Tony Freeman, President, A.S. Freeman Advisors LLC02.03.23
It would be difficult to find a medical device supply chain manager who has never thought about mergers and acquisitions. The industry has seen a steady flow of deals for the last 20 years, some of which have significantly impacted the market. One of the M&A topics that is well understood by financial managers and transaction professionals but not necessarily by executives in other parts of the supply chain is deal pricing. M&A pricing is often perceived as a disciplined series of mathematical calculations known only to those involved in the deal itself, but this notion is untrue. While a full study of deal pricing would fill several volumes of weighty textbooks (and do), the basics of how a number is selected comes down to a few core items. Pricing is a mix of art and science, hard numbers, and best guesses based on commonly-held beliefs about what might be valuable to a company’s future.
From the top line, deal teams move directly to the bottom line—net income. They look for slightly negative to highly positive numbers, especially in the last 12 months. It may seem odd that losses are tolerated but net income is just the launch pad for calculating the metric commonly used in deal pricing. The metric, EBITDA (or its cousin, adjusted EBITDA), refers to Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income. Expressed as formula:
EBITDA = Net Income + (Interest Expense – Interest Income) + Income Taxes + (Depreciation + Amortization)
For better or worse, EBITDA is used to measure a company’s profitability. The debate over its utility has raged for decades but, like a yardstick, it is a consistent measurement tool, even if superior methods exist. It is easy to calculate and accurate enough to measure the type of profits intriguing to the financial world.
Besides the EBITDA number, most companies can claim special circumstances that hide legitimate profitability. These items, called adjustments, include compensation and benefits well over a job title’s average pay that owners award themselves. Other common adjustments include unusual one-time expenses like a lawsuit, move-related costs, tax audit expenses, etc. These adjustments are totaled and added to EBITDA to produce adjusted EBITDA.
Adjusted EBITDA is subject to intense scrutiny and testing but its initial calculation, which takes only a few minutes, is usually fairly accurate. With both EBITDA and adjusted EBITDA, the math is fast and simple.
Most medical device supply chain deals of the last 20 years have seen multiples falling within two ranges. The multiples for companies generating less than $25 million in sales have ranged from 5.5 to 10. Metals houses tend to have higher multiples than plastics companies, for example, but this only a general rule. Contrarily, multiples for organizations generating more than $25 million in sales—particularly those over $100 million—have ranged between 10 and 18. A significant premium is paid for scale, transaction efficiency, and desirable market position, among various other factors.
Not surprisingly, all companies want to be at the high end of the range. However, the criteria deal teams use to select the multiple are often not based on numbers or only weakly so. At this point, business owners may have an opportunity to show overmarket value. No single criteria dominates but several are considered; a few of the more common benchmarks follow.
Customer/Project Concentration Risk. Deal teams are usually unnerved if a single customer represents more than a third of a company’s revenue and for good reason: Should the relationship sour, revenues and profits could drop sharply. Historically a 35% discount on the multiple has been used in these situations but a more open-minded approach has evolved in recent years. Medtech deal teams study the mix of projects and programs. Companies whose revenue is solely dependent on a single product family or customer will receive discounts toward the bottom of the multiple range. But if revenue is spread across various product lines and divisions, there may be little or no discount. Deal makers also prefer a diversified customer list, as it suggests the organization is not wholly dependent on a single customer (or product) for survival.
Customer Type. Deal teams study the types of customers serviced by potential acquisitions. Companies working with major OEMs are considered for higher multiples than those manufacturing for other contract manufacturers (CMs), regardless of the profitability of the work. The perception is that OEMs are less likely to bring competing capabilities in-house. The data does not bear this fear out, but it is nevertheless the current belief.
Position in the Customer Product Mix. Higher multiples are awarded to supply chain firms working on new products vs. those building legacy products. Deal professionals view new product work as more profitable and having a longer runway than items with a long market history. This decision, though, has little to do with a project’s current profitability. Supply chain firms often earn more money on legacy programs where costs have been driven out over time than in less-optimized new product efforts.
Management Bench and Succession Plan. Deal teams intensely study the future growth potential a target company may bring. Companies with a capable management team and a plan to bring junior staff members forward to handle growth usually receive a higher multiple than entities with no succession plan and only a few centralized decision makers.
Strategic Plan. Few American manufacturers under $100 million have a strategic plan worthy of its name. Buyers spending millions of dollars gain comfort knowing that management has a thoughtful plan knitting markets, customers, and operations into a realistic growth path. Such a plan demonstrates to the acquirer the depth of management’s understanding of their position in the industry and the best success routes. Deal teams will vet the plan against results but if the plan pairs to a company’s historic outcomes the seller should expect a higher multiple than an identical company lacking a plan.
These criteria are amongst the many that deal professionals use to choose a multiple. Some standards like customer concentration, lend themselves to mathematical adjustments. Others require what often comes down to belief, rather than proven fact, as to the impact on value.
A seller should not be overwhelmed by spreadsheets. While the arcane world of deal-making has precision with regards to earnings, the multiple is skewed by numerous factors that can be addressed by sellers before a transaction.
Tony Freeman is the President of A.S. Freeman Advisors, LLC, a merger and acquisitions advisory firm specializing in precision manufacturing and materials sciences companies. He can be reached at tfreeman@asfreeman.com. Special thanks to John Coltrane for his assistance with this column.
The Science—How Deal Makers Look at Financial Statements and EBITDA
While deal professionals carefully review every detail of an acquisition target’s financial statements, non-pecuniary managers would be surprised to learn of the actions taken within minutes of examining the numbers. Deal teams start with the top line, studying not only the size of revenues but their trend as well. Ideally, they wish to see average 4%-10% revenue growth annually, matching or surpassing the overall medtech supply industry growth rate. Although a higher rate is not a problem, it will be subject to scrutiny to determine its sustainability. A lower growth rate is cause for concern. Few decisions are made in these first moments of review but since demonstrable growth and profitability attract investors, revenue trend is an important litmus test leading to the next calculation.From the top line, deal teams move directly to the bottom line—net income. They look for slightly negative to highly positive numbers, especially in the last 12 months. It may seem odd that losses are tolerated but net income is just the launch pad for calculating the metric commonly used in deal pricing. The metric, EBITDA (or its cousin, adjusted EBITDA), refers to Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income. Expressed as formula:
EBITDA = Net Income + (Interest Expense – Interest Income) + Income Taxes + (Depreciation + Amortization)
For better or worse, EBITDA is used to measure a company’s profitability. The debate over its utility has raged for decades but, like a yardstick, it is a consistent measurement tool, even if superior methods exist. It is easy to calculate and accurate enough to measure the type of profits intriguing to the financial world.
Besides the EBITDA number, most companies can claim special circumstances that hide legitimate profitability. These items, called adjustments, include compensation and benefits well over a job title’s average pay that owners award themselves. Other common adjustments include unusual one-time expenses like a lawsuit, move-related costs, tax audit expenses, etc. These adjustments are totaled and added to EBITDA to produce adjusted EBITDA.
Adjusted EBITDA is subject to intense scrutiny and testing but its initial calculation, which takes only a few minutes, is usually fairly accurate. With both EBITDA and adjusted EBITDA, the math is fast and simple.
The Art – Choosing the Multiple
EBITDA tells only half the story of deal pricing, though. The other half is the multiple. Deal makers multiply EBITDA or adjusted EBITDA by a multiple to calculate the acquisition’s value. Unlike EBITDA, however, multiples are subjective.Most medical device supply chain deals of the last 20 years have seen multiples falling within two ranges. The multiples for companies generating less than $25 million in sales have ranged from 5.5 to 10. Metals houses tend to have higher multiples than plastics companies, for example, but this only a general rule. Contrarily, multiples for organizations generating more than $25 million in sales—particularly those over $100 million—have ranged between 10 and 18. A significant premium is paid for scale, transaction efficiency, and desirable market position, among various other factors.
Not surprisingly, all companies want to be at the high end of the range. However, the criteria deal teams use to select the multiple are often not based on numbers or only weakly so. At this point, business owners may have an opportunity to show overmarket value. No single criteria dominates but several are considered; a few of the more common benchmarks follow.
Customer/Project Concentration Risk. Deal teams are usually unnerved if a single customer represents more than a third of a company’s revenue and for good reason: Should the relationship sour, revenues and profits could drop sharply. Historically a 35% discount on the multiple has been used in these situations but a more open-minded approach has evolved in recent years. Medtech deal teams study the mix of projects and programs. Companies whose revenue is solely dependent on a single product family or customer will receive discounts toward the bottom of the multiple range. But if revenue is spread across various product lines and divisions, there may be little or no discount. Deal makers also prefer a diversified customer list, as it suggests the organization is not wholly dependent on a single customer (or product) for survival.
Customer Type. Deal teams study the types of customers serviced by potential acquisitions. Companies working with major OEMs are considered for higher multiples than those manufacturing for other contract manufacturers (CMs), regardless of the profitability of the work. The perception is that OEMs are less likely to bring competing capabilities in-house. The data does not bear this fear out, but it is nevertheless the current belief.
Position in the Customer Product Mix. Higher multiples are awarded to supply chain firms working on new products vs. those building legacy products. Deal professionals view new product work as more profitable and having a longer runway than items with a long market history. This decision, though, has little to do with a project’s current profitability. Supply chain firms often earn more money on legacy programs where costs have been driven out over time than in less-optimized new product efforts.
Management Bench and Succession Plan. Deal teams intensely study the future growth potential a target company may bring. Companies with a capable management team and a plan to bring junior staff members forward to handle growth usually receive a higher multiple than entities with no succession plan and only a few centralized decision makers.
Strategic Plan. Few American manufacturers under $100 million have a strategic plan worthy of its name. Buyers spending millions of dollars gain comfort knowing that management has a thoughtful plan knitting markets, customers, and operations into a realistic growth path. Such a plan demonstrates to the acquirer the depth of management’s understanding of their position in the industry and the best success routes. Deal teams will vet the plan against results but if the plan pairs to a company’s historic outcomes the seller should expect a higher multiple than an identical company lacking a plan.
These criteria are amongst the many that deal professionals use to choose a multiple. Some standards like customer concentration, lend themselves to mathematical adjustments. Others require what often comes down to belief, rather than proven fact, as to the impact on value.
A seller should not be overwhelmed by spreadsheets. While the arcane world of deal-making has precision with regards to earnings, the multiple is skewed by numerous factors that can be addressed by sellers before a transaction.
Tony Freeman is the President of A.S. Freeman Advisors, LLC, a merger and acquisitions advisory firm specializing in precision manufacturing and materials sciences companies. He can be reached at tfreeman@asfreeman.com. Special thanks to John Coltrane for his assistance with this column.
