It’s the Execution That Distinguishes Success: A Case History of a Start-up Gone Wrong

By Bruce E. Jacobs

The business strategy for a durable medical equipment (DME) start-up venture was sound and forward thinking. The new business would take advantage of a void in the DME market and leverage the business issues customers of DME manufacturers were wrestling with—eg, lowest cost, highest quality, product availability and the manufacturer’s ability to respond reliably to customer needs. The strategic intent was to enter the DME market segment with a business model different from those of the major competitors and create a competitive distinction with high-quality, high-volume products at substantially lower prices than the competitors. It would cherry-pick the high-volume products from DME product families and provide them at the lowest total price to home medical equipment (HME) dealers and their consumers. The larger competitors in the segment have a vast product selection in each of the DME product families, which creates customer confusion because there is little distinction between the various models. Moreover, the breadth and depth of product selection had not secured loyalty from dealers, whose primary objective is to sell high-quality products with the lowest cost and highest margin to meet reimbursement cutbacks and compete with larger dealers.

Get the business started, grow it rapidly and, in three to five years, sell it. With a good strategy, experienced people, a growing market and different business model, capitalism would succeed, and stakeholders would cash out from the sale of the company at the highest price. Everyone wins: the private equity firm that raised the capital; investors who provided capital; and the management that started the company, executed the strategy and reaped the benefits of stock awards and options.

The business strategy and business model would take advantage of specific voids in the market. The growth plan was aggressive but achievable. The management team was comprised of seasoned industry professionals, some coming from the competition. The strategy and business plan were well defined, and the concept was simple:

• Provide high-quality DME products at significantly lower prices to customers in a price-sensitive growing market segment

• Fund the new business start-up by raising more than $50 million in capital with a private equity firm

• Provide the numerous small and medium-sized HME dealers and their consumers with the lowest-priced products to help them compete against the large dealers

• Assemble a seasoned and experienced management team from the industry

• Purchase Chinese-based manufacturing operations to control the manufacturing process, ensure product quality and create an average gross profit of 55% on products manufactured in the plant

• Create a product offering from only the top-selling products in the DME product lines, leaving major competitors to provide breadth and depth of product-family assortment

• Distribute product in the United States from five distribution centers located across the country, outsourced to a third-party logistics supplier

The overall strategy—provide high-volume products at the lowest total price, with the highest level of customer service—would create competitive distinction by offering only selected products the majority of the HME dealers and consumers purchased. In addition, it would take advantage of the fact that HME dealers have no loyalty to suppliers and continually search for higher-quality products at lower prices, thus, creating a point of entry for a new supplier.

What Went Wrong?

The strategy, business plan, financing, management, sales force, and manufacturing and distribution operations were in place. So what went wrong?

In this case, a good strategy and plan were put on the shelf and forgotten as the experienced management team became distracted by the day-to-day operations of the start-up. Within 24 months of the start-up date, the company began an orderly liquidation to generate cash, stop the losses, conserve capital and salvage the investment. The asset-based lender called the note for working capital, the board of directors resigned, management was terminated, distribution centers closed, inventory was liquidated, employees were let go and the product offering was revamped. Today, the company barely resembles what it started out to be.

The fundamental problem contributing to the company’s demise was the experienced management failure to implement the strategy and execute the business plan. Instead, it lost focus and forgot the business model was to serve the HME dealers and consumers with selected high-volume products at the lowest cost—a high-volume, low-cost provider model of key products. Dealers and customers would buy from the company because of the price advantage, resulting in higher volume. Additional factors contributed to the company’s failure and supported the fact the strategy and plan had not been executed.

No Cost Advantage

The cost advantage thought possible from the purchase of the Chinese operations was never realized. It never generated more than a 1.6% gross margin because the total landed cost of goods sold and distribution costs totaled 98.4% of total revenue.

The third-party logistics provider hired to outsource distribution operations management was not capable of cost-effectively operating five distribution centers. Its primary business was freight forwarding; therefore, products were shipped to customers using the provider’s fleet, with little consideration for least freight cost delivery. In addition, the inventory management, inventory accuracy, product damage and control, order accuracy and standard distribution operations practices were not in place, and a physical inventory could not adequately be performed because the provider didn’t have the processes defined or in place.

The selling, general and administrative costs were more than 70% of total revenue. With a 1.6% gross margin, these costs, along with the required operating profit, were far from being covered by the minimum gross margin generated. As the cost structure continued out of control, an obvious correlation developed between monthly sales volume and operating profit loss: The larger the monthly sales revenue, the larger the loss. Break-even wasn’t possible with this cost structure.

No Key Products and Low Volume

The company established a base product offering of more than 220 products spread across the DME family. Ninety products generated 95% of the revenue. The 130 remaining products (or 59% of the SKUs) generated the remaining 5% of revenue. An analysis indicated more than 80% of each product family’s revenue was generated by less than 30% of the individual product models. A typical example of the complexity caused by the proliferation of product models was the wheelchair product family, which generated more than 30% of the company’s annual revenue. However, only 18 models (or 30%) generated more than 80% of the wheelchair revenue. For the wheelchair product family, 35 models (or 57%) generated 95% of the wheelchair revenue. The remaining 43% of the wheelchair models generated only 5% of the wheelchair revenue.

High volume was never achieved in any of the individual products because of the assortment of products in each product family. A review of orders also indicated customers did not purchase product in large quantities but ordered two line items and averaged four to six pieces per line. Consequently, these small orders made it difficult to achieve economies in freight and distribution costs. An additional issue became apparent when days of receivables were reviewed. The customer base was concentrated in the “D” crowd of customers who didn’t buy in volume, cherry-picked products for price and were slow to pay the invoice.

No Supply Chain Management

When the business structure was developed, no supply chain operations function was defined, no management processes were developed, inventory deployment and replenishment were not defined, performance measurements were not developed and no demand forecasts were developed to help establish production volumes and inventory levels by product and distribution center location. The information support systems the company purchased and installed were not configured appropriately to enable the supply chain business processes to operate effectively. The system’s capabilities were underutilized.

No Business Start-up Expertise

The management team had a wealth of industry experience, knew the products and customers, the product development process, accounting and finance, sales, marketing and regulatory requirements. However, not one person on the management team had previous experience with a start-up business using other people’s money. Its expertise was founded on administering established businesses with large staffs. Getting dirty in the details as well as developing and implementing corrective solutions were not capabilities that had been developed. Hands-on management was not a competency of the management team, and neither was quick resolution to business problems.

As the company continued to underperform, management team members reverted to practices that had served them well in established businesses, which only made matters worse, raised the frustration levels of management and investors and contributed to the failure of a unique opportunity.

Learn From These Mistakes

This case study has several messages:

• A start-up business requires management skills different than those required by an established business

• Cost control, cost containment and quick remedies to cost and performance issues must be standard practices in a start-up

• Implement the strategy and execute the business plan

• Manage and control volume and costs if your competitive distinction is based on high volume and low cost

• To serve customers at the least total landed cost, your supply chain and its effective operations and management are the foundation

Bruce E. Jacobs is a principal with BKD, LLP, a CPA and advisory firm, and a member of BKD Manufacturing & Distribution Group, providing solutions for the management and financial needs of medical device businesses. Bruce has more than 26 years of experience in manufacturing and distribution strategies. Contact the author at [email protected].