Leveraging Smallcap Stock Status

An example of the benefits of using publicly traded status to execute on business strategy.

ByAdam Ismail

Over the past few years, there has been a minor explosion in the number of publicly traded smallcap stocks in our industry. Few firms, however, have been able to take advantage of their situation to build sustainable business models, and many end up with stock prices valued at a penny or two. However, corporate titans like Citigroup were built on unique acquisition structures that used the benefits of being publicly traded. In March, Dynamic Health Products (OTCBB:DYHP) acquired a Rhode Island-based sports beverage distributor, Dy­namic Marketing Inc. (DMI), in a transaction that was designed to leverage Dynamic Health’s public listing.

Small distributors are typically relationship-based companies that live or die with the owner/operator of the business. In fact, acquisitions of small distributors in any industry often fail simply because the owner no longer has the motivation to be part of the business and the relationships end up migrating to other distributors. However, there is also significant opportunity because small distributors don’t often have a lot of products and being acquired can give them access to many more sales opportunities.

Dynamic Health announced it was acquiring DMI for $3 million, but that doesn’t necessarily tell the whole story. Only $75,000 of that price was paid in cash, with the remainder in earnout payments, stock options and restricted shares of stock. What this does is give the incentive for the seller to stick with the company under the deal and help make it a success. This is not a new technique, and when both the buyer and seller are motivated, both parties can become quite wealthy. Though that is not the only benefit of this structure. DMI had a loss of $0.3 million dollars last year and relied primarily on a cash overdraft to generate positive cash flow. There was significant financial risk in acquiring DMI, so by paying little cash upfront, Dynamic Health can sleep well knowing that it did not overpay if DMI does not perform.

In fact, if you look at the stock portion of the transaction, you can see how little Dynamic Health is risking in the $3 million purchase price. The restricted stock DMI received was valued around $110,000 at the time the deal was announced. Dynamic Health al­ready has 13 million shares outstanding, so its shareholders do not have to worry about being significantly diluted from the issuance of 100,000 new shares. In addition, the restrictions on the shares help prevent Gregg Madsen, the owner of DMI, from selling them right away to cash in on his new wealth. In fact, as part of the deal, he has signed an employment contract committing him to continue working for the company. That agreement, combined with his shares in the company, give him a real incentive to make the new deal succeed.

The options in this deal give Mr. Madsen the right to buy 250,000 shares of Dynamic Health’s stock at $1.55 in three years. This helps commit him to the company for three years and gives him a strong incentive to boost earnings. If Dynamic Health’s shares double to $3 in the next three years, he would net an extra $500,000 from the transaction.

The third component to the deal is the earnout. The way the earnout is structured in this deal, Mr. Madsen will essentially receive more stock in Dynamic Health if DMI delivers on strong profit growth objectives. Every year he is eligible to receive 50,000 Dynamic Health shares if its EBITDA (earnings before interest, taxes, depreciation and amortization) im­prove by 5% in 2006, 25% in 2007 and 50% in 2008. Given that his division is currently losing money, he could potentially have a big impact on the organization.

The final component, and the biggest part of the deal price, is that Dynamic Health will pay off DMIs debt, valued at nearly $2 million. DMI seemed to be hurting, drawing heavily on its line of credit and cash overdraft, so using Dynamic Health’s ability to get funds because of its public status could have saved DMI.

This was just one case of a company in our industry using its publicly traded status to execute on its strategy. Too often there are companies that end up flailing under the burden of costs and reports associated with being public. By the way, Dynamic Health also noted that it has signed a letter of intent to pay $65 million in cash for a supplement manufacturer. It will have to once again use its public status to raise the capital required for that acquisition.NW