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Successful Divesting
Reprinted from MX Magazine (Business Strategies for Medical Technology Executives) with Permission

Ten tips for handling a crucial, although often underestimated, business phase.

Richard S. Cohen

Those selling a business, division, or product line often do not conduct the planning necessary to make the process efficient, minimize disruptions to ongoing operations, and obtain the best transaction terms. Executives and managers are often enmeshed in day-to-day business affairs, struggling to get new accounts, improve manufacturing efficiency, convert new technologies into finished products, speed up order delivery, and resolve organizational issues. With so much on their daily business agenda, optimizing the divestiture process can easily be put on the back burner.

But failure to carefully plan for a divestiture may mean the difference between a successful transaction and a disappointing or even damaging outcome. Although a divestiture may appear to be a straightforward transaction, the process is always time-consuming, distracting, and complex, and it involves operating, strategic, financial, accounting, tax, personnel, and personality issues.

To handle these issues and conduct a successful divestiture, executives and managers can employ 10 helpful tips developed from insider experience with this difficult business process.

Assume the Role of the Acquirer

Assuming the role of the potential acquirer is by far the most important tip for a successful sale. Acquirers look for certain attributes in a business, often called acquisition criteria (see sidebar, page 65). By shaping a business for sale so that it conforms to or at least addresses these criteria and by contouring the presentation to the target audience, corporate sellers can make a business significantly more attractive. Sellers should try to think the way acquisition executives do and anticipate what might create a positive or negative impression.

Assuming the role of the acquirer is easier said than done. Businesses operate within the narrow confines of their own resources, experiences, and corporate cultures. It is often extremely difficult to anticipate the acquisition needs and expectations of the broader market of potential buyers, especially with different buyers seeking different elements in a business. But understanding the concerns of the acquirer is the best way to ensure that a business will sell and attract top value.

Assemble the Appropriate Advisers

The complexity of a divestiture is frequently underestimated. In most transactions, it pays to retain a qualified mergers and acquisitions (M&A) intermediary who is expert in the process and familiar with the industry segment involved.

If there are only a few logical acquirers, it may make sense to conduct the transaction without such outside professional assistance. However, even in such a situation an experienced, well-connected intermediary can perform several valuable functions.

First, the intermediary provides the critical outsider's perspective that positions the business to maximize its attractiveness and value. Very often, managers view their business in the context of its present corporate structure and limitations, and they fail to identify opportunities that may be seized by outside companies. An existing business may be restricted by inadequate resources devoted to research and development, manufacturing, sales and marketing, or distribution. Professional intermediaries can provide an independent view free of those constraints.

This independence also contrasts with conflicts of interest that may arise when a divesting company delegates the transactional responsibilities to the manager of the business being sold. The manager's interests may differ from those of the parent company.

Frequently, internal M&A professionals turn to competitors as prospective acquirers. But giving competitors an inside look at the company is risky. Instead of buying the subject business, a competitor may decide to integrate its newfound knowledge into its own product line. Besides, competitors are frequently unwilling to pay full value for a product line with which they are already familiar.

A qualified intermediary can identify companies that may not at first appear to be logical suitors, but that will be willing to pay top dollar because the business fits into their strategic plans. When conducted properly, the acquirer identification process often yields more than one bidder, providing alternatives for the seller and creating a competitive dynamic that can dramatically improve the transaction terms.

Intermediaries can also insulate the seller's operations from the potentially disruptive aspects of the transactional process. Top-level executives often want to keep potential divestitures confidential within their organizations until the transactions reach an advanced state. By moving the transactional efforts off-site, such executives can pursue their mainstream functions while keeping news of the impending sales from infiltrating their organizations.

An intermediary can also serve as a buffer during negotiations and as a source for information that otherwise may not be disclosed to the selling organization.

Along with the intermediary, seasoned lawyers with M&A experience and the firm's accountants should also be part of the divestiture process.

Time the Process to Maximize Value

The best time to sell is when it is not absolutely necessary to do so. Divestiture may be the last thing an executive considers when a subsidiary is performing well, new accounts are being obtained, and orders and order sizes are increasing. However, it is much better to sell a business when it is on the upswing than when growth is flattening out or reversing. Acquirers will typically value an upward trend by assuming it will continue.

The decision to hold or divest hinges, of course, on many factors, but two of the most important are whether the promise of future profit will be realized and whether outside market and other forces could jeopardize that promise.

Many unforeseen occurrences can subvert the best-laid plans for a business. Among these problems are employee departures, regulatory amendments, new market entrants, a market downturn, a technological change, loss of an important customer, or a key vendor incurring production or financial problems.

Executives should sell when the business has maximum perceived value and not incur undue risk. After all, there are opportunity costs involved in not selling; the parent company does not receive the transaction proceeds, which could be put to more profitable use elsewhere, and its organization is still required to operate the business while risking a future decline in valuation.

Obviously, an established product line with a historical growth pattern and wide-scale distribution would be very attractive. However, the motivating factor for divesting a medical device line is often a problem with distribution. Medical supply networks are tightening because of consolidations at the provider and distributor levels.

Inadequate distribution is certainly not fatal. In fact, it can be converted into an opportunity. Acquirers need to feel that they can add value to a business that they are buying. Therefore, a product line that has technological integrity, reflects certain advantages compared with the competition, and has the capability of greater sales volume will be attractive to acquirers even though the product line is not well distributed. Distribution is part of the value to be added by the buyer.

Typical Acquisition Criteria Acquirers may be attracted by different aspects of the companies they buy, but some values are generally favored. Following are some desirable characteristics that acquirers seek when they seek out companies to purchase. A niche, proprietary, or clearly defined product line that is distinctive compared to the rest of the market. A track record of profitability (or at least tangible evidence of near-term profit potential). Clearly discernible growth potential. A product line that consists of a family of products, justifying sales, marketing, and administrative efforts to support the product line. A diversified customer base without undue reliance on a few key accounts. An industry segment that is growing. A strong management team.

What is important is to demonstrate demand for the product in a manner that permits the acquirer to infer that it can significantly expand revenue by applying its own marketing prowess, product development capabilities, and distribution network.

Being prepared with financial statements that will withstand outside scrutiny is critical. Acquirers that are public or plan to be public will usually require audited numbers or statements that are incorporated into audited numbers. Corporate sellers should present income statements for at least three years, as well as for interim quarters in the current year and prior year. Balance sheets for the last two fiscal year-ends and a current quarter-end should also be provided. Certain cash flow amounts, notably capital expenditures and capitalized R&D costs, should be available as well.

When a product line, division, or business unit is being sold, stand-alone financials need to be presented in a manner that isolates the core business.

When addressing a strategic acquirer, it is useful to present a second set of operating statements on a direct variable cost, without parent-level overhead allocations. Every company has its unique cost structure, and the seller's overhead allocations, such as rent, utilities, management costs, and administrative expenses, will be different from the buyer's. With this alternative presentation, an acquirer can apply its own overhead assumptions to determine how much the product line or business unit will contribute to the acquirer's operating profits. With the existing overhead filtered out, operating earnings will be higher, providing a better basis for a high valuation.

Of course, any nonrecurring or extraordinary items should also be separately presented and added back to arrive at adjusted operating earnings. The key is to present the normative earnings of the business—the earnings an acquirer can expect to achieve after the acquisition.

If the business is expected to grow, the selling corporation should focus attention on future earnings. A budget for the current year as well as a projection for the next three to five years should be presented. Usually, serious acquirers will create their own forecast, but it makes sense to take the initiative. Sellers should be prepared to justify the forecast and to detail the steps required to meet the forecast milestones.

The projections should be based on reasonable assumptions and should not be overly aggressive, particularly in the early years. The transactional process can take many months, and actual monthly and quarterly results will be compared against the forecast budget. For this reason, it is better to be a bit conservative, so that actual results meet or exceed the projected budget, than to fall short and be put on the defensive.

Reduce Dependencies

A business will be rewarded if it has few dependencies. Perfection is a business that has a diversified customer base, is not tied to one or a few suppliers, and has a broad-based organizational structure that will not be crippled by the loss of a key employee.

A business that does not meet such an ideal profile cannot change overnight. But the seller can create a plan to make improvements and take some steps to implement the plan. Completing the task is not necessary. The important point is to provide acquirers with a blueprint for future action. The plan should be reasonable and build on existing strengths.

One of the most important dependencies to consider is dependency on the parent company. The business that is being sold should own all the machinery and tooling required to manufacture its product line. If this is not possible, alternatives should be proposed to the acquirer for ensuring sufficient production means, such as a list of outside contract manufacturers and sources of new or remanufactured machinery.

If key personnel are needed in R&D, production, or sales and marketing, efforts should be made to keep the organization intact. Administrative functions do not have to be retained. In fact, the acquirer will probably want to use its own administrative personnel in order to obtain operating leverage and centralize efforts.

Intercompany accounts should also be settled and cash balances resolved before presenting the transaction to an acquirer. Otherwise, these internal transactions will need to be justified to the outside party, with a possible negative effect on the price.

Create an Impressive but Credible Presentation

Everything about the presentation of information to a potential acquirer should reflect the professionalism and quality of the business under discussion. The seller should anticipate an acquirer's due diligence list and provide certain information before being asked to do so. Much of this information can be given to the potential acquirer in a transaction memorandum.

The transaction memorandum serves as an important medium to describe how the business should be positioned. The memorandum permits the seller to frame the issues and major themes for the acquirer.

Transaction Memorandum Topics By preparing a transaction memorandum, the seller can anticipate issues that will be raised by the buyer and can frame responses that will put its company in the best light. The transaction memorandum should include the following topics: Executive Summary. This section should provide a short, self-contained overview. In fact, some acquirers will abort their review of the deal if the summary does not make sense. Negatives should also be described, put into a larger context, and, if possible, presented as opportunities for improvement. Background. The historical development of the business in question should be described. The reasons behind the transaction can also be given. The rationale often reflects a lack of synergy and critical mass within the selling organization. Product Lines. Each product line should be described. Financial tables and charts displaying revenue and gross profits from each product line should be included. To the extent that the composition of total revenues has changed over the past few years or one or more product lines have shown marked growth, a multiyear presentation is merited. It can be helpful to present the cost of goods sold on a direct variable cost basis, while also describing inventory accounting methods. Customer Base. Each customer segment, such as acute-care facilities, alternate sites, or OEMs, should be addressed and the revenue contributions disclosed for each. If geographical market breakdowns are material, the business's experience in each market should be described. Certainly, domestic and foreign customer segments should be separated, and sales to important foreign markets should be highlighted. Again, if there is a historical shift in the proportion of total revenues derived from different geographical markets, several years of data should be shown. A customer ranking should also be supplied to address customer concentration issues. Sales and Marketing. The core marketing message should be clearly stated. The key elements of the marketing effort, such as product quality and effectiveness, customer satisfaction, and technological features, should be described. How the products are distributed should also be mentioned. Whether distribution is conducted via internal sales personnel, outside reps, distributors, direct marketing, or some combination of the above should be explained. Organization and Operations. The organization should be described, and an organizational chart listing titles, functions, and longevity, but not personnel names, should be provided. (Names are not included so that key employees will not be recruited or even contacted by one of the memorandum recipients.) This section should also a include description of the manufacturing and assembly operations, significant machinery requirements, proprietary production processes, outsourcing relationships (such as contract research, sterilization, or packaging companies), key supplier relationships, and raw material needs. An explanation of the general workflow and departmental responsibilities is also helpful. Management information systems, including material requirements planning, bills of materials, and other production modules, can be presented in this section as well. Markets and Competition.The business will likely be more valuable if the market for its devices is expanding and currently large enough to justify an expenditure of time, effort, and funding by the acquirer. Market size and growth data should be given, but not overstated. All that should be conveyed and supported is that the market presents significant opportunities for expansion. Competitors should also be mentioned, but need not be examined in detail. Financial Information. A description of the present and projected financial situation of the business should be included.

Of course, no confidential information should be provided before an acquirer signs a nondisclosure agreement that not only compels the acquirer and its affiliates and advisers to keep the imparted information confidential, but also compels them not to disclose that the discussions are taking place or that the seller is considering a corporate transaction. An added provision may also prevent the recruiting of key personnel for a certain period of time.

It is neither vital nor prudent to include every last detail in the memorandum. Presumably, the memorandum will be presented to some parties who may not want to proceed further; therefore, it is important to scale the information flow to the level of interest expressed by the acquirer. Additional information can always be given later.

Topics that should be addressed in a transaction memorandum include an executive summary, company background, product lines, customer base, sales and marketing strategies, organization and operations, markets and competition, and financial situation.

In addition to the transaction memorandum, due diligence items, such as contracts, leases, patents, trademarks, clinical studies, and corporate proceedings, should be readied for later inspection.

Provide a Plan for Growth

Just because a business is not realizing its potential within the seller's organization doesn't mean it won't flourish within another. An acquirer may have the needed resources, such as R&D, manufacturing, marketing, or distribution capabilities, to propel the business forward.

Ten Tips for Divesting 1. Assume the role of the acquirer. 2. Assemble the appropriate advisers. 3. Time the process to maximize value. 4. Show how distribution can be improved. 5. Present an organized set of financials. 6. Reduce dependencies. 7. Create an impressive but credible presentation. 8. Provide a plan for growth. 9. Develop a creative list of prospects. 10. Create a compelling basis for your valuation.

A seller should provide a plan for a potential acquirer that shows how the business can be expanded. Often this plan is used by the acquirer as a basis for deciding whether to go forward, or at least to stimulate an assessment of the opportunities.

To compose a list of companies to contact, a seller can start with competitors. But the seller may not want to contact many of them for reasons discussed above, and should be creative in developing a list of other contacts.

Potential market entrants are likely to represent a better pool of prospects. Depending upon the circumstances, it is usually less expensive and less risky to enter a market by acquisition than by starting a new line from scratch. Researching these companies takes some time, but it is likely to yield acquirers who are willing to pay more than competitors.

Generally, businesses that generate a positive cash flow are valued on their ability to continue to do so, and substantiating this valuation to an acquirer is essential.

One of the textbook valuation methods is to derive net present values by discounting future cash flow streams using rates that reflect the risk involved with obtaining those cash flows. Often, a matrix is created posting the results of variable inputs. Typically, so many assumptions are built into this model that acquirers may not rely on it, even though they will perform their own net present value and internal rate-of-return analysis.

The common shorthand is some multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA)—a somewhat superficial valuation method, but one that is so commonplace it must be considered. This multiple method is really the capitalization of a perpetuity. It assumes a constant amount (EBITDA) and multiplies it by a number that is the reciprocal of a capitalization rate. The key is to find the representative EBITDA amount, which is adjusted to reflect the business's normative earnings, and an appropriate multiplier, which reflects the business's growth potential and the risks in obtaining the stated EBITDA annually.

As noted previously, care should be taken to reconstruct the cash-basis operating earnings the acquirer can expect to achieve after acquisition. If the present year is more representative than the prior year, attention should be shifted toward it, even though the current year is not completed.

Established businesses with moderate growth potential are typically accorded a multiple of between 5 and 7 (capitalization rates of between 14.3 and 20.0%). Businesses with a steeper growth trajectory should be given a higher multiple. An understanding of the valuation of comparable transactions is helpful here as a frame of reference.

Because of the importance of the adjusted EBITDA amount and multiple in deriving a valuation, sellers should make the case to increase each. As a backup, or if the business is not profitable, an asset value orientation may also be used.

The corporate divestiture process is complex and involves many factors, but potential sellers can significantly enhance the likelihood of a successful transaction by following a few basic tips. Because divestiture terms can be critical to the overall health of the selling company, it is wise not to underestimate the effort and planning needed for this important business process.

Richard S. Cohen is president of the Walden Group Inc. (Franklin Lakes, NJ), a merger and acquisitions firm specializing in the healthcare industry.

Copyright ©1999 Medical Device Executive Portfolio

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