Medical Device Link.

Mergers and Acquisitions:
What Every Company Should Know before Saying "I Do"

The decision to acquire or be acquired is one that nearly every medical manufacturing firm will eventually face. If a company plans carefully, finds the right partner, and follows a considered process, the merger, like a good marriage, will benefit both parties.

Ralph W. Carmichael

With so many businesses in every industry joining forces through mergers and acquisitions, deciding whether to enter into such agreements must be an essential part of strategic planning for any company. Analysts estimate that during 1999, some 6877 companies in all industries were acquired at a total value of more than $971.8 billion.¹ By fall 2000, 6312 companies had been sold for more than $1 trillion.

Like businesses in other industries, medical device manufacturers must take into account the frequently shifting relationships of their competitors. Fortune 500 medical device manufacturers acquire or merge with other companies to increase their market share and leverage research and development investments. Smaller firms enter relationships to gain access to distribution and financial resources. Large or small, all medical manufacturers must consider mergers and acquisitions as a way to stay competitive in a constantly changing industry.

Companies enter relationships not only to survive competition, but also to grow. When other methods of growth, such as new product development, are not viable given a firm's resources, mergers and acquisitions can offer the best solution. Because of the current high employment rate in the United States, the personnel needed for new product development may not be available. Also, as interest rates rise, the capital needed for product development may be too costly. Therefore, firms may find that the most effective way to grow is to enter into an agreement with other companies.

As useful as these agreements can be, however, mergers and acquisitions can also be very risky to all parties involved. Therefore, companies must consider their needs and develop a comprehensive plan well before they actually look for a partner. Proper planning is key to achieving the company's objectives. A clear and concise strategy may make the difference between selling a company for 10 times its annual revenue or selling it at a mere fraction of its annual revenue.

Once the planning stage is complete, companies must determine whether the timing is right and whether to use an intermediary to handle negotiations, and compile a list of potential partners. The company must meet with these candidates and, once the determination is made to begin negotiations, follow an open, carefully considered process to successfully conclude the deal.

Analyzing Strengths and Weaknesses

To develop a mergers-and-acquisitions strategy, a company should begin with a comprehensive analysis of its own strengths and weaknesses. If the company is seeking to be acquired, this analysis should be conducted from a potential buyer's point of view. This is the best way to ensure that all issues related to the sale will be objectively considered. If the company is seeking to acquire another firm, the analysis of strengths and weaknesses is conducted to point out the areas in which the additional resources of another company are needed.

Typically, large companies have adequate financial and distribution resources, but lack creativity in developing new products. Smaller companies are in the opposite situation; they have innovative product development teams, but they also have limited capital and ineffective distribution networks. Through an agreement between a large and a small company, the large company can gain access to new products, and the small company can receive more financial and distribution resources.

Honesty is the key to a successful analysis. Managers often have a difficult time evaluating their own company's weaknesses. However, companies must be aware that potential partners will be more critical and will look for even small problems as a way to reduce or raise the cost of an acquisition.

Companies seeking to be acquired should be aware of how potential buyers will be assessing them, and purchasers should evaluate each of the following aspects of an acquisition candidate.

Products. A purchaser must consider not only the strength of a company's products in terms of design or functionality, but also what production resources will be required and whether the products will be a good fit for its own product line. The purchaser should assess whether the products are fully developed or need additional development time. The company should also consider whether products have the necessary FDA or CE approvals, whether the products perform as advertised, and whether they complement its existing products.

Technology and Intellectual Property. An early-stage company's value often hinges on the strength of its intellectual property position. A purchaser must consider whether a promising new technology will really be profitable if competitors begin to produce it as well. The buyer should consider whether the acquisition candidate owns its patents, copyrights, trademarks, or trade secrets.

Market Acceptance. A buyer must determine whether products are likely to be accepted by the medical market. To predict this, the company can review the market share that the products already have or use research to determine what the market share is likely to be. Market share must be carefully evaluated, however, because a large share can actually be either a positive or a negative factor, depending on antitrust legal issues. Other factors the purchaser can take into account to determine the market acceptance of products are whether the products have a champion doctor or whether they are used in top hospitals, such as Massachusetts General (Boston), the Mayo Clinic (Rochester, MN), or the Cleveland Clinic.

Capacity. A buyer should consider the production capacity of a potential acquisition as well as its own production capacity. It may be difficult to staff a large facility in a short period of time. Therefore, a purchaser should make sure that it will be able to provide adequate production facilities and staff after the acquisition.

Time to Market. Because a purchasing company brings new resources to a product development effort, an acquisition will no doubt decrease the time to market of new products. However, a purchaser must consider its resources, as well as the acquisition's resources, to determine whether the time to market will be adequate to ensure that the relationship can be profitable.

Geography. An acquisition candidate's physical location must be taken into account in a purchaser's decision. A small company in New York may not be a good fit for a company in Arizona, because such a distance between the two may strain management resources. However, an acquisition in a distant area, even in another part of the world, may allow a company to break into a new market.

Management. Human resource issues are an essential part of any acquisition transaction. Sometimes buyers even acquire companies to expand their management resources. However, lack of management resources or management teams that do not work well together can be a serious problem in a relationship between companies. For example, entrepreneurial managers dominate many small companies, but may not fit well within a large organization.

Corporate Culture. Just as management personalities are an essential consideration for buyers, the culture of the companies as a whole is also critical in the success or failure of the acquisition. Combining an entrepreneurial culture with a bureaucratic environment can lead to disaster.

Cash Flow. Buyers should look at the cash resources of a potential acquisition. If the candidate has a positive cash flow, that company will obviously be worth more in an acquisition than one that needs capital to survive. If the purchaser has access to a large amount of capital, a cash-poor company may actually be a good investment, as its valuation will be low.

Valuing an Acquisition

Once a company has considered its own strengths and weaknesses, it can begin determining what kind of value it can place on itself or what it may be likely to pay for an acquisition.

Company valuations are an art, not a science. Basically, the value of a company will be determined by what a buyer is willing to pay. Assumptions are built into valuations about the future performance of a company. Buyers evaluate a variety of factors in determining the value of a company, such as returns on investment, cost of capital, potential dilution on earnings per share, future capital requirements for the acquired company, and payback periods.

A survey of recent acquisitions in the medical device industry conducted by Carmichael & Co. (New York City) shows that companies are typically valued at 3.97 to 10.42 times their annual revenue. Guidant Corp. (Indianapolis) is currently paying some of the highest values for medical device companies, at 12.73 to 38.73 times annual revenue. Values vary widely. Some companies sell for 10 times their annual revenue—for example, Spine-Tech (Minneapolis) to Sulzer Medica (Winterthur, Switzerland)—while others go for only 1.27 times their annual revenue—for instance, Image Guided Technologies Inc. (Boulder, CO) to Stryker Corp. (Kalamazoo, MI). Typically, the potential for future profits drives valuation. However, in the medical device industry, protection of market position may be the determining factor in valuation.

Defensive acquisitions are becoming commonplace in the medical industry. A defensive acquisition is one in which a large company buys a smaller company to protect market dominance. This trend will no doubt continue as the medical device industry continues to consolidate and become an oligopoly. Valuations for defensive acquisitions are generally high. For example, Stryker Corp. dominates the bone cement market with its Simplex product, and has approximately $100 million in earnings at risk in that segment. It is therefore worth a great deal to Stryker to prevent Zimmer Inc. (Warsaw, IN), a wholly owned subsidiary of Bristol-Myers Squibb Co. (Stamford, CT), from gaining control of a small company with superior bone cement technology. Fear of competition drives values up. Proprietary technology and a perceived competitive threat in the market are important factors in increased valuations.

Given an analysis of strengths, weaknesses, and market conditions, a selling price can be proposed. Owners of the potential acquisition should establish a range of values that they are willing to accept. Buyers should consider the amount and form of consideration they are willing to pay. The key to successful agreement is that both parties are realistic in these expectations. If companies in a particular sector of the industry are selling for 2 to 10 times their annual revenue, then chances are that about 98% of all acquisitions will fall within this range. Trying to negotiate for a much higher or lower selling price may jeopardize an otherwise favorable transaction.

Getting the Timing Right

As with investing, market timing is a critical factor in a successful merger or acquisition. Once the assessment and valuation have taken place, companies must consider whether the time is right for a transaction.

Buyers may not see a return on their investment for years, if ever. For example, The Quaker Oats Co. (Chicago) paid $1.7 billion for Snapple Beverage Group (White Plains, NY) in December 1994, and sold it for a $1.4 billion loss to Triarc Cos. Inc. (New York City) in March 1997. Quaker had underestimated the market for iced tea products.

Sellers should also evaluate market conditions before deciding to enter an acquisition transaction. Selling companies should consider whether they are in a growing sector of the market. The greater the perceived market potential is, the higher the value placed on companies within that market will be.

Deciding Whether to Use Intermediaries

Often the relationship between two companies can be greatly facilitated by the diplomatic efforts of a third party, such as an investment banking group. The mergers-and-acquisitions process is unfamiliar to most companies. The process of buying or selling a business is also time-consuming and a drain on resources. Because acquisitions are so important to the financial future of the company and of the principals involved, companies are well advised to use investment bankers for these essential transactions.

Investment bankers are skilled in negotiating, structuring, and closing such deals. Of course, bankers will charge fees for their services, ranging from 2–10% of the transaction value, depending on the size of the transaction. Companies must assess whether bankers will add sufficient value in terms of the price of the transaction, the time saved, and the increased probability that the transaction will close successfully.

Also, the use of intermediaries can be essential to keep acrimony from arising between companies that must later work together. In the case of a competitive auction or bidding war, for example, the valuation of an acquisition may become inflated, leading to animosity after the closing. Investment bankers can shoulder the responsibility for such a high valuation.

Finding a Partner

Once the planning phase is complete, companies must actively seek the right partner for their needs. Potential sellers must compile a complete description of the company, often referred to as a selling memorandum. All relevant information concerning management, marketing, products, and operations should be disclosed in this document. The analysis of strengths and weaknesses completed during the planning phase will assist in the development of the selling memorandum. The memorandum should be honest and objective. Any problems must be disclosed to potential purchasers early in the process, because they will ultimately be discovered in the due diligence phase of the transaction. At that time, potential purchasers may walk away from a transaction if they have been misled.

Whether a company wants to buy or sell, it must establish a set of criteria, such as a price range or product type, to help it identify a suitable partner. The initial analysis of strengths and weaknesses will help a company to develop these criteria. The company should then create a list of potential partners that meet the criteria. Industry databases, such as Bloomberg or Dun & Bradstreet, can be used to determine candidates. Trade publications can also be used to identify suitable medical device companies.

Before initiating any contact with potential partners, a company should carefully research the candidates. Publicly available documents, such as SEC or legal filings, should be reviewed, and a search of pending litigation should be conducted using Lexis-Nexis or WestLaw.

Making Contact

Initiating contact with potential partners can be stressful, but companies should remember that if the terms are right, any company will be willing to negotiate. If a company is ready to discuss an acquisition, a confidentiality and standstill, or no-shop, agreement should be executed. The confidentiality provisions will allow the parties to be open in their discussions. The standstill aspect of the agreement prevents a company from using a proposed transaction to begin a bidding war. A buyer does not want to get into a bidding war, because the valuation may become inflated, and a seller does not want a buyer to negotiate with competitors to force the valuation lower.

For the first meeting, companies should prepare a specific agenda that addresses the scope of the potential transaction, valuation, possible structures, financial resources, and timing and be ready to discuss terms. Typically, the first meeting will accomplish only introductions, but one of the parties may wish to move faster.

As the meetings progress, both parties should take the time necessary to gain a thorough understanding of their potential partner.

Coming to Terms

If both parties decide to enter a transaction, their next step is to negotiate a term sheet or letter of intent that discusses all major business points. There is disagreement among mergers-and-acquisitions professionals about whether a letter of intent is really necessary, as these documents are generally nonbinding. However, the negotiation of the term sheet is likely to uncover potential problems with the transaction. If the terms cannot be agreed to, it is doubtful that the transaction will ever be consummated. Also, the term sheet gives the lawyers a road map to follow that should lessen the work they must do and reduce their fees.

Structures of mergers and acquisitions are often driven by tax considerations. For example, development companies may have large tax-loss carry-forwards that are valuable to a purchaser. In some cases, it is advantageous to purchase only the assets of the company and reduce the exposure to liabilities. In others, it makes more sense to take advantage of the benefits of pooling. Pooling is an accounting method in which goodwill is not recorded on the books of the purchaser. Goodwill is unattractive, because it is amortized and expensed.

In coming to terms, companies should be open to the possibility that a buyer may wish to pay for acquisitions with stock or notes. Generally, valuations for such transactions are at least 35% greater than those for comparable cash transactions. Sellers should be ready to discuss a stock-based transaction if the buyer is a public company. Stock-based transactions may provide extremely favorable terms to the sellers, especially if the stock appreciates quickly. Also, stock-based transactions allow sellers to defer taxes until the stock is sold.

Proceeding with Care

Finding the right partner for a merger or acquisition can help to eliminate the weaknesses and enhance the strengths of a company. When a business becomes unable to expand further given its internal resources or the state of its market, it can use a well-planned agreement to gain access to essential capital, research and development facilities, or distribution networks. A successful acquisition brings together a buyer and seller whose resources and needs are a perfect match.

But the mergers and acquisitions process can be very difficult for many companies. The parties involved must plan carefully, analyzing their own strengths and weaknesses, determining whether the timing is right, choosing whether to use intermediaries to handle the process, and conducting research to find suitable partners. Once contact is made between candidates for a transaction, the companies must work to come to terms in an open and structured process. The process can require a large investment of time and other resources, but, like any marriage, a binding relationship between two companies should not be entered into lightly.

Reference

1. Mergers & Acquisitions Report 13, no. 33 (2000): 1.

Ralph W. Carmichael is founder and principal of Carmichael & Co. LLC (New York City), an investment bank that specializes in the medical device and telecommunications industries.

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