Strategic Insights: Navigating Minority Investments in Healthcare Companies

Minority investments in the healthcare industry are often a way for strategic investors (e.g., health systems or medtech companies) to gain early access to innovative technologies, deepen commercial relationships or influence product development without fully acquiring the company. As minority investments become increasingly common in the healthcare industry, it is important to consider the nuances of such investments, particularly with respect to risk mitigation, governance rights and economic terms.

Risk Mitigation

In a minority investment, the investor is acquiring a less than controlling interest in the company and frequently has limited visibility to the operations and financial conditions of the company. Therefore, it is important for an investor to evaluate the healthcare company from both a business and legal perspective prior to committing capital.

Legal due diligence can be glossed over in connection with minority investments, but it is a valuable risk mitigation tool for investors.

Conducting legal due diligence can help an investor evaluate and assess, among other things:

Legal and Regulatory Risks

Healthcare is a highly regulated industry, and it is important to ensure that the healthcare company is in compliance with applicable laws, for example, state and federal privacy laws, anti-kickback and self-referral prohibitions, billing rules, and licensure requirements and Food and Drug Administration rules and regulations. Failure to comply with these laws can result in significant penalties and consequences to the company and jeopardize an investor’s investment.

Contractual Obligations

Healthcare companies frequently rely on contracts with insurers, government payers and third-party vendors. Legal due diligence can help an investor gauge the viability of a healthcare company’s revenue streams by confirming the terms of the agreements, evaluating potential reimbursement risks and identifying agreement terms (e.g., exclusivity clauses) that could restrict a company’s growth.

Hidden Liabilities

Legal due diligence can help identify risks that may not be apparent from the company’s financial statements, such as pending or past litigation, regulatory investigations or audits and employment law violations.

Intellectual Property (IP) Strength

A healthcare company’s most valuable asset may be its IP, such as patents, proprietary software, clinical protocols and trade secrets. Legal due diligence will confirm the ownership, validity and enforceability of the IP.

Minority investments in healthcare companies can offer strategic advantages but come with unique risks, and legal due diligence is an important tool in mitigating those risks.

Governance Rights

Since a minority investor typically lacks control and visibility into the day-to-day operations of a healthcare company, an investor should consider negotiating some governance rights to monitor their investment, understand regulatory changes or business challenges affecting the company and have input on major company decisions. Governance rights can include:

Board Representation or Observer Rights

Minority investors may negotiate for a seat on the board of directors or observer rights. This allows the investor to stay informed about the company’s strategic direction and provide input on key decisions without having formal voting power on the board. Companies are often reluctant to have representatives of a strategic investor sitting on the board, particularly in the early rounds. There is often significant discussion and negotiation regarding confidentiality, conflict of interest and exclusion with respect strategic investor representatives in the board room, whether as a director or an observer.

Information Rights

These rights ensure that the investor receives regular updates on the company’s financial performance and strategic initiatives. This may include access to quarterly financial statements and annual budgets.

Protective Provisions

These are veto rights over certain major corporate actions, such as mergers and acquisitions, changes to the company’s governing documents or issuances of new securities. Protective provisions help safeguard the investor’s interests and prevent dilution or strategic shifts that could negatively impact their investment. The voting threshold for these protective provisions is often a majority or super majority of all Preferred Stock voting together as a separate class. Sometimes there are separate protective provisions for one or more series of preferred that generally cover a narrower group of company actions that can be vetoed.

Participation Rights

Also known as preemptive rights, these allow the investor to participate in future financing rounds to maintain their ownership percentage. This is particularly important in high-growth healthcare companies that may raise multiple rounds of capital.

Exit Rights

These provisions provide a path for the investor to exit the investment under certain conditions. Common exit rights include registration rights (for public offerings), tag-along rights (to sell shares alongside majority stockholders) and drag-along rights (to compel minority stockholders to sell in a sale of the company).

Strategic Acquisition Provisions

Strategic investors often pursue a full acquisition of a company in which they have a minority interest as an alternative to other exit events. The common provisions used to further this objective are: right of first notice, right of first offer, right of first negotiation and right of first refusal. Each of which gives the strategic investor different levels of information regarding a sale process, and a potential blocking or matching right to prevent acquisition by a competitor. Each of these rights will render the company less attractive to other potential buyers in a sale process. When talking with strategic investors, many companies are open to a right of first notice, but most will push hard to avoid a right of first refusal. These are among the most negotiated and contentious terms in strategic minority investments.

Establishing clear governance rights ensures minority investors have a voice in key decisions and safeguard their investment.

Economic Considerations

While a strategic investor may prioritize access to innovation or partnerships over immediate returns when investing in a healthcare company, it is still important for the investor to carefully evaluate the economic structure of the investment. Key considerations include:

Valuation

The investor should assess whether the company’s valuation is justified based on its current performance, market opportunity and growth potential. Overpaying at entry can significantly impact returns, especially in a minority position where control over future financing is limited.

Liquidation Preferences

These provisions determine the order and amount of proceeds distributed to stockholders in the event of a sale or liquidation. Investors often negotiate for a return of their capital (or a multiple thereof) before certain other stockholders receive proceeds.

Dividend Rights

While most early-stage healthcare companies do not pay dividends, investors may negotiate for cumulative or non-cumulative dividends to ensure some return on capital, particularly as the company grows and becomes revenue-generating.

Antidilution

These provisions protect investors from value erosion in the event of future down rounds (i.e., securities issued at a lower price). These provisions can be weighted average or full ratchet, with varying impacts on ownership and valuation.

Careful consideration of an investment’s economic rights and preferences is key to ensuring alignment of incentives and enhancing the likelihood of a successful investment outcome.

Minority investments in healthcare companies present a compelling opportunity for investors to participate in innovation and growth without assuming full control. However, these investments require a nuanced approach to risk assessment, governance and economic structuring. A thoughtful approach to minority investing can create strategic value while supporting the advancement of healthcare solutions.