Selling Your Practice: The Importance of Representation
As someone who for a long while operated on the "buy" side of both a small regional dental service organization (DSO) and an elite national DSO, I can honestly say I was not a friend of the seller! Although I assured practice owners looking to sell that they had built an incredible business and that I was going to make sure any partnership was a good fit for all parties involved and get them the value they were looking to receive, in reality, as a buy side representative, my job was to find opportunities that were good fits for my organization and pay as little as possible for those opportunities. In this way, it would maximize the arbitrage that the organization would experience at its next capital event. This was done repeatedly, through a myriad of strategies, some of which are described below.
An unsolicited offer is the easiest way to source an inexpensive deal. Without the seller having proper representation there is little if any competitive process or properly determined EBITDA (earnings before interest, taxes, depreciation, and amortization) numbers. Speaking from experience, I can say that most sellers are minimally educated in this area and believe that the value of their practice is based off of a percentage of trailing 12-month revenue, ie, 70% of prior year collections. Although a skilled local broker perhaps may get 90% to 100% for the right practices, this is rare. As a comparable, most $1 million practices running at a healthy margin rate of 20% ($200,000 EBITDA) could sell for $800,000 in the private markets but upwards of $1.4 million to $1.6 million in the DSO space. The buy side representative is tasked with finding these opportunities before they are broadly represented and acquire them for somewhere in between those numbers, representing a healthy discount.
For example, I regularly offered $200,000 to $400,000 more than a private buyer would while still offering well below the standards my organization set. If the delta was to my organization's benefit by a large enough amount, I would receive a bonus for the extra value to the organization. Roughly 80% of the transactions consummated were "unrepresented" and typically traded at a 20% to 40% discount versus the opportunities my organization purchased from a dental mergers and acquisition (M&A) advisory firm.
Pro Forma Financials/Numbers Voodoo
Much of why DSOs both thrive and rapidly expand, and the entire reason why the dental market is consolidating as quickly as it is, can be attributed to efficiencies of scale. When private capital entered the market and allowed for professional management services to be built, profitability within the dental space improved dramatically for those organizations. The scale also allowed for en masse negotiations, with payers and vendors often yielding staggering results. On the private practice side, every action has an equal and opposite reaction and those payors and vendors often reacted to the lessening margins on the corporate side by working to make up for some of those losses on the entities that had little or no leverage-the private practitioners.
In an M&A transaction this allows for two sets of books to be looked at: the numbers from the seller's immediate practice performance, which are often provided by the practice's certified public accountant and reflective of the actual state of the business; and the comparable set of numbers that the DSO buyer will generate that indicates exactly how the practice will run within the DSO's ecosystem. The net effect is a dramatic increase in EBITDA and, correspondingly, a substantial reduction in the multiple paid for the practice. That is, a 7X paid for the practice based on the practice's performance is very possibly a 4X based on the DSO's pro forma modeling (Figure 1). While sellers can never assume they will get credit for all of those efficiencies, understanding how much room they have to negotiate will help minimize the chances of leaving money on the table.
Incentives With Unreasonable Benchmarks
When working with both a seller who is well-versed in M&A valuations and an equally competent accountant, buy side representatives may attempt to back-end load as much of the value as they can while ensuring that reasonably significant portions of the deal value are housed in a performance-dependent earnout with clawback options should the practice fail to hit the performance levels necessary. Generally, these performance levels are reasonable and tied to simple maintenance of existing practice performance. However, in some cases where the valuation gets higher than a certain multiple, the buyer may step up the performance benchmarks to offset the value increase. For example, a deal may be worth $10 million total, with $4 million of that available after 1 year, provided the practice hits 100% of trailing 12 months' numbers established at closing. But, perhaps the buyer has to increase the value to $12 million to win the deal. They may still provide $6 million cash at close, however the remaining might be broken up as follows: for Year 1, $4 million at 100% performance, and for Year 2, $2 million at 120% performance.
I've used this simple math to establish a simple example whereby the buyer essentially meets the $12 million enterprise value the doctor wants while requiring significant growth in the entity for the doctor to actually receive it. Also, if the seller can get the practice to 120% performance, it has significantly diluted the overall multiple paid on the deal because the additional EBITDA earned on the growth was not figured into the deal valuation.
Ensuring Sellers Remain Unrepresented
That a buyer can dictate how a seller operates seems unfathomable, but unfortunately it is happening in the dental space. Such a scenario involves a buyer representative beginning a relationship with a seller, building some rapport, gathering financials from the seller, and ultimately submitting a letter of intent (LOI) to the seller. Wanting to ensure they are making the right decision, sellers may decide to enlist the help of an expert in the space, such as a dental M&A advisory firm, but is promptly told by the buyers that they will rescind their LOI and walk away from the opportunity if the doctor is working with representation. The offer that was too good to be true is contingent upon ensuring there is no competing offer being submitted. These types of offers only survive if the brazen buyer is able to prevent anyone else from participating. A seller should be wary anytime a buyer tries to limit the buyer pool, as they likely are covering up a shortfall in the LOI.
There are many things for dentists to consider when valuing and selling their business. While overall enterprise value is vitally important and can provide generations beyond them with life-altering wealth, it is rarely the most critical component of any transaction. When beginning the process, it is important to understand the players that are present, the goals they have (maximizing arbitrage, growth through acquisition), and the strategies employed to satisfy these goals. The dental M&A process is built entirely around one single function: large entities (DSOs) making a purchase for as little as possible while providing the sellers with enough value for them to believe they are getting a great offer. Corporations thrive off of an uneducated seller's emotion and inability to identify the actual value of their asset. The delta is larger than the seller thinks, and missed opportunity is the single greatest risk of every transaction.
About the Author
Director, Mergers & Acquisitions, TUSK Partners, Charlotte, North Carolina (tusk-partners.com), a dental M&A advisory firm for large practices and DSOs