Knowing When To Fold ‘Em

You've got to know when to hold 'em
Know when to fold 'em
Know when to walk away
Know when to run
You never count your money
When you're sittin' at the table
There'll be time enough for countin'
When the dealin's done

If you’re a Baby Boomer, you remember well hearing Kenny Rogers’ iconic hit, The Gambler. If you’re like me, you’ve often wondered how Kenny’s advice might be applied to important business and investment decisions. If you’re a business owner who has survived our generation’s version of the Great Depression, you need good counsel now more than ever.

Perhaps you’re feeling pretty good about your prospects – business is improving and profits are as high as you’ve ever enjoyed. Is now the time to go all in? Or is it time to cash your chips and leave the table to new faces?

To help you puzzle through these difficult and emotionally charged questions, we’ll take you through the process through the eyes of a not untypical business owner whom we will call Frank Mayfield.

Like the fables we all read in our youth, while the names, industry identifiers and specific fact set have been modified to fit the narrative, the story describes situations we and our clients confront daily. The dilemma described here is quite real.

Our friend Frank Mayfield recently approached us with a dilemma. Frank founded Limbtronics, a medical device manufacturer, 30 years ago to provide leading orthopedic doctors with specialized tools for performing innovative surgeries on damaged joints and ligaments.

Over time, he expanded into manufacturing surgical implants for complete joint replacements. The business has been good to Frank and in 2013 Limbtronics had a record year with revenue of $28 million and pretax profits of more than $5 million.

Over the past 15 years, Frank has seen several of his competitors acquired by global orthopedic giants such as Medtronic, Stryker, Smith and Nephew, and others. He’s been approached a number of times, but never felt the time was right to sell. Recently he’s begun to wonder if it might be time to reconsider.

While Frank has always considered himself to be reasonably fit (he plays 18 holes most Saturdays weather permitting), he has put on a bit of weight and recently began taking blood pressure meds and other drugs Frank’s physician said would help him deal with his “stressful” lifestyle.

Upon questioning, Frank admitted that, while the business is going great guns today, he does have some concerns. He’s been successful in fending off foreign competition due to the stringent quality control and regulatory requirements of his industry and the semi-custom nature of his products.

Recently, however, a new domestic competitor has made a splash with some of his customers using social media to introduce additive manufacturing (makerbots) capabilities to produce and ship a variety of implants almost overnight at very favorable pricing. Longer term, he worries about newly emerging technologies to regenerate cartilage and other tissue in situ, without the need for any form of implant.

We sat down with Frank in order to better understand not only his competitive position, but also his personal desires and concerns. First, we explored numerous personal issues that could play a significant role in Frank’s plans.

In addition to questions about Frank’s health, we explored family and management succession, Frank’s outside interests and personal retirement desires along with his wife Sarah’s opinion about these matters.

Bottom line, Frank’s children have no interest in the business and his senior management team is in their mid to late 50s with no clear succession plan in place. Sarah is pushing for more time for travel and Frank has begun to think that might not be a bad idea.

He’s never been able to devote the amount of time he’d like to fly fishing and he’s recently been asked to teach an entrepreneurial skills class at his alma mater. Clearly some planning was in order with regard to Frank’s desired balance between his role at Limbtronics and his personal life.

Our next area of inquiry was related to Limbtronics. We noted the technology challenges the business would face. After additional inquiry, Frank confided that while the business was currently as profitable as it had ever been, he was concerned about future profit erosion and even more concerned about losing some of his key people.

As the discussion moved forward, it became increasingly clear that the business was at risk of sliding backward without some fundamental change.

We put it straight. The global economy is in the midst of the most profound period of change we have yet witnessed. The explosion of internet connectivity means everyone in the world has access to information that was once reserved to an elite few.

Over the past 30 years, digital technologies have reached a point in terms of power, cost, and size that they can now be applied to make virtually every aspect of human endeavor more efficient. As a result, new technologies and business ideas are radically transforming industry after industry at an exponential rate.

Our advice to Frank:

“The next 10 to 15 years are going to be an incredibly exciting time. To remain successful, Limbtronics must address the impact of robotics, nanotechnology, advances in materials technologies, embedded intelligence, synthetic biology, social media, and other new ways of selling; and must do so while competing on price, innovation, and product quality in a global marketplace.

If you’re up to the challenge, it’s going to be a wonderful time to be in the business. We’re now part of a rapidly growing global economy and opportunities for exponential growth will abound as never before.

In evaluating your options, consider Limbtronics’ ability to compete for the capital and human resources that will be required to meet the new challenges of this rapidly changing market.

You’ve got a great management team, but several of them are rapidly approaching retirement age. Are they ready to take on the new challenges? And what about the competition; we can reasonably assume they’re not standing still.”

About a month later, we had a follow-up meeting with Frank. This time he brought in some additional numbers and asked if we would review his options in the current market. We were pleased to note that after a rough couple years in 2009 and 2010, Limbtronics had come back very strong. 2014 sales were projected to hit $35 million and, with some luck, EBITDA could hit as much as $8 million. Going forward, order books were bulging and $40 million was in sight for 2015. We congratulated Frank on the fantastic results and went to work.

Our analysis included a review of recent comparable company sales to major global medical device manufacturers as well as current activity in the private equity community. We learned that several of Frank’s competitors had been acquired since the crash often by strategic buyers. Five have already acquired a presence in Limbtronics’ market. Three of the remaining five potential buyers seemed to have the financial wherewithal to do a deal of the size required to buy Limbtronics.

In addition to Limbtronics, there were four other significant privately held firms in his sector. With one exception, the owners of each of these firms were in their 50s or 60s and likely having similar discussions about possible sale. Bottom line – the industry was consolidating fast and one or more players were at risk of being left at the altar if they failed to act quickly.

A review of the private equity community was more encouraging. Several major middle market buyers were aggressively searching for medical device companies to serve as a platform for additional acquisitions in the sector. Based on other processes currently underway, as well as publically available data, we reported the following to Frank:

  • The private equity community remains awash in “dry powder” and is aggressively seeking new opportunities.
  • Banks have loosened up significantly in their lending parameters; leverage ratios in the middle market were approaching, and in some cases, significantly exceeding those of the peak years of the mid 2000s. Having witnessed many lending cycles during our career, we feel confident this situation will not last forever. At some point, lending criteria will again tighten and when they do, deals will be harder to close.
  • Overall, middle market valuations are reported to have reached new historical highs in 2014.
  • Also, after years on the sidelines, many strategic buyers have concluded that their only opportunity for revenue growth must come through acquisitions.
  • Bottom line: 2014 appears to be an opportunistic time to sell a profitable and growing middle market business.

Median EBITDA Multiples for Buyouts (H1 2014)http://www.capmatters.com/wp/wp-content/uploads/2014/July/EBITDA.jpg

What might this mean for Frank and Limbtronics? Where middle market cash flow was for many years priced at six to seven times earnings before interest, taxes, depreciation, and amortization (EBITDA), offers of seven to eight times EBITDA are now commonplace. For larger companies and special situations, offers of 10x EBITDA or greater are occurring with some regularity.

We explained to Frank that valuation is not a precise number and depends not only on company results, but also on the quality of the process employed to market a company for sale. Achieving superior results in a business sale requires hard work to put the Company’s best foot forward. This includes creating a competitive environment for the process in order to obtain multiple offers.

Taking all these factors into account, Frank concluded now is the time to sell. While there were no immediate clouds on the horizon, Frank has seen enough business cycles to know trees do not grow to the sky. By selling in 2014, he could in good conscience assure the buyer that 2015 is going to be a great year.

As for Frank, the decision to sell is only the beginning of a process that could take six months to a year to complete. As things move forward, many additional decisions must be made and much work lies ahead. In future articles, we’ll dig a bit more into the sale process and some of the issues Frank will face as he moves forward.