March 12, 2019 PAP-Q1-2019-CL-007
Companies that prepare themselves as an investment “target” will be in an advantageous position when seeking growth capital. Strategic positioning, customer relations and corporate structure are among the key elements that make companies attractive to investors. Pharmaceutical companies increasingly outsource research, development and manufacturing activities to gain access to specialized capabilities that can accelerate the commercialization of complex drug candidates. With foresight on investment, those outsourced providers that support multiple projects across a broad range of molecules using diverse technologies are positioned to create real value for their customers and make those qualities attractive to investors.
For middle-market service providers, some areas to keep in mind where investors derive value include differentiated capabilities, customer portfolio, next-generation leadership and audited financials.
The most successful contract research organizations (CROs) and contract development and manufacturing organizations (CDMOs) have established specialized capabilities. Some examples of these capabilities include expertise in handling highly potent compounds and sterile fill/finish of biologics. DEA certification for handling controlled substances and specialized expertise in the production of certain types of formulations or new technologies on the forefront of advancing trends are also valuable. What is key is being able to clearly demonstrate how the company creates value through differentiation.
For smaller CROs and CDMOs (<$40 million in sales), it is not uncommon to have one or two customers that account for a majority of sales. Such customer concentration can be an issue because the profit- ability of the company is too closely tied to the success and choices of a limited number of customers. If any one customer accounts for more than 25% of sales, then the company should be working to diversify its customer base, as it will be a topic of discussion with any potential investor. The preferred approach is to attract new customers and increase sales.
Many middle-market CROs and CDMOs are headed by a CEO/founder that remains responsible for running all of the day-to-day activities. This management strategy is not scalable, however, and is often a liability from the perspective of investors. Investors are seeking a platform for growth. To ensure continuity of the business, it is essential that a management team capable of running the company be appointed, in case the CEO decides to leave (for whatever reason), including a sale in which the CEO does not transition to the acquired operation.
Before seeking funds from investors, it is essential for middle-market CROs and CDMOs to ensure that the financials they intend to present are those that will be acted upon. In smaller companies, misallocations of ownership (e.g., IP, infrastructure) or hidden costs often occur and can dramatically impact a firm’s financials. Problems uncovered after investors have been approached that require adjustments can affect the company’s valuation and create serious obstacles for any transaction. Auditing by a third party is the most effective means of identifying any issues and ultimately achieving clean financials. For smaller CROs and CDMOs, a mid-tier auditing firm is more than sufficient and will ensure that the company will receive the attention of senior accounting experts.
When a middle-market CRO or CDMO begins to seriously consider non-organic growth options or a sale, it is critical to ensure that it is positioned properly to attract investment, and there is often considerable work to be done. The company’s differentiated value-creating capabilities must be clearly delineated, additional business development action should be taken to increase and diversify the company’s current customer base, and a strong, knowledgeable management team (on par with the CEO) must share decision-making responsibilities. In addition, taking the time to ensure a formal accounting system is in place — and that all financials have been audited — will ensure that engagement with investors or buyers begins on the right footing.
All of these steps are time sensitive and must be initiated well in advance. If the proper preparations are made before conversations with potential investors take place, the management of the CRO/CDMO will be in a position to lead that conversation rather than be dictated to.
Jeff is also Executive in Residence at Revelstoke Capital Partners. Previously, Jeff was Managing Director and head of the New York office of ORIX Healthcare Capital, and Director of Investments at Mitsui & Co. (U.S.A.), Inc. He has been a Board Director of MED3000, Inc. among others. Jeff began his career as an investment banker for Brown, Gibbons, Lang & Co. and UBS Investment Bank. He is a member of The Brookings Council at The Brookings Institution.