This article is the twenty-first chapter of The Entrepreneur's Journey, a collection of stories about startup companies and the entrepreneurs who built them. To continue reading about key startup themes and lessons learned, check out the entire series here in The Seraf Compass, or purchase the book on Amazon in paperback or Kindle format.
“There are only so many IPO candidates out there. I invest to make a return. If the entrepreneur or I can’t put our finger on obvious alternatives to an IPO, something is wrong,” said Ron Conway, one of San Francisco’s most prolific and successful early stage investors. Ron has been an active angel investor for over twenty years, investing early in companies such as Google, PayPal and Facebook. So, you can surmise he knows a thing or two about making successful investments.
Given his focus on exits, one of the critical success factors Ron uses when evaluating a new investment is whether the entrepreneur knows the universe of potential buyers. And, knowing everything there is to know about these buyers, as we shall see, is a critical element for driving a successful financial return for a company’s founders and investors.
This brings us to the story of a company called InSound Medical (yes, the same InSound Medical where Alex Tilson of Loma Vista served a stormy term as Director of Engineering). The founders of InSound were passionate entrepreneurs focused on improving the lives of the large and growing segment of our population with a hearing impairment. The number of people in this segment is staggering. Millions of individuals collectively spend billions of dollars every year on some form of hearing aid. But, it’s a crowded market with many companies selling a wide range of hearing aids. When InSound launched its first product, there were already several well-established market leaders trying to differentiate themselves from one another and be the device of choice for new purchasers.
As to Ron Conway’s point about knowing potential acquirers, there were many for InSound. All of the market leaders kept a watchful eye on any new products entering the hearing loss market. In fact, several of these bigger companies expressed strong interest in acquiring InSound throughout the company’s history. As we all know, however, nothing is simple. Despite interest from multiple parties, there were circumstances beyond the company’s control that drove the timing of InSound’s exit and its choice of acquirer. The outcome was somewhat positive for investors but it could have been substantially improved had InSound better understood its buyers and if it had the luxury of controlling its own exit timeline.
Adnan Shennib, an experienced industry engineer, and Dr. Robert Schindler, a highly respected Ear, Nose and Throat specialist at the University of California San Francisco founded InSound Medical. The company was initially funded by several deep pocketed angel investors, none of whom had hearing industry experience.
The founders’ vision, which early investors endorsed, was to build a large, successful, industry leading company that addressed one of the biggest issues affecting hearing aid adoption. A key market objection to wearing hearing devices is their visibility, which can drive perception that the wearer is old or infirm.
Enter the Lyric, the world’s first invisible hearing aid. It is invisible because of its small size and could be manually placed by a hearing professional deep in the hearing canal, adjacent to the eardrum. The Lyric’s design allows customers to wear the device continuously for as many as 120 days. It is a disposable device that does not require battery changes. And, in a survey, 96% of users preferred Lyric over other devices they used in the past.
InSound’s product development pathway was no different from that of many early stage companies. It was a long, costly and rocky one. The company tended to release each version of its product before it was ready, and in the process, burned through large sums of capital going from fix to fix.
Initially, InSound’s co-founder, engineer Adnan Shennib, led the company. He focused his fundraising on angel money and priced each round higher than the last round without regard to the market realistic valuation the company deserved. As a result, subsequent institutional financings became challenging, costly and dilutive to early investors. The early angel investors developed short tempers as the value of their holding diminished. One key investor, Ken Rainin said, “I have completely lost trust in the company and its management.” As the largest investor, Ken’s attitude influenced other angels as they considered investing. As angel feedback trended negative, the company needed to rethink its fundraising strategy. A decision was made by the board to reach out to the venture capital community.
Two venture firms, Psilos Ventures and CMEA, agreed to co-lead an investment into InSound. De Novo Ventures and Johnson & Johnson’s venture arm both joined as new investors. The round was substantial with $25 million added to the company’s coffer. The company’s financial plan indicated this would be enough funding to get their product all the way to market launch. Rod Altman, the partner in charge of the CMEA investment, when asked about his motivation to invest said, “The product was truly disruptive, it met many customer objections to current offerings, and the market is huge.” If successful, InSound could turn the hearing industry upside down. Rod added, “There was no product remotely like InSound’s long lasting, deep in the ear canal, invisible hearing aid.”
Before finalizing their investment, the VC syndicate believed the company needed change. First, it needed an experienced, disciplined CEO. They were looking for someone who could effectively lead the company to a successful product launch, and ultimately, a sale of the company.
Second, the company needed a clearer exit strategy. The founders’ objective was to build a standalone company. However, new investors wanted an opportunity to exit, when appropriate, via acquisition. The industry was lacking in truly meaningful innovation and there were a number of potential acquirers competing on modest feature improvements, benefits and price. Finally, InSound needed to restructure its board with cooler heads and applicable industry expertise.
Following a CEO search, the company hired David Thrower to run the business. He was an ideal candidate. David was a Stanford graduate with a degree in mathematical and computational sciences and a Harvard MBA. He had experience in the hearing aid industry as VP of Global Marketing at GN Resound, and had also served as VP of Marketing for Align Technology, the developer of Invisalign invisible braces.
David checked all the boxes. He had experience marketing hybrid medical/consumer devices directly to the consumer. He knew how to overcome the resistance of the clinical customer to adopt new, disruptive technologies. And, he understood the hearing market and its key players. David’s motivation was clear, “It was a chance to be a CEO. I loved leadership, strategy, and driving cross-functional problem solving. Being a CEO allowed me to do all three in an industry I know.”
After taking the helm at InSound, David spent significant time and money overcoming a number of continuing product performance challenges, hiring key members of his leadership team, reducing costs, and building a sales organization. He led the company to a successful launch, ending year one at a $10 million dollar revenue run rate. It was a strong beginning. But, it also accelerated the need for expansion capital on top of the $70 million raised in prior rounds of financing.
In 2009, David and his team drafted a plan to raise additional capital. The business was growing and he wanted to accelerate that growth. The economy, however, got in the way. With the stock market in freefall at that point in time, early-stage venture backed companies had limited access to funding. Furthermore, healthcare focused venture funds lost their identity and their station in the Silicon Valley ecosystem. They avoided what they perceived to be early, unproven opportunities, including InSound. Frustrated with the pace of fundraising and unwilling to put in more of their own money, the board advised David to consider strategic alternatives.
The Lyric hearing aid was gaining market traction, and InSound was starting to attract attention from bigger companies. Rod Altman said, “David had done a good job of getting in front of industry leaders. Interest in the company surfaced and that interest provoked more interest.” Rod added, “Then, out of nowhere, Siemens, an industry leader, announced that it was getting out of the hearing aid business. It was a shock to InSound and the loss of a key potential partner.”
Given the state of the economy, the hearing aid industry, and the nearterm need for cash, the board advised David to begin a formal process to sell the company. They hired Gravitas Healthcare, a small investment banking firm, to assist in the process.
Gravitas reached out to a universe of ten or more traditional and less traditional potential acquirers. Two European companies, both industry leaders, emerged from the process expressing serious interest. The two contenders were Phonak, the market leader based in Switzerland, and Oticon, a large Danish company. In both cases, InSound was a logical potential acquisition to fill a corporate technology gap. Neither company had a product to attack 40% of the market dissatisfied with current offerings.
Gravitas was able to create a moderately competitive bidding process between Phonak and Oticon. However, companies in the hearing industry aren’t known for having aggressive acquisition strategies. So a bidding frenzy was not in the cards. An exacerbating factor was that these were conservative European companies. European device companies tend to be slow, methodic, and careful buyers. And, they tend to not overpay.
The bankers at Gravitas pushed the competing parties. After much back and forth, Phonak invited InSound’s CEO and chairman to a face-to-face meeting in Los Angeles. The meeting’s objective, they said, was to negotiate a deal.
The meeting was a disappointment. It went on for several hours replete with nonstop posturing and exaggeration. In the end, Phonak proposed a lowball offer for InSound, amounting to approximately 20% of what ended up as the final transaction price. As CEO, it was clear to David that the company was not communicating its value properly and that it had more work to do. David said, “The offer demonstrated they clearly did not appreciate the strategic value of InSound and did not view it as a potentially disruptive product.”
So why was the initial offer so low? Was it based on a traditional multiple of sales calculation? Perhaps the bidder believed InSound had no other offer? Or, given InSound’s modest sales, was Phonak interested in its intellectual property to keep it from competitors? David continued, “They were there to buy what they thought was an unproven asset, interesting IP, at a bargain price.” They were not there to aggressively acquire a strategically critical or disruptive technology, nor to develop a long term and trusting relationship with InSound’s leadership.
But, according to Rod Altman, the VC from CMEA, “We had our backs to the wall, we needed to get something done.” So, the discussions continued, albeit at a snail’s pace. The bankers, aggressively supported by management, kept both potential acquirers engaged and effectively negotiated between the two until InSound and Phonak reached a mutually acceptable price.
For InSound, the purchase price included a so-called earnout component. With an earnout, some of the purchase price is paid over time when and if certain milestones are met. An earnout allows the seller to capture a higher price based on superior performance by meeting qualitative and quantitative objectives. In this case, the metric for measuring performance was solely quantitative. InSound would have to achieve ambitious revenue and growth goals. While challenging to achieve, it would result in a more positive return for investors.
Earnouts can be great. They allow the seller to achieve a potentially higher return. For the buyer, it can be a relatively painless way to hedge risk and incent outstanding performance. In order to be motivating, however, the earnout must be achievable, and the incentivized party must be in a position to control its ability to achieve the objective.
At the time of Phonak’s offer, InSound felt it could sell enough to achieve the earnout. They believed this because they had a third party distribution relationship with a large chain of hearing aid dispensers. This chain had recently committed to InSound a significant amount of annual minimum purchases. Given the distribution deal, David said, “I felt we had a shot. We believed the earnout was a real possibility.”
After agreeing to the general terms of the acquisition, the next step was to negotiate documents. The documents turned into a long ordeal, and provided further insight into the buyer’s thinking. Every issue, no matter how small, warranted a lengthy and tedious discussion. It demonstrated to InSound something was missing from this relationship. It was as if Phonak was laying traps which might inhibit InSound’s success.
The negotiation came to an end and the deal closed in January 2010. David visited Phonak’s company headquarters in Europe soon thereafter. On the day of his arrival, David slipped and broke his ankle. This was not a good beginning, and perhaps, a harbinger of things to come. David said, “I was injured. We had worked so hard. The negotiation was excruciating. And here I am, lying on the streets of Zurich with a trimalleolar fracture far from home.”
Soon after, David returned home for surgery and recovery. When he went back to the office, his immediate task was to develop a sales strategy for the combined company. Global sales leadership resided at corporate headquarters in Switzerland. The worldwide sales leader, in David’s words, “had no idea what to do with Lyric.” Phonak’s senior sales management viewed the product as a risky unknown. As a result, there was no pre-vetted plan for integrating the combined salesforce or highlighting the Lyric product.
The invisible InSound device could have, and should have, been positioned for and targeted to a distinct market segment, i.e. the reluctant user, the vanity user, or the first time user. There were many choices. Positioned this way the Lyric device could fill a big gap in Phonak's product line and allow them to address that 40% of the market. In Phonak’s view, however, Lyric was just another alternative available to the existing customer who was considering a hearing device from its broad line of products.
Given the centralization of sales leadership in Switzerland, and the misaligned incentives of management, InSound was essentially a distraction. David felt he had to force his way into strategic discussions to plead his case for Lyric being a critical product for the combined company. Given the misalignment of corporate sales incentives, it was soon clear that achieving the earnout was at risk.
Another curve ball came David’s way after the close. Phonak had acquired a majority interest in Lyric’s biggest distribution partner. InSound was anticipating significant revenues from this partner, and those revenues might be at risk. The earnout they were counting on might very well be out of reach.
For InSound, this was shocking news. It was all the more stunning because Phonak had been working on investing in this distributor while it was negotiating the acquisition of InSound. Yet none of this was disclosed in advance. Given how material this information would have been to the final deal terms, Phonak should have disclosed it to InSound. David said, “I was crushed and disappointed.” For all intents and purposes, InSound had lost control over its earnout.
With the benefit of hindsight, David and his board came to realize how little they knew of their buyer. While InSound’s story is extreme, the proposition stands: know your buyer. Understanding the value your company creates, for whom that value is most compelling, and how those potential acquirers operate is key to getting a great exit for your company. InSound focused on the exit late. By that time, it was too late to control its fate and do a careful vetting process. The result was an exit outcome which was lower than it might have been.
Having said all that, the story continues with a mostly positive outcome. A series of conversations took place between InSound and Phonak to address this issue. Progress was slow, tensions were mounting, and there was no visibility on a speedy resolution. To break the logjam, InSound's Chairman proposed a one-on-one discussion with Phonak's CEO at the earliest possible date.
A few days later, at the conclusion of a 5:00am call between InSound’s Chairman and the President of Phonak, Phonak agreed to an immediate cash payment to InSound investors. This payment was essentially a purchase of the earnout. The final payment resulted in a 2.5x return to the investors on their original invested capital. While Ken Rainin and the other early investors had hoped for more, they were pleased to get a decent return.
The Lyric hearing aids continue to be available today, with many satisfied users. David Thrower, the very capable CEO, left the combined company exactly one year and one day after the acquisition of InSound by Phonak. He said, “I made a one year commitment. I fulfilled my commitment and then I was out of there.” David has since gone on to lead several other startups and served on a number of corporate boards. He is a wiser man now and understands that although the Lyric was and continues to be a highly impactful and successful product, it does not mean that the company responsible for its creation was able to reap its full share of the rewards. As a growth company leader, one must think about the right potential exit partners early and often.