In recent years, the emergence of Dental Service Organizations, Private Equity, and small group practice buyers has significantly changed the dental practice market landscape. Revered by some, while feared and even loathed by others in the dental industry, these groups are aggressively buying up dental practices at an unprecedented pace. We regularly hear about dental practice owners receiving multiple unsolicited offers from these firms…often for valuations that can sound too good to be true. With all the rumors and message board chatter, it is often difficult to get straight answers about how these kinds of deals work and what’s real and what isn’t. In this article, we will share a number of insights about these buyers and how they pursue dental practice acquisitions, and what to consider when entertaining one of these offers.
First, as a point of reference a Dental Service Organization or DSO is an organization that owns and manages dental practices. They come in many forms and there are a number of variations on what they are called. Sometimes called Dental Management Organizations (DMO’s) or Dental Partnership Organizations (DPO’s) these organizations can have a wide range of ownership structures and business models. For our purposes, we will consider all of these together and refer to them as DSO’s, but you should know there are nuances between each type of organization and there can be pros and cons to each. Second, Private Equity or PE firms usually do not purchase dental practices directly. While there are exceptions out there, PE firms usually invest in DSO’s or small group practices and provide or arrange access to credit facilities to fund dental practice acquisitions. This is an important distinction because while you may be negotiating with a DSO, some or all of the terms of the deal may be subject to review and approval of a PE firm.
Another key element to consider is the way DSO’s and PE firms analyze and value dental practices. In most transactions where a solo dentist is selling to another solo dentist, a multiple of Seller’s Discretionary Earnings (SDE) is developed and applied to the subject practice. In a sale to a DSO or PE group, they will develop and apply a multiple of Earnings Before Interest, Taxes, Depreciations and Amortization (EBITDA). This is a key difference and something that many practice owners don’t fully understand. Both are a measure of a practice’s profitability, but they are significantly different. Think of SDE as the net economic benefit of owning and operating (i.e. working in) your own practice if you were to purchase it without any debt. SDE actually includes EBITDA and adds to it any compensation, perks or other discretionary expenses of an owner/operator of the business. In other words, SDE assumes that the buyer will purchase the practice and work in the practice. EBITDA on the other hand assumes that the owner of the practice will not work in the practice. That is, the owner will have to pay an associate doctor to do the dental work in the practice. In some cases, EBITDA may also assume additional costs for managing the day-to-day operations of the practice. These key differences mean that in any given practice SDE is, by definition, going to be larger than EBITDA. This also means that multiples applied to EBITDA will be larger than those applied to SDE. Let’s consider an illustration. I have a client with a practice with SDE of $600,000 and EBITDA of $300,000. If the practice sold for $1,200,000, that would reflect an approximate multiple of 2X SDE or 4X EBITDA. It is important to note that solo practices will often sell for 4-5 times EBITDA to a DSO or PE group whereas small group practices and larger multiple location practices can command considerably higher multiples if they are well run and the cash flow is healthy. The takeaway here is to make sure you are comparing apples to apples when you hear about the multiple that a friend or colleague received for their practice.
The most important thing to keep in mind when considering a DSO or small group practice acquisition is that the devil is ALWAYS in the details. No matter how good the valuation or offering price, there will always be caveats, contingencies and other provisions in the deal that you need to understand before you accept an offer or spend large amounts of time working on one of these deals. Here are a few things to consider:
1) Work Back Requirement – Most DSO’s, Small Groups and PE firms will require the seller to stay on and work as an associate in the practice after the sale (or sometimes as a partner). In most cases, they will require the seller to work for 2 years or more. There are some instances where the buyer may be willing to waive this requirement, but it depends on the nature of the dental practice, availability of associates in the area and a number of other situational factors. Compensation for associates can vary widely from 25% to 35% of the associate’s production. There can also be other elements of the compensation package to consider such as production goals, production bonuses, lab fees, implants or other high dollar supplies, CE benefits, health insurance, etc. It is extremely important that you fully understand exactly what the DSO or Small group is offering and what the day-to-day work will look like after the sale. In many cases, in addition to treating patients, associate doctors are required to take on some kind of formal or informal management role. This can be frustrating to a seller who’s motivation to sell is to minimize or eliminate the headaches of managing a practice! Conversely, this can be attractive to a dentist who wants to get a premium for their practice and continue to keep working after the sale.
2) Holdbacks, Earnouts and Equity – Many DSO and Small Group purchasers will require that part of the purchase price of the practice be held back for a period of time or earned by the seller over time after closing the sale. In most cases, this will be tied to the performance of the practice after the sale as well as the seller’s fulfillment of their workback obligation. This is done with the intention of aligning the interests of the buyer and seller after closing. The thinking is that it provides an incentive for the seller to ensure a smooth transition of staff and patients and continue to produce after the sale. The challenge with these arrangements is that they give the buyer complete operational control of the practice and its management but they shift a significant portion of the risk for those actions to the seller. For example, consider a seller that sells his or her practice for $1.2 Million dollars and is required to work back for the seller for 2 years after the sale. Let’s assume that $200,000 of the sales price will be held back and distributed to the seller in annual installments of $100,000 for 2 years, but only if the practice meets or exceeds certain performance thresholds each year. So if the DSO or group that buys the practice fouls up the marketing, or mismanages the staff or scheduling, it is quite possible that they will not have to pay the $200,000 to the seller when it comes due! This dynamic can also be complicated by the fact that a number of DSO’s give equity in their business as part of the consideration for the practice. So instead of our hypothetical seller receiving $1 million in cash and having $200,000 at risk in the holdback, he or she may have only received $800,000 in cash and received another $200,0000 in equity in the buyer’s business that may be difficult to convert to cash due to lockup periods, etc. So while the rumor may be that someone sold their practice for some large amount, there can often be a significant risk that the seller may not realize all of that money.
3) Due Diligence and Renegotiations – DSO’s, PE firms and even some smaller group practice buyers are notorious for having extremely rigorous due diligence requirements. It is important to remember that these buyers are very sophisticated and many sellers find the due diligence process to be extremely overwhelming and frustrating. In some cases, the things that the DSO requires for their due diligence aren’t in the best interest of the seller to provide. We were once brought in to help sell a dental practice after the owner had tried and failed to complete a deal with a small group buyer. Unfortunately, the seller had agreed to let the buyer interview all of the employees as part of their due diligence. As part of the interview process, the buyer told several key staff members that they were overpaid and that they were going to be cutting pay and benefits. As a result, a number of employees decided to quit before the sale was completed. The buyer came back to the table right before closing to renegotiate the sales price stating that since key staff members had left, the practice was no longer as valuable! After the deal was terminated, the buyer then poached several other staff members from the practice! We were brought in to try to pick up the pieces and get the practice sold, but by that point a lot of damage had already been done. While this case may be extreme, it illustrates the point. There can be serious unintended consequences to blindly providing information and access to your dental practice for a buyer’s due diligence and sellers need to watch out for 11th hour renegotiations. And to make matters worse, many DSO’s and PE firms try to dissuade sellers from working with a broker or practice transition consultant under the guise of saving the seller money. In reality this allows them to dictate the terms of the deal and sometimes put the unwitting seller at a serious disadvantage.
Selling to a DSO or small group is often intriguing to many sellers. And for some practice owners, selling to a DSO makes sense both financially and strategically. In other cases, it may not be the right path for exiting your practice. If you decide to entertain a deal with a DSO, small group or PE firm, it is important for you to understand that they are not all created equal. Just like in any profession, there are good ones and bad ones. A good broker or practice transition consultant knows the difference and can help you explore the options and key differences between each, while making sure your interests are protected throughout the deal. They can also add a lot of value by helping you navigate the additional complexity, nuance and due diligence required in these kinds of deals. When it comes to the sale of your practice, details and experience matter! DSO’s, PE firms and groups have sophisticated and experienced advisors and employees working hard on their side. You should have someone with experience and integrity in your corner that is looking after your interests and keeping the other party accountable. If you are considering a sale to a DSO, PE firm or group practice, we can help!
Aaron Pershall is the founder of Pershall Transitions. He has specialized in dental practice sales, transitions and mergers throughout AK, WA, OR, ID and HI for over 15 years and helped hundreds of doctors achieve their practice transition goals. Aaron is also a Certified Business Appraiser (CBA) and a member of the Practice Valuation Study Group. He can be reached at aaron@pershalltransitions.com or 888-896-6322. When he isn’t working with clients, Aaron loves spending time with his family in the great outdoors traveling, hiking, camping, skiing, boating and kiteboarding. Aaron lives in Olympia, WA with his lovely wife and two children.
