without determining a specific price for the equity.
4. Be Clear on Who the Lead Investor Is. In many offerings, the company identifies an investor who’s willing to put the largest amount of money in, and that investor typically will take the laboring oar on negotiating the investment terms. This person may be you. If it’s not you, however, understand that another investor may be negotiating the terms on which you ultimately invest, which you may or may not agree with—although usually your interests will be aligned. Even if there’s another lead investor, you can always attempt to negotiate changes in terms—although you may have less leverage than you might like.
5. Negotiate Adequate Rights. Depending on the investment type, the rights you want to negotiate will differ. For equity, consider these questions as you negotiate your rights: Do you want a voting interest? What information do you want to receive about the company, and how often? Can you sell your interest, and if so, to whom? Can your ownership interest be diluted, and can you prevent that (more on this below)? Can you remove the company’s managers for cause? Are you entitled to a preferred return? For debt, consider these questions: When is the maturity date? Is the debt convertible, and if so, what are the triggers and what discount will apply to the conversion of your principal (and accrued interest) to equity? What is the interest rate, and is it simple or compounding? If compounding, how often will the interest compound? Can the company pre-pay the debt, and if so, will the pre-payment be with or without penalty?
6. Be Familiar with the Relevant Documents. The company’s courtship process typically starts with a term sheet, a short document that highlights the most important terms of the investment. Keep in mind that term sheets are non-binding (often with a carve-out for non-disclosure of certain confidential information), so signing one doesn’t lock you into the investment. However, the company will view your signature of a term sheet as a strong indicator that you’ll be investing. To commit to the investment, you’ll be asked to sign a contract that obligates you to contribute a given amount on certain terms and conditions. This is called a “Subscription Agreement” (or, in the case of a promissory note, it may be called a “Note Purchase Agreement”). In the agreement, you’ll be required to make certain representations (i.e., promises that certain facts are true about yourself), and it will specify the timing and amount of your contribution, among other rights and duties. For a debt investment, you’ll sign a promissory note, an instrument reflecting your rights as a creditor, including when and how much interest will be paid and what happens if the company defaults. For an equity investment in a LLC, you’ll sign an operating agreement (or a joinder to one) that defines your rights as a “member” (owner) of the company. Other agreements also may apply but this suffices as a general overview of what you’ll need to sign.
7. Have Enough Cash to Meet Capital Calls or Exercise Preemptive Rights. Some investments (such as those in many private funds) will require that you initially commit to contribute a certain amount of capital, which you must contribute upon the company’s request at some point (or multiple points) in the future (referred to as a “capital call” or “draw”). Make sure you know what your obligations are to contribute capital down the road, because often there are serious consequences to failing to fund a capital call. Those are set forth in the investment documents, so read those carefully to know what they are beforehand—the company may be able to prohibit you from making further capital contributions or to redeem (buy out) your interest, as just a few examples. The investment documents also may give you “preemptive rights,” which enable you to buy more equity in a future financing to ensure that your interest isn’t diluted (see #8 below for more about dilution), and which obviously require more cash.
8. Know That Your Interest May Be Diluted. If you’re an equity holder, the company may have the ability to issue more equity to new investors in the future, which will reduce your percentage ownership in the company on the “cap table” (short for “capitalization table”) and reduce your relative share of distributions from the company. This is common in start-up investing, so know in advance whether your interest may be diluted. Keep in mind, too, that investors can, and often do, negotiate anti-dilution rights, which serve to protect the investor from such dilution.
Physicians are often approached by entrepreneurs who are seeking capital to grow their businesses. But investing in a private company is no small undertaking. This article addresses a number of considerations that should be top of mind as physicians work through whether to fund a private investment opportunity. First, physicians should know that state and federal laws—including, for example, licensure requirements, fraud and abuse prohibitions and other health care regulations—impose certain conditions on physician investments. Second, physicians should understand the requirements that apply to investors and understand the process, rights and duties that investors have—from being an “accredited investor,” to knowing your negotiating position, to maximizing an economic interest in the company, and beyond. This article provides helpful advice if you’re a physician who’s looking to become an investor.
If you have any questions or would like to discuss further, please reach out to Kate Hickner at keh@kjk.com or 216.736.7279, or contact Cary Zimmerman at caz@kjk.com or 216.736.7275.
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