Evaluating Risk When Selling Your Dental Practice
Dentists selling their practices often have unrealistic demands. Some that the author hears a lot go something like this: "I want a 9X on 1.8MM in EBITDA, 80% cash at close, and no earnout!" or "I want an 8X on 550k in EBITDA, 100% cash at close, and a 12-month employment agreement."
One has to wonder where these expectations come from. There are dozens of funnels of information that somehow find their way into the general dental population. However, a vast chasm currently seems to exist between expectations and reality, and the reasons for it appear to be multifactorial.
Dental support organizations (DSOs) contend they are offering premium multiples with huge equity upside, conditioning sellers to expect numbers that are out of market and generally unobtainable. Brokers do much the same to "win" the listing. Private equity (PE) groups are constantly trying to find platforms and regularly announce recap multiples to founding partners that may or may not have any obtainable goals attached to them and have minimal attachment to the reality of a platform investment without existing infrastructure. Certified public accountants and attorneys with nominal merger and acquisition (M&A) experience typically believe that practices are worth more than they are.
So, where does a seller turn for help? How does one determine what is viable and what isn't? Selling in today's space is laden with complications, which may be compounded by the many emotional speed bumps dentists are likely to confront when selling their life's work. It is important to understand expectations from both the buyer and seller viewpoints as part of the up-front process, and to recognize how valuations are driven and what the critical components are that influence valuation.
The Evolution of Valuation Methods
For decades, the traditional method of transitioning a practice involved dentists simply finding an associate that they believed would take good care of their patient base and, whether quickly or gradually, passing the business over to that associate. Valuations were consistently between 70% and 90% of prior-year collections, with the variance due largely to geography, condition of the equipment/space, composition of the payor environment, and procedural mix. Some might say these were the good old days-when being a practice transition specialist was simple and the variables were known and understood.
More recently, an influx of private capital has flooded the dental space, bringing with it far more complex funding mechanisms, analytics, and objectives and a term that was once relatively obscure in dentistry: EBITDA (earnings before interest, taxes, depreciation, and amortization). Essentially a base profitability metric, EBITDA shined a light brightly on those practices that operated efficiently and profitably while exposing those that were merely good at bringing in revenue without efficiency. It provided a simple metric to dramatically contrast healthy practices versus those that appeared healthy but really weren't. As a result, the payoff for those healthy, profitable practices was considerable, producing a massive difference in valuation between a private practice sale and a PE-backed valuation. And such is the mechanism that led to the explosion in the DSO space. Acquisitions increased at a frenetic pace, as did the thrill of victory for those sellers that "rang the bell" and, subsequently, the agony of defeat for those that could not.
Thus, seller expectations need to be viable, and practice owners should have a plan for their inevitable transition, be it doctor-to-doctor or DSO/PE-driven.
Stepping back for a second, it is important to state that DSO valuations are largely driven by a measure of risk. While DSOs may love pro-forma efficiencies and salivate about the thought of organic growth and their ability to perform above par for the industry, operating within the PE space is equally highly perilous, and risk impacts the valuation more than any metric reviewed. The following risk considerations play heavily into a practice valuation.
Provider risk-Some questions a DSO buyer might ask when considering a valuation are: What is the timeline of the doctor transitioning? Will it be easy to recruit a replacement? Is the doctor a super producer, thus indicating significant key-man risk? Does the practice have the requisite footprint to support transitioning an associate in? Are there existing DSO assets in the local geography for support? Will the lead doctor commit to 4 or 5 years post close?
These are all significant considerations in a DSO transaction and will factor greatly into the valuation they provide. Stability of the organization post close is a key focal point, and the lead provider is the most important part of that equation. Taking that away early (1 to 4 years) will lead to a valuation decrease. If the seller is comfortable committing to full-time work for 4 to 5 years post close and a reduced schedule thereafter, the risk profile is lowered and valuations increase accordingly. Sellers, thus, should start their process early rather than late.
Payor risk-Heavy preferred provider organization (PPO) involvement can offer a significant upside lift for a large DSO that has heavily negotiated its reimbursement rates. Comparably, however, a practice that has a strong fee-for-service (FFS) program (eg, Delta Dental Premier) presence will lose that benefit at re-credentialing with most acquirers, thus impacting overall profitability. Medicaid is difficult to process across the board, and most buyers shy away from any concentration higher than about 20%. Similarly, fee for service can be a warning signal to some buyers, as FFS practices tend to be largely reputation-dependent within their local markets and replacing a legacy provider in this type of practice tends to be difficult, even with the significantly higher margin rates. Obviously, one's business is what it is, and there is little that can be done to truly change that ahead of a sale. However, being cognizant of these hurdles can help dentists set expectations and determine an opportune time to exit. Also, understanding these market dynamics can inform changes that dentists may make now for growth purposes if their exit is likely 5 years or more away.
Geography-While some states are business friendly, some simply are not, and in this case the regulatory environment matters. Growth matters. States that have favorable tax environments and population growth are valued at a premium, and those experiencing decline are not. DSOs want to be where the patients are and they want practices where the patients are going; thus, these types of geopolitical factors have a tangible impact. This is mentioned here not so much to inform change, but to help provide some context to the vastly different multiples being paid in various geographies. For dentists in mid-career who are contemplating a change, resetting their location may be a smart long-term financial decision.
Financials/leverage/rates/environment-Dentists might think that having a private equity backer will provide unlimited "dry powder" investment into a given space. However, this is a misconception. In many cases, PE groups leverage their free capital against bank financing and that incestuous relationship leads to challenges when interest rates skyrocket, financing gets restricted, and cash becomes expensive, as is currently the case. This also brings into focus the type of PE group backing the DSO with whom the dentist may be speaking, as well as the longevity of the PE fund, the PE group's experience within the healthcare vertical, its operational experience within dentistry, the timeline of the investment, and the leadership of the organization. These factors all impact the cost and availability of capital, which has a direct correlation to the offer values presented. While this may seem like a lot for a dentist to consider, just know that the "highest offer" is not always the best option. The people "writing the checks" behind the scenes have full control over the support services offered, growth of the organization, stock value, operational oversight, etc. They can "turn on the spicket" or shut it off equally as quickly, and in instances where potentially 30% of the dentist's transaction value will be tied up in company stock, it is important to know who the "puppeteers" are.
Maximizing Value at Exit
Fortunately for dentists contemplating selling their business, there are literally hundreds of buyers in the dental/healthcare/medspa/medical space. Invariably, there are a few "hot hands" in the acquisition market who utilize various environmental factors (positive or negative) to their advantage to hit growth targets. This can have a muting effect on many of the factors listed above, and finding those "golden ticket" buyers can alleviate issues with funding, lower valuations, difficult purchasing terms, irrational future value projections, and the like.
A good M&A advisory firm is one that finds an optimal partner while maximizing the seller's value at exit. There are countless variables for sellers to work through, and the M&A advisory firm should be able to extract the highest possible EBITDA number, defendable at quality of earnings (QofE), and position the seller optimally in front of a pool of buyers that will look favorably on the various intricacies of the seller's business, future goals, and risk factors. Selling one's life's work is a major endeavor, and understanding fluctuations in the industry will go a long way toward ensuring a favorable process.
About the Author
Josh Swearingen Director, Mergers & Acquisitions, TUSK Partners, Charlotte, North Carolina (tusk-partners.com), a dental M&A advisory firm for large practices and DSOs
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