Is the Value of Your Practice Higher Than You Think?
Kevin G. Cumbus
Much has changed over the past decade in the business of valuing and selling dental practices. In 2007, I joined a well-established dental practice valuation and transition company. We worked exclusively with dentists to help them establish a value for their business for the purpose of either a 100% sale or a buy-in from the associate or future partner. The valuation process was always the same. We would request a stack of documents, including tax returns, profit and loss statements (P&Ls), historical production and collections reports, and payer-by-source reports. The client, in turn, would mail back a mountain of paper, through which we would wade, then we'd pour all of the data into a financial model and turn it into information. Next, we would work with the dentist to establish the net income from the business, then perform seven intricate valuation methodologies and weigh each one based on various qualitative aspects of the business. It was a thorough and rigorous process that took many days to complete.
After establishing the value, we would then author a more-than 50-page book detailing the methodologies and academic theories on which we relied to obtain our "answer." Without fail, after all that work, the value always ended up somewhere between 75% to 80% of collections.
There are two primary reasons for this result. The first is "ability to pay." Our company would run a 10-year future cash flow to show that the buying doctor would earn (on a pre-tax, after-debt basis) somewhere around $125,000 (in 2007) in the first year and show an increase each year thereafter. The second reason is the "bank's lending ceiling." Banks simply were not willing to lend money to a dentist for more than 80% to 90% of value to 1 year's revenue. Period. This set the artificial ceiling on dental practice valuations.
These were the two driving forces that kept values at or around 75% to 80% of collections. Whether these businesses were selling 2x EBITDA (earnings before interest, taxes, depreciation, and amortization) or 16x EBITDA, all that mattered was that the bank would fund the sale and a buyer could live off the cash flow.
To be clear, EBITDA is a proxy for "operating cash flow," meaning it is the cash that the business provides the owner, irrespective of capital structure (debt and the accompanying interest payments), taxes on sales (so different tax strategies can be distilled), amount of fixed assets needed to create the revenue and how quickly the business is writing them off (depreciation expense), and goodwill from acquisitions (amortization expense, because the valuation company isn't concerned with whether the seller built or bought the profit). EBITDA is the metric on which most businesses are measured.
In the example provided in Table 1, both practices generate $1 million in collections. Many brokers today would still value both of these businesses at 80% of collections, but when looking at each value as a multiple of EBITDA, it becomes readily apparent that Practice A is much more expensive than Practice B. Practice B provides the owner 7.7x ($385,000/$50,000 = 7.7x) more cash flow than practice A, hands down.
When private equity groups (PEGs) began buying dental practices, it came as no surprise that they might have been interested in revenue but were focused on EBITDA. It was not until private equity-backed group practices and dental service organizations (DSOs) entered the market that sale prices began to rise above the artificially low values of prior valuations.
There are two main reasons why it took this event to move practice values up: (1) DSOs backed by PEGs have access to more capital than average dentists interested in buying a practice. Solo dentists are capitally constrained by what a bank will lend to them (80% to 90% of collections), while a PEG does not have this ceiling. As a result, PEGs can pay significantly more than the average dentist. (2) DSOs are "playing a different game" than solo dentists. DSOs themselves are valued on EBITDA. Regularly, DSOs sell at 10x to 12x EBITDA. So, although DSOs do not want to pay any more than they must for dental practices, financially they can and do pay anything less than that 10x to 12x range for solo and group practices. They do this because there is a financial arbitrage for their business every time they buy a dental practice for less than their expected trade value. They are not focused on how many locations a group consists of or how much revenue the business collected in the past 12 months. Their primary focus is on EBITDA.
To illustrate this point, consider a transaction my current company completed in the last 12 months. Our client owned a large general practice in the Southeast. He was the lone dentist, and the business generated $2.6 million in revenue with a lean team in a rural area. He was told by a local broker to expect no more than $1.8 million (70% of collections) for his practice because buyers simply could not get a loan larger than this due to the fact that the business simply had too much risk and was too rural to warrant a higher price.
Our firm assured him that was not the case and worked with him to position the practice as a partnership opportunity with a DSO. He was excited about the possibility of continuing to work in his practice post-sale while giving up the managerial headaches. We took him through a marketed sales process, and within 121 days his business sold for more than $4.5 million (over 170% of collections).
This was able to happen because the buyer was not interested in the collections; it was focused on the EBITDA. Our client was an excellent dentist and ran an efficient business, creating a huge amount of EBITDA (more than $800,000). From the buyer's perspective, it paid over 5x EBTIDA, which is within market range (not 170+% of collections). The buyer is likely to go to market in the coming 24 months and sell for 10x to 12x its collective EBITDA. In short, everyone wins in transactions like this.
Thus, when thinking about the value of their business, dentists should not believe it is worth some percentage of collections. This is simply not the case. To those dentists who currently own dental practices, congratulations-you own an extremely valuable asset!
About the Author
Kevin G. Cumbus
Cofounder, Partner, and President, TUSK Partners, Charlotte, North Carolina. TUSK Partners (tusk-partners.com) provides resources to group dental practices and DSOs, helping clients start, grow, and sell their business.