Prepare and Prevent Common Due Diligence Issues in Health IT Transactions: Operations Considerations (Part 4 of 6)March 14, 2018
Over the next few months, HGP is publishing a 6-part research series covering a range of due diligence issues that are common to Health IT and Services transactions. The 6 sections cover: Accounting and Tax, Legal, Human Resources, Operations, Intellectual Property, and Technology. In today’s edition, we are covering the Operations topics.
There is no specific threshold for client concentration. Our judgement is that this can occur when a single customer drives over 20% of total revenue, or when a handful of customers taken together generate 50% or more of total revenue (or profit). Client concentration can create synergy opportunities for an acquirer when a seller’s customer concentration becomes a buyer’s customer diversification, creating an arbitrage opportunity for the buyer. However, client concentration issues can be magnified when there is historical attrition or pricing pressure from key accounts. Sellers need to prepare for some form of customer reference calls to key accounts. These calls may be handled directly by a buyer with reference to the potential acquisition, under the guise of a partnership, or with design to look like a third-party market survey. Long-term contracts and strong reference calls can appease concentration issues.
Retention rates are key to the financial performance of a business and reflect the overall value proposition to customers. Each business has many unique factors that play into target retention rates, however, based on our experience in enterprise health IT, retention rates more than 95% of revenue are exceptional, and companies should target revenue retention rates in excess of 90%. Lower retention rates may be acceptable depending on the nature of the product and market (e.g., B2C may experience higher attrition than B2B). Companies should document the rationale behind customer losses, not only to address this question when it comes up during due diligence, but also for best practices.
Net promoter score is the most frequently used standard to document client satisfaction. NPS is an index ranging from -100 to 100 that measures the willingness of customers to recommend a company's products or services to others. However, NPS is certainly not a requirement, as it does not necessarily apply to all businesses. Client satisfaction is obviously reflected in retention, as well as return-on-investment measures, pricing power, and customer reference calls.
Price inflation is an excellent way to organically grow a business, in the same way that price compression is a difficult headwind. Pricing trends may be the result of a company’s value proposition, competitive dynamics, technological advancement, and changes in market paradigms. Since pricing often has a dollar-for-dollar impact on profits, these trends may add or detract significant value to or from an enterprise. To the extent a business is undergoing some price fluctuation, either offensive or defensive measures should be taken leading up to a transaction to both create and protect value.
Many of the points about customer and pricing trends link back to the competitive dynamics of the market. Market leaders and market followers may be perceived differently, with leaders usually fetching a premium over followers. While often discussed, competitively disruptive situations are rare in health IT (such as Amazon’s acquisition of Whole Foods). One of the most common competitive issues is the interplay between enterprise EMR and specialty health IT vendors. The general trend is that the competitive footprint of enterprise EMR is expanding and encroaching on specialty health IT vendors. For certain sectors, this interplay may dramatically alter the competitive landscape. We encourage companies to closely monitor competitive dynamics, as these shifts may be leading indicators of the optimal time to pursue a transaction.
Often the best time to sell is when the business is in the middle of a growth inflection, which also makes it the hardest time to sell. Sales trends should be closely monitored, as revenue growth is the #1 driver of valuation multiples. We encourage companies to maintain strong operating metrics, since these metrics may support assigning more value to bookings and pipeline conversion. Strong historical data around operating metrics can be used to extrapolate future expectations and provide counterparties with greater confidence in the accuracy of sales projections during transaction discussions.
Creating a strong link between operating metrics and financial metrics may help identify opportunities for revenue enhancement and resource allocation, as well as provide early indicators for opportunities and risks within the business. Gross margin is an underappreciated metric by many companies. To the extent possible, we encourage monitoring gross margin by product, revenue category, and even customer. Strong metrics reflect the sophistication and controls of the business, and, all things equal, should result in better business performance as well as higher valuations.
One of the most important items on this list is the performance of a business against projections during a transaction process. A reasonable buyer will give a company credit for the performance of the business up until the close date of a transaction, which may involve looking at a mix of trailing-twelve-month performance, run-rate performance, bookings, and near-term pipeline. Projections should be very carefully prepared leading into a transaction process to ensure that a company remains on plan, both not underperforming or outperforming against expectations. Unfortunately, many sellers come to market with overly aggressive projections, which results in an instinct by buyers to discount projections. To avoid re-pricing a transaction or a transaction falling apart altogether, sellers should honestly and carefully communicate the reasonableness and basis of their financial forecast.