Charles Loretto
We have seen a significant upswing in the number of buyout offers being made by private equity (PE) firms, leading many private practitioners to consider selling their practices much earlier than they had planned. In the past, the offers put on the table by PE firms were final, leaving little room for negotiation. However, times are changing; we have seen increased room for negotiation as more and more firms have entered the market over the last 5 years. Today there are investor and Dental Service Organization (DSO) conferences that attract regular attendees in the thousands, all of them wanting to enter the dental space and reap its financial benefits. Given their recent success, we believe PE firms are here to stay, and at this time it’s hard to know how this trend will ultimately impact the industry.
Prior to accepting any offer to buy your hard-earned business, it is important to understand your personal financial situation and how the sale would both positively and negatively impact you. There are many factors that must be carefully considered, including:
- Time value of money
- Tax planning for you as the owner
- Pension planning
- Uncertainty over the withheld balance of the sale
- Loss of control
- Reduction of stress
A sale is more than what you get—it’s also what you miss out on. But if everything is for sale for the right price, as the saying goes, how is the “right price” for a practice calculated?
This “right price” is not just a monetary sales price; it also takes into consideration something referred to as the opportunity cost. The opportunity cost is the cost of the benefits an individual, investor, or business misses out on when they select one offer or option over another. When faced with a business decision like whether to sell their practice, an owner should look at the opportunity cost, along with other factors, when there are multiple options before them. The right price ultimately is the one that is likely to yield the greatest return over time, taking into account the potential benefits one might give up with the accepted offer. This can only be determined by taking a close look at opportunity costs.
The right price and the right time to accept an offer are different for every practice and every doctor. In the following case study, we will perform a couple of the exercises that PE firms and financial services firms like CWA undertake prior to making or accepting an offer.
Case Study 1: General Dental Practice with Collections of $1.4 Million
To understand a PE firm’s offer, we first need to gain a full picture of the financial benefit the doctor receives as an owner. More than just the owner’s salary or taxable income, this includes benefits such as pensions, meals and entertainment, and the value of other non-cash expenses such as auto mileage that would be recorded against the owner’s bottom line. This exercise is similar to the due diligence a bank would perform during a traditional valuation of your dental practice.
Shown below is what this exercise might look like using the example of a general dental practice with collections of $1.4 million. Let’s assume the doctor’s collections are $1.1 million and hygiene produces $300,000.
Step 1: Figure out your EBITDA
The best way to understand a PE firm offer is to figure out your EBITDA, which refers to your earnings before interest (EBI), taxes (T), depreciation (D), and amortization (A). Our dental transition affiliate, National Dental Placements (NDP), refers to this exercise as the normalization of the business.
Based on this case example, here is how a PE firm will generally calculate the EBITDA. The net benefit is the baseline, which in this example is $520,000. The baseline is reduced by what the firm would pay the doctor to work in the office following the sale. In this case we estimate this amount to be $300,000, which is the $1.1 million in doctor collections multiplied by a standard compensation rate of 27% of collections. This results in a $220,000 EBITDA, to which the PE firm will apply a 5–7 multiplier number to arrive at the price it is willing to pay.
Step 2: Understand the multiplier
How do PE firms determine what multiplier makes sense? They will look at risk factors unique to the practice to arrive at the appropriate multiplier. Factors that could impact a multiplier include location, finish out (ie, age and condition of the building), patient flow, and state of technology. If we assume in this example that the multiplier utilized was 6, then the offered price would be 6 times the $220,000 EBITDA, or $1,320,000. This figure amounts to 94% of last year’s collections.
These multipliers are attractive to most owners. If the practice used in this example was valued according to the industry standard dental valuation models (rather than the PE valuation method), it would be reasonable to expect that the practice would sell for only 75% to 80% of collections, or $1,120,000 (80%).
Step 3: Consider the nonfinancial requirements of the deal
Appealing multipliers and monetary offers are typically only one part of the deal. Another important factor to consider in these types of deals is the guaranteed work back that the seller would be required to commit to as part of the sale. Industry standard is typically a minimum requirement of 3 years, although we have seen requirements up to 5 years. This commitment may be undesirable or unfeasible for some sellers depending on their personal situation.
Another very important factor to consider with this kind of deal, that does not get as much attention, is the contingency and sale stipulations for payment. In many of the deals with PE firms that we see, the sellers do not receive 100% of the sale right away. These deals include a clause offering a certain percentage up front and the remaining percentage to be paid in the future. For example, the initial deal may be a sale of 60% of the practice at 6 times earnings. What will happen to the remaining 40%? The theory is that the PE firm will grow the organization by purchasing and packaging together additional offices with the goal of selling to another company for profit.
This presents additional future uncertainty as one cannot anticipate the conditions of the next 40% sale. Consider a situation where the next buyer will want you to stay on another 3 to 5 years, just when you thought you were out. This would transform the offer from a straightforward $792,000 (60%) of the value today, with a salary of $300,000 to run the practice for 3 to 5 years, to a level of uncertainty that accompanies the value and timing of the remaining 40% of the practice.
Step 4: Weigh the opportunity cost
When looking at the whole deal, it’s equally important for you to consider what you would be giving up as well as the actual dollar amount of the sale. In this example, the doctor must consider the $220,000 reduction in annual income—the difference between the doctor’s $520,000 net benefit versus the $300,000 in salary he or she would receive post-sale—over the 5-year period. Other owner benefits that would be lost with the sale may include business owner tax-planning opportunities, pension plan contributions, and the satisfaction many doctors feel in having key decision-making and overall practice control.
In this example, our team would likely advise the client against selling based on the estimated loss incurred over the 5 additional years, or if sold in a traditional outright private sale. Next, let’s look at an example involving a specialty practice.
Case Study 2: Orthodontics Practice with Collections of $3 Million
This example involves an orthodontics practice that carries 50% overhead after normalization (ie, EBITDA calculation explained above). In this practice’s case, the PE firm’s offer would likely require the one-doctor owner to work in the practice for 2 to 3 years at $300,000 per year, thus leaving $1.2 million for EBITDA.
Applying a multiplier of 6 to $1.2 million results in a $7.2 million valuation. This particular PE firm has been paying 80% of the value up front and the remaining balance at the end of the 2 to 3 years, with hope of the same higher multiplier. Considering that average valuations typically range from 70% to 85% of market price, at 240%, this offer is hard to turn down.
A key difference between an orthodontics practice and a general dental practice is the ability of the orthodontist alone to complete all of the treatment for the $3 million in collections. In addition, the overhead is also much lower, contributing to the much higher EBITDA.
Over the past year, CWA has had numerous orthodontists sell to PE firms under this type of model. Although each doctor’s opportunity cost is unique, CWA’s advisors typically support a sale when the value of the business is higher than the traditional market value, and the work back commitment is low. In our experience, based on these models, several practices have sold for more than 8 times their EBITDA. As of this article we have yet to see an offer by a PE firm make financial sense in the oral surgery, periodontics, or endodontics space.
Conclusion
Every PE offer should be considered individually and weighed against the owner’s financial plan and long-term goals. When contemplating the opportunity cost, it’s important to understand not just the monetary value but also how the sale will both positively and negatively impact the owner personally. There will always be practices where these PE models will make sense for both general and specialty practices—particularly those in which the associates do not want to buy in under a traditional model, or when the practice has very low overhead and therefore the EBITDA yields a much higher value. We encourage you to consult a professional who can review an offer through an objective lens.
Disclosure: Cain Watters & Associates LLC is an investment advisor registered with the Securities & Exchange Commission. Information provided does not take into account individual financial circumstances and should not be considered investment advice to the reader. Request form ADV Part 2A for a complete description of CWA’s financial planning and investment advisory services. There is no assurance that other client actual results will be similar to information presented. Estimated future results may not be obtained due to economic, business and personal circumstances.
