David Reilly

Cronus Partners LLC

The orthopedic industry is highly fragmented and the majority of the suppliers have remained private and non-institutionally owned. In contrast (highlighted in Figure 1) most OEMs or technology-focused product companies tend to raise institutional capital along the way, due to funding needed and risks inherent in developing proprietary orthopedic products. Private business owners eventually exit—selling all or part of the business, merging with another company, selling shares to the public or passing the business to family members or employees. Regardless of size or whether an OEM or supplier to the industry, there are certain actions that owners can take to help enhance value now and maximize it in the future.

Start With an Exit Strategy

Businesses backed by venture capital or private equity typically have a formal exit strategy from the start. In contrast, most private business owners do not thoroughly plan for the inevitable transition. Owners first should determine the optimal alternatives in the context of their own objectives and should be realistic about priorities, recognizing that non-financial attributes such as pride, independence and strategic and operational control (the “personal value”) are likely to contribute to an overall value that exceeds the financial value of the business. Each type of exit calls for a different plan, corporate structure and timetable. Expecting a buyer to approach with an offer too hard to resist is not a strategy for maximizing value, and relatively few satisfying exits happen that way.

Three criteria dictate the optimal time to maximize value, and each evolves, requiring constant monitoring. The first is lifestyle priorities, when financial value trumps personal value. The second is the capital market and industry-specific mergers-and-acquisitions environment, because a business’ value changes with market conditions. The third is the business’ specific position on its growth curve, which are company-specific criteria within an owner’s control. Buyers do not ascribe value to effort or sacrifices—only successful execution of a plan to enhance value.

Back to the Future

In simplified terms, the financial value of a business is equal to the future free cash flows discounted back at a risk-adjusted rate. The value may be higher (ie, at a premium) to a different owner because synergies lead to greater free cash flows and/or a lower discount rate is justified. The common challenge for all owners is determining the right levels of free cash flow to sacrifice (reinvest) for the prospect of greater cash flows in the future. In the real world, the value of a business translates into what a buyer is willing to pay; thus, a successful strategy should consider what those potential buyers will value.

The Good, the Bad
and the Ugly

Valuation is a blend of both quantitative and qualitative factors, and all companies are valued differently based on different attributes, many of which can be quantified and monitored. Start by benchmarking the company’s metrics with those of industry peers and by understanding meaningful variations.

While conceptually complex, valuation multiples reflect a required return on investment based on confidence in the growth of that parameter—the greater the risk, the higher the required rate of return, the lower the multiple and vice versa. An understanding of the metrics that are relevant for your business enables you to identify what drives its value and what fits different buyers’ objectives.

It’s Not All About
the Bottom Line

Strong management, competitive differentiation, intellectual property, brand identity and reputation, as well as scale and scope of business are key business attributes across industries. A valuable corporate brand is the perception of core competencies, technological expertise, defensible competitive advantages, product quality, reliability and responsiveness, independent of current ownership. The future value of the business should not be dependent on the current owner remaining with the company. A strong brand identity supports the value potential of cross-marketing with a buyer’s business.

Value is derived from the business’ perceived opportunity for expansion and revenue growth, as well as specific technologies, manufacturing competencies and/or excess capacity that can be utilized across a buyer’s business. And size does matter—other factors being equal, a business with revenues of $50 million typically will enjoy a higher multiple than one with $25 million; however, one should consider whether the capital and time requirements to grow the business (and the associated risks) are worth the potential incremental value.

Risky Business

Valuation partially is based on the risk associated with the business’ prospects, which is implicit in a multiple. While many risk factors—such as reimbursement, the regulatory climate or raw material prices—in the orthopedic industry cannot be controlled, several factors remain within the owner’s control. In addition to having strong financial controls and clean books, owners can minimize risk with an optimal product mix and diversified customer base. An orthopedic supplier whose gross profits derive from a dozen customers will generally enjoy a much higher valuation than an otherwise identical supplier dependent on just a few.

Customer or distribution relationships are more valuable the less dependent they are on the owner or a few key managers. Diversifying responsibility for important accounts may be inefficient in the short run but often can be expected to be more than offset by the long-term value.

Better Late Than Never

If addressed early enough, the right corporate structure also can help maximize value at the time of exit by minimizing risk and tax consequences, not only to the seller but also to the buyer (potentially unlocking more value to the seller).

While devising and monitoring a value-enhancing exit strategy may not now be on the list of priorities, doing so early and often will enable a company to be well positioned to seek to maximize value once the timing is right.

David Reilly is a managing director of Cronus Partners LLC, an investment banking firm that specializes in mergers and acquisitions, private placements and financial advisory services. He leads the firm’s healthcare practice and can be reached at (203) 642-0200 or [email protected].

Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.