Do Your Healthcare Software Sales Match the Excellence of Your Product

Smaller healthcare software companies often face a very difficult time penetrating the larger customers and achieving a critical mass in sales. The industry is quite conservative and has a bias toward doing business with the old reliable legacy providers. This post discusses this dynamic and approaches to minimizing the impact on growing sales.

When asked if their company sales matched the excellence of their products,  many entrepreneurs, technology based companies or healthcare companies, the answer to that question is a resounding, NO! There is an exception to this with the rapid rise of the new economy, new media, highly scalable companies like Open Table, Uber, Airbnb, YouTube, and others.

In their case, their prospective customers highly value their newness, their breaking the mold, their non-establishment approach. They are viewed as doing what they do far better than the technology establishment stalwarts. The notable exception to this is Apple who has been able to transcend old establishment and be accepted as both old and new economy.

But I digress. Back to topic. Most companies that sell to other companies, or B2B companies are evaluated by their potential customers in a traditional risk reward analysis. Or using computer terminology, their buying decisions are made using a legacy system. It was once said that no one ever got fired for making an IBM decision.

Let's look at this legacy buying model and see exactly why your company's sales do not match the elegance of your solution.

One of our healthcare clients insisted that we read CROSSING THE CHASM by Geoffrey Moore to give us greater perspective on his company's situation. By the way, if you are a smaller technology based or healthcare company selling in the B2B space, this should be required reading.

Our client was a two year old company selling a cutting edge, on-line nurse shift bidding and self scheduling system to hospitals. This is a great product. The ROI's were easily quantifiable. The handful of installed accounts loved it. Most importantly, it had a positive effect on the nursing staff's morale. This alone could justify the cost of the system.

Our client had some very encouraging early success selling his solution to some of the more progressive hospitals. They received some outstanding early PR. After that initial success, however, our little edgy technology based company hit the wall.

The sales cycle went from six months to beyond twelve months. Cash flow became an issue and, to top it off, a generously funded venture backed competitor with well known industry executives was aggressively developing this new market.

What was happening? Our clients were very smart people and figured out what was happening. They knew that they would have to make some difficult and dramatic decisions in short order. Turns out the majority of hospitals are legacy buyers and make buying decisions based on a risk avoidance paradigm.

Our client's early success was realized as a result of selling to the small minority of early adapters in their industry. These are the pioneers that don't mind the arrows in their backs from heading out West with new products or new vendors.

Legacy buyers, however, do not value references that are early adapters. They are known to have a much higher risk tolerance than the traditional majority. Below are some buying criteria from these legacy buyers:

1. Big is good. Bigger is better. Buying inferior technology solutions from a blue chip publicly traded company wins most of the time.

2. Old is good. There is no replacement for experience and the grey haired company beats the gelled hair Tech Wizard company more often than not.

3. Industry Cred means everything. If you are a company that adapted your product from success in another vertical market and you are entering our space, the old familiar face carries the most weight.

4. Will the little guy be in business next year? The failure rate for the sub $ million company is a thousand times greater than for the $ billion company. This change in technology is painful enough. Do I want to risk having to do it over again in a year?

5. If I have problems, the big guy can fill the skies with blue suits until my problem is solved. The little guys cannot appropriately respond to my problem.

This is a punishing gauntlet for the small companies and it is amazing that any new companies survive in this environment. Let's look at a few of the "crossing the chasm" strategies that have been effective in swaying legacy buyers decision making in favor of the smaller provider with superior technology.

A. A well-known executive from an established healthcare company is put at the helm of the new company. The thinking from the buyer is that if he did it once, he can do it again.

B. Get an industry-recognized authority to endorse your solution or, better yet, have them join your board or advisory council.

C. Close a deal with a conservative, well respected customer and make them your marquee account with all the trimmings - i.e. a contract with a favored nations clause, the technology or computer code held in escrow with specific instructions if you go out of business, case studies and Public Relations glorifying the progressive decision maker, and providing an equity stake in your company are some examples.

D. Forging a strategic alliance, joint marketing agreement or resellers agreement with an industry giant. All of a sudden your small company risk factors have been eliminated and it has only cost you 30%-50% of revenue on each sale they make.

E. Sell your company to the best strategic buyer. Sometimes the best solution is to sell your company to the best strategic buyer for your greatest economic value. This is the most difficult decision for an entrepreneur to make. Below are some of the market dynamics that would point to that decision. Note: several of these factors influenced our entrepreneurial clients to ultimately sell their business to an industry giant.

You see your window of opportunity closing rapidly. You may have great technology and the market is starting to recognize the value of the solution. However, you have a small competitor that was just acquired by a big industry player. The bad news is you probably have to sell to remain competitive. The good news is that the market will likely bid up the value of your company to offset the competitive move of the big buyer.

The strategic alliance is with the right company, but the sales force has no sense of urgency or no focus on selling your product. The large company lacks the commitment to drive your sales. An amazing thing happens with an acquisition. The CEO is out to prove that his decision was the right one. He will make his decision right. All of a sudden there is laser focus on integrating this new product and driving sales.

You have created a strategic alliance and poured your company's resources into educating, supporting, and evangelizing your product. Whoops, you have counted on this golden goose and it has not met your expectations. Also you have neglected your other business development and sales efforts while focusing on this partner.

Many large healthcare companies now employ a try it before you buy it approach to M&A. They find a good technology, formalize a strategic alliance, dangle the carrot of massive distribution and expect the small company to educate and integrate with his sales force. Often this relationship drains the financial performance of the smaller company. If you decide to sell at this point your value to another potential buyer has been diminished.

Do not despair. If you have demonstrated a cultural fit and have helped your products work in conjunction with the big company's product suite, you have largely eliminated post acquisition integration risk. This can often more than offset any short-term profit erosion you may have suffered.

It is not easy for the smaller healthcare company to reach critical mass in this very competitive and conservative environment. Working harder will not necessarily get you where you need to be. Step back and look at your environment through the eyes of your buyers. Implement some of these strategies to remove the risk barriers to doing business with your company. Now you have created an opportunity for your sales to match the elegance of your technology solution.

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of healthcare companies. For more information about selling your healthcare company, visit our website MidMarket Capital

Healthcare Information Technology - Business Valuation

Business valuations for healthcare information technology companies is more of an art than a science. Ultimately a competitive market bid situation is the only true method. I attempt to quantify the important valuation elements in this article.

One of the most challenging aspects of selling a healthcare information technology company is coming up with a business valuation. Sometimes the valuations provided by the market (translation - a completed transaction) defy all logic. In other industry segments there are some pretty handy rules of thumb for valuation metrics. In one industry it may be 1 X Revenue, in another it could be 7.5 X EBITDA.

Since it is critical to our business to help our healthcare information technology clients maximize their business selling price, I have given this considerable thought. Why are some of these software company valuations so high? It is because of the profitability leverage of technology. A simple example is what is Microsoft's incremental cost to produce the next copy of Office Professional? It is probably $1.20 for three CD's and 80 cents for packaging. Let's say the license cost is $400. The gross margin is north of 99%. That does not happen in manufacturing or services or retail or most other industries.

One problem in selling a small healthcare technology company is that they do not have any of the brand name, distribution, or standards leverage that the big companies possess. So, on their own, they cannot create this profitability leverage. The acquiring company, however, does not want to compensate the small seller for the post acquisition results that are directly attributable to the buyer's market presence. This is what we refer to as the valuation gap.

What we attempt to do is to help the buyer justify paying a much higher price than a pre-acquisition financial valuation of the target company. In other words, we want to get strategic value for our seller. Below are the factors that we use in our analysis:

1. Cost for the buyer to write the code internally - Many years ago, Barry Boehm, in his book, Software Engineering Economics, developed a constructive cost model for projecting the programming costs for writing computer code. He called it the COCOMO model. It was quite detailed and complex, but I have boiled it down and simplified it for our purposes. We have the advantage of estimating the "projects" retrospectively because we already know the number of lines of code comprising our client's products. In general terms he projected that it takes 3.6 person months to write one thousand SLOC (source lines of code). So if you looked at a senior software engineer at a $70,000 fully loaded compensation package writing a program with 15,000 SLOC, your calculation is as follows - 15 X 3.6 = 54 person months X $5,800 per month = $313,200 divided by 15,000 = $20.88/SLOC

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Before you guys with 1,000,000 million lines of code get too excited about your $20.88 million business value, there are several caveats. Unfortunately the market does not care and will not pay for what it cost you to develop your product. Secondly, this information is designed to help us understand what it might cost the buyer to develop it internally so that he starts his own build versus buy analysis. Thirdly, we have to apply discounts to this analysis if the software is three generations old legacy code, for example. In that case, it is discounted by 90%. You are no longer a technology sale with high profitability leverage. They are essentially acquiring your customer base and the valuation will not be that exciting.

If, however, your application is a brand new application that has legs, start sizing your yacht. Examples of this might be a click fraud application, Pay Pal, or Internet Telephony. The second high value platform would be where your software technology "leap frogs" a popular legacy application. An example of this is when we sold a company that had completely rewritten their legacy management platform in Microsoft.Net. They leap frogged the dominant player in that space that was supporting multiple second generation solutions. Our client became a compelling strategic acquisition. Fast forward one year and I hear the acquirer is selling one of these $100,000 systems per week. Now that's leverage!

2. Most acquirers could write the code themselves, but we suggest they analyze the cost of their time to market delay. Believe me, with first mover advantage from a competitor or, worse, customer defections, there is a very real cost of not having your product today. We were able to convince one buyer that they would be able to justify our seller's entire purchase price based on the number of client defections their acquisition would prevent. As it turned out, the buyer had a huge install base and through multiple prior acquisitions was maintaining six disparate software platforms to deliver essentially the same functionality.

This was very expensive to maintain and they passed those costs on to their disgruntled install base. The buyer had been promising upgrades for a few years, but nothing was delivered. Customers were beginning to sign on with their major competitor. Our pitch to the buyer was to make this acquisition, demonstrate to your client base that you are really providing an upgrade path and give notice of support withdrawal for 4 or 5 of the other platforms. The acquisition was completed and, even though their customers that were contemplating leaving did not immediately upgrade, they did not defect either. Apparently the devil that you know is better than the devil you don't in the world of healthcare information technology.

3. Another arrow in our valuation driving quiver for our sellers is we restate historical financials using the pricing power of the brand name acquirer. We had one client that was a small healthcare IT company that had developed a fine piece of software that compared favorably with a large, publicly traded company's solution. Our product had the same functionality, ease of use, and open systems platform, but there was one very important difference. The end-user customer's perception of risk was far greater with the little IT company that could be "out of business tomorrow." We were literally able to double the financial performance of our client on paper and present a compelling argument to the big company buyer that those economics would be immediately available to him post acquisition. It certainly was not GAP Accounting, but it was effective as a tool to drive transaction value.

4. Financials are important so we have to acknowledge this aspect of buyer valuation as well. We generally like to build in a baseline value (before we start adding the strategic value components) of 2 X contractually recurring revenue during the current year. So, for example, if the company has monthly maintenance contracts of $100,000 times 12 months = $1.2 million X 2 = $2.4 million as a baseline company value component. Another component we add is for any contracts that extend beyond one year. We take an estimate of the gross margin produced in the firm contract years beyond year one and assign a 5 X multiple to that and discount it to present value.

Let's use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final tree years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2 X recurring year 1 revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.

5. We try to assign values for miscellaneous assets that the seller is providing to the buyer. Don't overlook the strategic value of Blue Chip Accounts. Those accounts become a platform for the buyer's entire product suite being sold post acquisition into an "installed account." It is far easier to sell add-on applications and products into an existing account than it is to open up that new account. These strategic accounts can have huge value to a buyer.

6. Finally, we use a customer acquisition cost model to drive value in the eyes of a potential buyer. Let's say that your sales person at 100% of Quota earns total salary and commissions of $125,000 and sells 5 net new accounts. That would mean that your base customer acquisition cost per account was $25,000. Add a 20% company overhead for the 85 accounts, for example, and the company value, using this methodology would be $2,550,000.

7. Our final valuation component is what we call the defensive factor. This is very real in the healthcare information technology arena. What is the value to a large firm of preventing his competitor from acquiring your technology and improving their competitive position in the marketplace. One of our clients had an outcomes database and nurse staffing software algorithm. The owner was the recognized expert in this area and had industry credibility. This was a small add on application to two large industry players' integrated hospital applications suite. This module was viewed as providing a slight features advantage to the company that could integrate it with their main systems. The selling price for one of these major software systems to a hospital chain was often more than $50 million. The value paid for our client was determined, not by the financial performance of our client, but by the competitive edge they could provide post acquisition. Our client did very well on her company sale.

After reading this you may be saying to yourself, come on, this is a little far fetched. These components do have real value, but that value is open to a broad interpretation by the marketplace. We are attempting to assign metrics to a very subjective set of components. The buyers are smart, and experienced in the M&A process and quite frankly, they try to deflect these artistic approaches to driving up their financial outlay. The best leverage point we have is that those buyers know that we are presenting the same analysis to their competitors and they don't know which component or components of value that we have presented will resonate with their competition. In the final analysis, we are just trying to provide the buyers some reasonable explanation for their board of directors to justify paying 8 X revenues for an acquisition.

 
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of healthcare companies. For more information about selling your healthcare company, visit our website MidMarket Capital