Medical Device Link.

Originally Published MX March/April 2004

BUSINESS PLANNING & TECHNOLOGY DEVELOPMENT

Large medtech companies may be eager for corporate matrimony, but buyers and sellers still have a lot to consider before tying the knot.

Steve Halasey

For the past few years, the anemic condition of the global economy and correspondingly weak public equity markets have combined to restrain investment in medical technology companies. For many medtech companies seeking to pay off investors, the only viable exit strategy has been to seek out a merger or agree to be acquired—and hope that favorable terms could be found.

Today, with the U.S. economy seemingly on its way to recovery, the pace of mergers and acquisitions among medtech companies is showing signs of even greater favor. Large-company acquirers are actively on the lookout for emerging companies whose technologies could represent a breakthrough or key product-line extension. Meanwhile target companies are eagerly grooming themselves for sale at a valuation that might finally provide their early-stage investors with a reasonable return on investment.

But before the deals close, both buyers and sellers have a lot to consider. Working on such essentials in advance can ultimately help to smooth the way toward deals in which each side gains benefits, with a minimum of anxiety for both parties.

Buyer Aware

Brewster

Every specialist in medtech M&A has a list of top items that buyers should remember to consider when selecting potential acquisition targets—but not everyone's list is the same. Some of the differences reflect the experts' experience in dealing with companies at distinct stages of development.

"The elements that buyers need to be aware of change somewhat according to their sector of interest, but they differ substantially between an emerging company and a more established company," says Gary Brewster, senior vice president at Houlihan Lokey Howard & Zukin (New York City), an international investment bank. "Acquiring an emerging company is typically an intellectual property (IP) play, so the buyer needs to look at IP protection. For a more established target company, by contrast, the quality of the company's earnings is likely to be more important."

Following are some important factors that prospective acquirers should consider when selecting target companies.

Cohen

Strategic Fit and Synergies. Ideally, the acquirer and the target should each benefit meaningfully, says Richard S. Cohen, president of The Walden Group Inc. (Tarrytown, NY), a merger, acquisition, and strategic transaction firm specializing in the healthcare industry. "For instance, a large cardiovascular equipment and disposables manufacturer with an internal nationwide sales force calling on the cath lab and cardiac surgeons would benefit from, and could better commercialize, the new catheter technologies of a smaller company with limited sales and marketing resources."

"To optimize the value of the deal, both the buyer and seller should have a clear understanding of their own value—of what they are bringing to the table," says Brewster. "This knowledge will help the companies to determine whether the terms of the deal meet their objectives."

Growth Potential. "The buyer should determine the target company's key elements of value, and project how they can be protected or leveraged to create further growth," says Brewster.

"The target should either have discernible growth potential or fortify that of the acquirer," agrees Cohen. "Acquisitions are more successful when made to further top-line growth, as opposed to one-time cost reductions (eliminating duplicative functions and redundancies). As a long-term acquisition objective, revenue growth is a repeatable and self-reinforcing attribute, not a one-shot fix."

Profitability. "An acquirer needs to rigorously assess how profitable the target would be within its aegis," says Cohen. "Acquirers should not deceive themselves about cost-saving measures and other advantages whose achievement involves high levels of risk. On the other hand, target companies often have cost structures that can be significantly reduced through automation, creating economies of scale, and so on. Acquirers should have a plan how to increase margins."

"Buyers must determine what factors are the major contributors to the value of the deal," says Brewster. "To assess the potential of the deal, it's important for the buyer to know whether its value will derive primarily from growth, synergies, cash flow, economies of scale, or some other source."

Ryan

Employees and Corporate Culture. "It should be obvious, but many buyers focus on products, strategic fit, valuation, and so on, and forget to think about most companies' key asset—people," says Renee Compton Ryan, managing director in the Silicon Valley office of Broadview, a Jefferies Co. (Foster City, CA), a global M&A advisor with a specialty focus on the healthcare technology industry. "This consideration can cut both ways, leading acquirers to decide whether to keep a target's employees or use the acquisition as the means for rationalizing the organization. But whatever the determination, this is certainly the consideration foremost in the minds of a target company's employees."

"People are the strength of any organization," agrees Cohen. "Acquirers need to evaluate the key employees and whether the culture of the target will mesh with that of the acquirer so that there will be proper buy-in by each side. Integration planning should start well before the closing; teams of managers from both companies should collaborate on making the combination work. By involving managers in different disciplines early on, problems can be avoided after the closing and red flags have a higher likelihood of surfacing before closing."

Risk. "Often acquirers see what they want to see and overlook execution risk, competitors' countermoves, and so on," observes Cohen. "Acquirers should view acquisitions with a 'wide-angle lens.'"

Getting the Right Value

Even after a potential acquisition target has been selected, valuing the company can be tricky. In some areas, say the experts, the valuations adopted by medtech executives habitually miss the mark.

Highly uncertain assets and liabilities such as early-stage intellectual properties and regulatory risks are notoriously difficult to value, says Brewster. "This is true for both upside opportunities and downside risks. There is a tendency to round everything to either a 0% or 100% likelihood of success. If an event has a low likelihood of occurrence, it is often ignored; and if it has a high likelihood, it is often assumed as a fact. But neither assumption contributes to a more-accurate valuation."

"I'm a big fan of the real-options or decision-tree school of valuation for growth-oriented medtech assets," says Brewster. "But for those who find the analytics of that approach to be a little bit much, a well-structured qualitative process of evaluating risks and opportunities is still extremely helpful."

For some aspects of company valuation, adopting such a qualitative approach is essential, says Ryan. "Since many aspects of medical device M&A are nonquantitative—including patents, regulatory affairs, and reimbursement issues—buyers should build their own financial model of the business according to what they believe. The model should include factors such as strategic fit, follow-on products, cost rationalization, and so on.

"And since these key nonquantitative factors can have a decisive influence in driving valuation," Ryan adds, "target companies should be very explicit about their value in these areas."

"In valuing any such assets (regulatory approvals, reimbursement challenges, IP, and information technologies), acquirers need to consider not only risk, but also the time it would take the acquirer to achieve the same objective and get the products in question to market," agrees Cohen.

"Assets should generally be valued in terms of their contribution to the ability of the company to generate cash flow," says Cohen. "Certain acquired assets, such as patents, might be defensive in nature, shoring up the buyer's cash-flow generation.

"Some assets that may contribute to profits in future years, and therefore involve uncertainty, could be valued, to a certain extent, on performance measures. For instance, if reimbursement is not obtained for a critical target product line within a given period, an offset might be made to a portion of the purchase price that has been deferred."

Even when such strategies are employed, however, some assets and liabilities defy valuation, says Brewster. "The costs related to postmerger integration are often undervalued," says Brewster. "So is the challenge involved in getting additional funding, if it is needed—as it often is for emerging medtech companies."

High-Value Neglect

When it comes to preparing for an acquisition, it makes sense that target companies should seek to match their qualities to those that acquirers find most desirable—and most valuable. According to the experts, however, many start-up medtech companies fail to focus on the key areas that can ultimately bring them the greatest return.

"It's essential for target companies to get the basics right," says Brewster. "That means that its financial statements should be well organized, providing clear documentation of the company's assets and intellectual properties. If a potential acquirer expects to see certain information, but doesn't, it will assume the worst."

It also means that target companies should be able to show a strong performance record. "Demonstrating that the company can set and meet its goals will go a long way with prospective acquirers," adds Brewster.

An ability to focus is also an important asset. "Start-up medtech companies often seek to replicate large companies, assembling expensive infrastructure and sales and marketing resources to advance a core technology and product line," notes Cohen. "Instead, targets should focus on their core technology, research, and product-line development. Only large companies have the breadth of products and the economies of scale to support a large internal sales and marketing organization. Smaller companies should consider sticking to what they do best—developing and refining distinctive products and services—and should align with larger companies for sales, marketing, and administrative services."

"Companies should focus their investment on the areas in which they do well," agrees Brewster. "If the company is a technology innovator, company leaders should make sure that aspect of the company continues to move forward. If it has a therapeutic area or particular customer focus, they should maintain that strength."

The one area in which a start-up medical device company with limited resources shouldn't scrimp is in its clinical trials, says Ryan. "Running robust, well-designed, well-managed clinical trials is expensive but it can reap long-term benefits. Since any exit strategy is highly unpredictable, the more a company can do to position itself for successful commercialization, the better. Good clinical results aid in gaining reimbursement, clinical acceptance, market adoption and, ultimately, a high sale price."

Illustration by BARTON STABLER

Copyright ©2004 MX