Investment and corporate actions

Raising fresh capital

Irrespective of scale, any company seeking to grow in the digital health space is likely from time to time to need to raise fresh capital. Funding can range from growth, venture or patient capital, through initial public offerings (IPOs) and other large and complex international debt and equity offerings to bank financings, securitisations and bespoke equity derivatives transactions. This requirement presents attractive opportunities for financial and strategic investors.

With scale, most companies in the digital health space are going to need to consider acquiring outside skills or assets (including intangible assets such as intellectual property) through inorganic growth, particularly through mergers & acquisitions, joint ventures or strategic investment, in order to remain competitive. The resulting appetite for deals provides exciting growth and exit opportunities for start-ups and financial investors across an increasingly international market place.

Growth can also create new corporate governance issues and risks. One of the most difficult areas for boards of growing companies is, for example, information risk, the risk of directors making the wrong decision because they did not have the right information:

This section focuses on key considerations associated with:

• the digital health business model and the challenges of due diligence
• how to structure an equity investment
• new business models and deal landscape
• the provision of information/warranties in a sale process
• corporate governance, and
• the market opportunity for expansion.

Business models and due diligence

The business model for a digital health business is, as for others, how it generates or preserves value over the longer term, and how it captures that value. The business model is what the entity does, why it does it, how the entity is structured, the markets in which it operates, and how the entity engages with those markets (for example, what part of the value chain it operates in, its main products, services, customers and its distribution methods).

A key element of commercial due diligence is to obtain an understanding of the nature of the relationships, resources and other dependencies that are sources of value and are necessary for the success of the business. In the case of a digital health business an integral part of its business model will be its key contracts, such as IP licences, co-marketing or distribution contracts and (depending on the nature of the business) dependencies on manufacturing and supply chains.

Whether diligencing for the purposes of investment, acquisition or IPO the review of key contracts needs carefully to take into account the multiple other considerations inherent in a digital health business model and described elsewhere on this website. In particular investors and acquirers will want to understand whether and how liabilities are flowed down to third parties and whether they are capped or restricted in some other way. Contractual terms like change of control clauses, prohibitions on assignment, and restrictions on the use of confidential information or personal data will also be important.

New business models

As digital health business models develop, companies will need to evolve their strategies to ensure that they are able to monetise the various business models associated with their digital health offerings. For example, patient data may have a unique value separate from that of the application which generates that data. In order to be able to monetise these new business models and also to establish tax efficient structures around them, companies and their lawyers will need to tailor effective corporate and contractual structures so that when an exit opportunity arises the relevant value is not lost.

Healthcare transformation and the need to adapt to a highly dynamic business, consumer and patient environment is driving different players to collaborate, creating a very fluid and exciting deal landscape for joint ventures and new types of less formal partnerships. For example, medical device and biotech companies increasingly need to utilise larger datasets that are held by other healthcare providers to conduct research to advance their therapies.

While these opportunities enable innovative venture structures, they also bring transactional challenges. In addition to managing cultural differences, for example between non-profit distributing and for-profit businesses, the parties will need to address risks related to compliance with legal and ethical requirements and contractual obligations.

Also, whether the arrangement is a more traditional corporate joint venture company or a more fluid partnership, the parties will need to decide early how to anticipate any termination of the venture and deal with issues such as the distribution of returns.

Other key contractual elements of these joint venture / partnership arrangements designed to help them navigate this changing environment include provisions governing: board composition, conflicts of interest, deadlocks between the parties (and how to resolve them), compliance programmes, and the ownership and protection of proprietary information.

More generally, in order to create an effective partnership strategy in the fast moving digital health space, parties will need to focus on

• (i) creating a flexible legal and governance framework that can be adapted as the company’s business model evolves;
  • (ii) establishing an efficient channel of communication and shared information between the partners and the core management team;
  • (iii) preparing for unexpected events such as market and/ or regulatory shifts, technology disruption and competitor moves; and (iv) developing an agreed exit strategy.

Structuring equity investment

The way in which an investment in a digital health company is structured at a pre-IPO stage will vary on the investors’ objectives, and in particular whether they are strategic or financial investors. In almost all cases, negotiations between the parties will include a focus on:

• board appointment rights
• control/veto rights for each investor (depending on its stake)
• restrictions on the company or shareholders dealing with third parties (particularly where a strategic investor is involved)
• information rights for shareholders (notably the extent to which they will have access to quarterly or monthly management information)
• the understanding between the parties as to what exit is envisaged for shareholders, and
• the basis on which shareholders may sell their shares and/or require other shareholders to sell their shares (with pre-emption rights/rights of first refusal, permitted transfer provisions, drag-along rights and tag-along rights being a feature of most investment documentation, requiring careful legal drafting).

It is important to try to reach broad agreement on all these points at the term sheet stage of the transaction.

Control/veto rights can often prove the most sensitive area for negotiation, with key areas of concern including the need not to prejudice:

• the value of investors’ stakes through actions by the company that may dilute the value of their investments
• the ability of the company to raise further capital in later funding rounds (with digital health companies likely -
• needing to go through multiple pre-IPO funding rounds), and
• the tax or accounting treatment of the investment for shareholders (including in the UK the eligibility of the investment for Enterprise Investment Scheme relief).

Restrictive covenants may require analysis from an anti-trust perspective to ensure that they will not be construed to be unenforceable restraints of trade. Exclusivity arrangements where an investor is seeking access to the underlying technology require particularly close analysis. The period of the restriction will be a key sensitivity in this respect.

Providing information/warranties

Once a confidentiality/non-disclosure agreement has been put in place, due diligence is the critical next phase of any pre-IPO investment in, or purchase of, a digital health business.

Those providing the information will want to limit their liability for information they provide about the business to the warranted statements (or warranties) they agree to give in an investment or sale agreement. Investors or buyers will want any assumptions they are making about the business, or statements on which they are relying, to be underpinned by such warranties (which, in a digital health context, can be very bespoke).

These warranties may also reveal (through disclosures to qualify these warranties) more information about the business. Such warranties and disclosures tend to be a more critical feature in mergers & acquisitions transactions than in the case of venture capital or similar investments.

Disclosures will put buyers in a better position to decide whether they need to protect themselves through:

• appropriate insurance cover for any risks
• specific indemnities in respect of any contingent liabilities (for example pending product liability or consumer claims), or
• an up-front price adjustment.

The basis on which a purchaser can claim damages for any breach of these warranties will vary according to the applicable governing law. An increasingly common feature of negotiations in relation to any digital health transaction, given the very different financial models buyers are applying to the investments they are making, is a focus not only on the financial thresholds, caps and time limits applying to any claims for breach of warranty, but also on the extent to which economic, indirect or consequential losses can be recovered.

Well drafted sale documentation should mitigate the parties’ risks in this respect, but it is still crucial from both sides’ perspectives that a seller takes reasonable steps to verify the accuracy of information it is providing about the business and makes clear from the outset the basis on which it is providing the information (for example by disclaiming any liability for the accuracy of the information other than through the warranties negotiated in the sale agreement).

Sellers are increasingly keen to explore the use of warranty and indemnity insurance (often at the purchaser’s expense) to allow them a relatively clean break from any liabilities associated with the business.

Although the costs of this insurance can prove prohibitive in the context of smaller transactions, insurance brokers and underwriters are interested in opportunities to facilitate transactions in the digital health sector through such cover, with many developing deeper sector knowledge as a result.

Corporate governance

The fiduciary duties of directors, most of which are enshrined in legislation, require them to have regard both to what will promote the success of their company, but also to a range of specific considerations that can have different consequences in different sectors. For example, UK company law requires directors to have regard to the desirability of their company maintaining a reputation for high standards of business conduct. Breaches of these legal duties can expose directors to a range of sanctions, including personal liability.

These legal duties fit within a framework of guidance and market norms about what constitutes good corporate governance. Although this guidance is often devised primarily for quoted or public companies, much of it is also relevant to, if not binding on, private companies. There is, for instance, increasing emphasis on the need for the board of any company to establish the culture, value and ethics of the company and set the company’s values and standards. Recent proposals by the UK Government will lead to a governance code being developed for large private companies.

A key area of risk mitigation is to enable boards to have the information they need to take effective decisions and to challenge appropriately the execution of the company’s strategy. Clear reporting structures, the timely escalation of information and the presentation of information in a way that enables directors quickly to find their way to the heart of the issues, are as critical components of good corporate governance as other appropriate systems and controls.

Audit and, in the case of digital health and other healthcare companies, clinical governance committees, play a critical role in this respect. Although in listed companies these committees should have non-executive directors on them, it is expected that these committees as a whole must have competence relevant to the company’s sector focus.

Expansion opportunities

A key commercial risk will be the size of the potential market, the portion of the market accessible and the product price at which this is planned.

As Sir John Bell’s August 2017 report on the UK life sciences sector’s industrial strategy stated very clearly, digital health has enormous potential:

“It is clear that the single most important changes in healthcare will emerge with the increasing digitisation of a wide range of information. Everything from patient records, X-rays, pathology, images, genomics, healthcare management tools, and the input from a wide range of digital monitoring devices will soon be available to healthcare providers digitally and will fundamentally change the way we think about human disease and how best to manage it.”

The opportunities associated with digital health are highlighted by our Digital Fusion report.

Nonetheless, digital health businesses face challenges in obtaining market access and the inter-relationship with their IP and regulatory positions will typically need to be a key part of the commercial due diligence on strategic investments, mergers & acquisitions and IPOs.