Messy split at Starkey Hearing is making industry waves

A few days before Christmas, 1,400 employees of Starkey Hearing Technologies gathered on the company's Eden Prairie campus for a pep talk.

It had been a tough three months. Sheriff's deputies had escorted the company's longtime president, Jerry Ruzicka, from the premises after his abrupt firing. The company terminated a succession of other veteran employees, and FBI agents searched the houses of several ousted executives for evidence of unspecified crimes.

Now company leaders — led by founder Bill Austin and his stepson, Brandon Sawalich — attempted to rally the troops. They reminded their shocked employees that Starkey was coming off its best year ever. Annual revenue had reached $800 million and was growing steadily. New hearing aids were selling well.

"People think, 'Oh my gosh, Mr. Austin has terminated four top executives. How does this company survive?' " Senior Vice President Sawalich said in a recent interview with the Star Tribune. "Well, we are not run by a bunch of people who don't know what they're doing. … We have a deep talent pool. The company is healthy and financially strong."

Austin and Ruzicka built Starkey into one of the world's top hearing aid companies through almost half a century of attentive salesmanship and, in recent years, technical innovation. The company and its related foundation are well known for hosting A-list celebrities and the political elite at epic fundraisers each year, as well as for donating hundreds of thousands of hearing aids to the needy.

Now Starkey is attracting a much different kind of attention. At least 20 managers and high-ranking employees are gone, including Ruzicka, who led Starkey for 17 years. Several former workers have sued the company. In one suit, Ruzicka accused Austin and Sawalich of a host of improprieties, from knowingly using defective parts to spending company money on personal expenses.

In response, Starkey's lawyer accused Ruzicka of stealing millions of dollars. Company officials have said the focus of the federal investigation was on former employees, not Starkey, which — according to a letter sent by federal authorities — may have been the victim of an unspecified crime.

As legal maneuvers continue, Starkey faces big challenges. In an industry where innovation is hugely important, Starkey's new patent filings reached a nine-year low in 2015. Its share of the fast-growing veterans market is shrinking. And its national network of independent dealers faces challenges from both big-box retailers and the Obama administration, which wants to reshape the way hearing aids are sold in an effort to bring down cost.

Industry watchers say Starkey's messy corporate divorce is also shaking up the brutally competitive hearing aid business, which a handful of European manufacturers dominate. Starkey currently ranks fourth in U.S. sales, with about 16 percent of the market.

"Their competitors are licking their chops," said Alex Morozov, a hearing aid analyst with Morningstar Inc. "Everybody is trying to figure out where the next market share gain is going to come from. And with the possible operational disruptions coming because of what is happening at the top of their company, the consensus is that Starkey is at risk right now."

Starkey started out as a minor player in the hearing aid industry. Austin paid $13,000 for an earmold business named Starkey Labs in 1970, three years after the medical school dropout started a small hearing aid repair shop at his home in St. Louis Park.

Known as a savvy salesman, Austin quickly found ways to endear himself to customers. He provided the industry's first 90-day trial period, and he broke new ground by offering to repair anyone's hearing aids — whether made by Starkey or not.

"We were the Nordstrom of the hearing aid industry," said one former manager, referring to the department store's reputation for customer service.

The company's first big break came in 1983, when President Ronald Reagan appeared in public with Starkey technology in his ears. The company's sales doubled overnight, overwhelming its manufacturing system. Ruzicka, who had joined in 1977, was charged with re-engineering the process.

Sales continued to climb as Starkey expanded into Europe, but the company's products were not keeping pace with the competition. In the mid-1990s, as digital technology revolutionized the industry, former managers say Starkey was caught flat-footed.

Austin made Ruzicka president in 1998, with a mandate to reinvent the company. Ruzicka plowed millions of dollars into new technology, building a respected research team of more than 450 scientists.

Their first major breakthrough arrived in 2006, when Starkey unveiled its Destiny series of hearing aids, which dramatically reduced whistling, allowing users to crank the volume. It cost $15 million and took three years to develop the new product, but it boosted sales 40 percent.

"Jerry realized that Starkey had to be a tech company and not a sales-driven company," said Dan Quall, a former managing director at Starkey. "It saved the company."

Today, thanks to engineering discoveries by Starkey and other manufacturers, hearing aids have become smaller, smarter and vastly better. Feedback, a perennial complaint, has almost been eliminated. Customers can adjust the settings to screen out background noise in restaurants and football games. They can even tie the devices into their iPhones and use them to stream music and make phone calls.

Such features don't come cheap. According to Ruzicka, Starkey spent $70 million on product development in his last year with the company, up from $10 million when he became president. Starkey, which rarely earned patents for its scientific work in the 1990s, has racked up 202 new patents since 2004, federal records show.

"Nobody makes the perfect hearing aid, but I think Starkey is best at more things than anybody else," said Dale Thorstad, a former Starkey executive who now runs a large buying group that works with all major manufacturers.

Starkey's technological prowess has not gone unnoticed. The walls surrounding Austin's open workstation are covered with photos of well-known clients, which include five American presidents, a pope and stars ranging from Paul Newman to Ozzy Osbourne.

"I treat them all the same," said Austin, looking like any other technician in his white smock while he worked on a client who recently flew in from Australia for a custom fitting.

But in a fast-moving business, it is easy to lose momentum. In 2015, Starkey sought patents for just 18 inventions, down nearly 50 percent from 2014 and well off the company's high of 69 patent applications in 2013, federal records show. Starkey was awarded 58 patents in 2015, the most in company history, but those applications had been awaiting approval an average of three years.

Patent activity is considered a key indicator of a technology company's competitive status, said Arthur Erdman, director of the Medical Devices Center at the University of Minnesota.

"If you are not continuing to innovate by adding more protection through patents, pretty soon you are like a one-hit wonder, and it's like — Where did that company go? They're not around anymore," Erdman said.

Austin and Sawalich spoke with Star Tribune reporters in January during a tour of the company's headquarters. But the company canceled several subsequent interviews after the Star Tribune submitted written questions, to which Starkey provided written responses.

Starkey's chief technology officer, Tim Trine, noted in a statement that the company is adding 35 positions to its research and development team this year.

"The company's investment and commitment to new product development has never been stronger," Trine said, "and more exciting breakthroughs are on the horizon."

When a hearing aid company falls behind its competitors, industry analysts say one of the first places it shows up is the Veterans Administration, the world's second largest buyer of hearing aids and a notoriously finicky client.

This fall, for the first time in years, Starkey slipped from its No. 2 position as emerging competitor GN ReSound nearly tripled its share of the vets' business and moved in front of the Minnesota company. Starkey's sales to vets dropped about 8 percent in 2015, federal records show.

As it looks to find new business elsewhere, the company is somewhat hamstrung. Unlike other major manufacturers, Starkey has avoided creating a large network of company-owned stores, relying instead on thousands of independent dealers, including audiologists.

"We have no interest in being in retail," Sawalich said. "It is not an offensive strategy for us."

Starkey also has avoided Costco, the fastest growing distribution channel for hearing aids. By 2018, analysts predict Costco will control 15 percent of the market, up from just 3 percent in 2004.

By staying away from Costco, Starkey has avoided alienating high-margin independent dealers, who resent the discounter for selling comparable hearing aids for 35 percent less. Other manufacturers have witnessed an exodus of dealers when they began selling at Costco.

Chris McCormick, Starkey's chief marketing officer, said in a written statement that the company has "no plans to sell our products through big-box retailers" because Starkey believes its "path to success" depends on the growth of independent dealers.

But Starkey's reliance on mom-and-pop outlets could cause problems. Independent dealers have lost 10 percent of the hearing aid market in the past decade, and that trend is expected to continue. Bernstein Research predicts independents will account for just 31 percent of U.S. sales by 2020, down from 49 percent in 2004.

"It's maybe not a great long-term strategy," said Bernstein analyst Lisa Clive. "Ultimately, a lot of those small stores are going to go out of business."

Moreover, the outlook for independent dealers could worsen.

In an October 2015 report, a White House advisory panel recommended a new system that would encourage people to shop around for hearing aids, taking hearing professionals out of the equation in many cases. The council said dramatic action is required to reduce the price of hearing aids, which averaged $2,363 in 2014. Most people have no insurance to cover those costs.

For many Starkey veterans, the big question hanging over the company is: Who will lead it now that Jerry Ruzicka is gone?

Starkey officials emphasize that the company still has seven of its 11 top executives, with the team averaging 21 years with Starkey.

Officially, at least, the new president and CEO is Austin, who is credited with being a visionary who left much of the detail work to his underlings. For more than a decade, Austin, who is 73, has spent most of his time working for his charitable foundation, traveling the world to dispense hearing aids to people who can't afford the technology. In a brief interview, Austin recently said that he currently travels about 10 months a year.

Former managers say the most likely successor to Austin is Sawalich, who has been working for Starkey since he was 19. Like Austin, Sawalich is considered a first-rate salesman who relies on others for financial and technical expertise. Ruzicka was allegedly fired after refusing to designate Sawalich as his replacement, according to a lawsuit by a former Starkey executive.

Some former managers question whether Sawalich, who did not graduate from college, has the skills necessary to run a large company in such a hotly competitive industry. In his lawsuit against the company, Ruzicka claimed that a "large number of Starkey executives ... feared that their job security would be in jeopardy because Sawalich had not demonstrated competency in business matters. He was also known to favor perceived loyalty over talent."

Starkey has not yet answered Ruzicka's allegations.

Other former managers say Sawalich could succeed if he surrounds himself with strong executives, like his stepfather did.

"Nobody is the best at everything," said Thorstad, who spent 33 years at Starkey before resigning as vice president of operations in 2002. "Jerry was an engineering guy and that is very unusual. Virtually every other president in our industry has been a sales guy."

For his part, Sawalich downplays the notion that he won the power struggle for control of Starkey.

"I don't care about the title," Sawalich said. "I do everything from getting a cup of coffee, picking someone up at the airport to engaging with customers. ... I am doing whatever it takes to make sure the people at Starkey are taken care of and our customers are taken care of."

Jeffrey Meitrodt • 612-673-4132

Dee DePass • 612-673-7725