Let’s take a real-life practice and a sale to a DSO before and during the event. Be sure you keep in mind the lists of good and not so good things of a DSO, try to understand the culture of a DSO, and the ultimate goal of the business plan or model in a typical DSO structure. Bottom line is that DSOs grow by mergers and acquisitions and not by obtaining a practice and taking it to the next level of excellence and profitability. That was never their goal. Their goal is to maintain the status quo while chipping away at inflation drag while frantically trying to hit a target in acquisitions in order to recapitalize a sale to another party. As you will see, there are black and white facts in this transition. There is also supposition and future predictions that may or may not come to fruition. Basically, this is a musical chairs scenario where the music begins and at some point, it ends – with not enough chairs to go around! This will continue until there is a winner. Be careful who you bet on.
The only way this works is if a DSO can find a greater “fool” than they were and sell what they have to someone else for a huge payday. Everything is organized towards that end game. The minute equity partners find out they cannot get the return on their investment for their clients by investing in dental practices, you will see the bottom drop out of DSO futures or what they like to call their “total enterprise valuation”.
Here is a true-life example: This is a solo doctor practice that has collected $2,100,000 dollars for each of the last two years. It is a doctor nearing retirement but still having a few more years to practice. Remember that you will owe the DSO 2-5 years after the sale, and that period of employment will be tied to you actually getting paid what they promised. Miss the mark and not collect what you did prior to the sale, and all bets are off.
In the back of the seller’s mind are two numbers. The first is a “freedom number” that allows them to sail into the future with what they feel like would give them financial independence. Most of the time this number is nebulous and has little to do with factual independence but in this case, the doctor had done his due diligence and found that selling the practice to another dentist would only get about 75% of the last 12 months collections (about, $1,575,000 cash at closing before taxes or paying off any debts that were currently in the practice) and they would be done.
Remember cash at closing because this will come up again and again. I am not sure what this seller’s net will be but in any “asset” sale” for tax purposes the amount tendered for the practice must be “allocated” to Goodwill, Non-compete, Supplies and Equipment, and Accounts Receivable. To the seller Goodwill is taxed at the Capital Gains rate and the other three will be taxed as ordinary income. That means what you get at closing will never be what you actually have after the taxes, legal expense, and debt pay offs. NOTE: Since all sellers want as much in Goodwill as possible, work hard to get 85% in that allocation category. The DSO offers in this example ranged from 60% to 80%. Don’t forget that when all is said and done, you have to place that money into another investment that is as safe as possible, because you just killed the golden goose.
The second number is time. The length of time it takes for the big pay off when the DSO recapitalizes or sells to that greater fool. Everyone enters these transitions with an idea that it will take 2-3 years to realize the gold at the end of their rainbow. If, and I say if, the time is 5 years, 10 years, or never, will you be happy having sold your practice, losing control, and being an employee? There is no way to assure that this future payday will every occur, but there is always that possibility. How long are you willing to wait? Keep in mind that you gave up money on the front end to hopefully make more on the undetermined back end.
The interesting thing about this transaction, which at the moment has not been consummated, is that there were 5 DSOs that proffered offers and Letters of Intent. I found this very interesting because in comparing the offers, there are ten numbers that are black and white given by each DSO. These numbers are the only real numbers in the equation: Black and white and true. Everything else is based on supposition, guesswork, and pure folly. Next, keep in mind that every one of these DSOs were given the same exact data: Three years tax returns, Profit & Loss Statements as well as other GAAP documents, information and access to their practice management software, and an asset list. They will definitely do a background check on you and the office. So, each of these companies started off with the same information but came up with widely different offers. It gets stranger.
Wouldn’t you think that a DSO, or even just a sale and purchase transaction would pretty much be the same if the practice numbers were the same? Yet their conclusions varied by 50%-200% difference on what they thought the practice was worth as well as the EBITDA and what the cash at closing money would be.
In order to not violate any Non-Disclosure Agreements, I will only refer to them as 1-5. From the first day, number 5 was dropped and was the worst offer as well as the youngest entity with no track record. The rest have been around for at least 5-20 years. We begin the actual race with 4 contenders.
The combined number of practices owned by these four DSOs were 2450 practices with one owning 2,200+ and one owning only 30. Should be a lot of experience in pricing and purchasing practices.
All of the sales except one would be an asset sale of 100% of the practice. There was one LOI that was purchasing only 60% and this was a stock sale (100% of the payout would be taxed at capital gains and not an allocation as in an asset sale).
Here is the practice valuation from 1-4: $1,300,000, $1,800,000, $1,575,000, and $2,072,000. That is a 40% variance from the lowest to highest. It is also about 61% to 99% of the last 12 months collections. How could such “professionals” (notice the lower case for professional) come up with so many varying values? Plus, they all knew they were bidding against one another because there was a “broker” involved and the broker takes 10% of the offer. Wow, that’s a lot of money for making a few phone calls.
EBITDA amount ranged from $225,000 to $303,132. How could that be. I thought EBITDA was a set scientific formula. Nope, no, not really. Same data but big difference and it gets weirder.
EBITDA multiples, which each used to formulate their final offers, ranged from 4.29 to 7 times “earnings”. That’s a 62% difference from top to bottom with one being close to 80% more than the lowest EBITDA. How did they each take the same data and arrive and hugely different numbers? Maybe this isn’t a science or accounting formula? Apparently not.
Cash at closing ranged from $748,125 to $1,304,000. A 57.4% difference. NOTE: One of these companies is only buying 60% of the practice but was the second highest cash at closing, with only $150,000 less than the highest bidder for 100% of the practice. This is huge difference in what they paid per percentage of the practice.
Just so you are following the math here, they all valued the practice at different amounts, each paid different amounts at closing, and all of them had the same information but arrived at a wide difference in their numbers. You will notice that none of the DSOs pay you 100% of the money they said the practice was worth as closing. So, where did the other amount go?
For the most part they all encourage you to “invest” in the DSO for a huge payoff at some time in the future when they sell to the greater fool or recapitalize the company. NOTE: It is very rare for a company to recapitalize their debt in a rising interest rate economy especially when we have seen interest rates go from 2% to 9% in six months. For most businesses, it doesn’t make sense to do this if it doubles or triples the interest they are already paying. It can happen, but it is not likely. The other thing nearly all of them do is some form of an of an equity buy out. In other words, if you owe them three years, and the difference between what they gave you at closing and what is left is about $300,000, then for the next three years they would give you $100,000 a year (a few paid 5% interest) as long as you collected the same or more than you did prior to the sale (some required a 5% increase each year). This, my friend, is their way of keeping you engaged. Most contracts stipulate that if you miss the target or are no longer working for the DSO (this happens more than you might think) you don’t get the money. That is why cash at closing is so important. You must move to get about 70%+ at closing because all the rest of the money may or may not come your way. At least if you got about what the practice was worth to an individual up front, you would have still gotten its real value out.
Employment terms ranged from 3 years to 5 years (3 of the 4 were for 5 years).
Owner compensation rates varied from 25% of collections to 32.5% of collections. Again, a big difference in the overall value of your 3-5 year commitment.
Only one of the DSOs charged a stated management fee and it was 7.5% of collections. Another stated that they expected a 16% return on their money. Another big difference in the after-sale expectations.
From this point on, the numbers are funny math with no real basis of fact or performance guarantees. This is where they state their recapitalization expectations and time period for this taking place. Time period is really important because as I already said, any selling doctor has some timeline in their mind. Maybe its 2 years, 3 or 4 but at some point, if the money you left with the DSO doesn’t come back to you, you are going to be upset. Upset, as an employee, is not good because in this DSO previous owner relationship, you are either part of the solution or part of the problem. If you tend to be a thorn in their side, they will free up your future. Once you get fired, all bets are off. They will not pay you any more money and that big pie in the sky greater fool just left the building. NOTE: If you use a broker, be sure and have your attorney dig into the small print. Many get from 6%-10% of the sales price, if real estate in involved there will be another 6%, and don’t forget that for the most part they will also get their percentage of any other pay out from future sales/recapitalizations. That should give you pause. Do the math, know the numbers, have wise legal counsel and reasonable expectations, and understand the reality of what you are agreeing to.
You will notice when you start looking at future performance discussions the language changes and you start to see words like “anticipated”, “possible”, and “hoped for”. Basically, vague numbers that look great but have no real basis in fact unless they actually happen. DSOs do employ wise counsel and you can bet that their contracts and legal business structures have been tested by State Boards and unhappy clients in a court of law. Guess what? They have CYA covered (Cover Your Assets or rather their assets). In most cases their lawyers will trump anyone you can find. They have been there and done that before, and usually many times.
The proposed timeline varied from 12-18 months to 1-10 years before you hopefully get your “total enterprise valuation”. Interesting word picture and choice of words for this future black swan event. It was also interesting that the DSO with the greatest number of offices and the most experience, was the one that thought it would take 10 years. The “projections” for this total payout went from $2,380,000 to $3,900,000. This will take your breath away, but you will see it because there is no recourse to the DSO if it does not occur.
It was funny that just before typing this I watched an episode of Flip or Flop on HGTV where a couple buys a run-down house, rehabs it, and sells it at a profit or loss. I am sure it is just me, but in a way, DSOs are a dental Flip or Flop business. On TV they buy a run-down house and fix it up hoping the cost is less than they can sell it for. In the realm of the DSO, they buy good practices and just hope they don’t decrease in value before they sell the entire venture to someone else for multiples of what they paid for it because they are never interested in putting more capital in the deal to help the practice grow. The difference is that, as a whole, over 90% of the DSOs are not interested in making capital improvements or expanding the facility and equipment. They rarely run their practices to improve them significantly. It is a close the deal, close a bunch more deals, and sell them to someone else for more money than they paid for them.
In my experience, DSOs have never really increased the production, profit, or lowered the overhead in any office they have purchased. I have seen a few offices continue to grow, but in every case, it was the doctor and existing culture that drove this, and it had nothing to do with the DSO that bought it. Therefore, I never see a net gain, and usually a 5-10% drop if we include inflation and the additional debt of purchase and subsequent management fees. Their hope is to just maintain what the practice was doing before the purchase. They are not interested in consistent growth and profitability if that means they must invest in the expansion of a facility. Their goal is to maintain what they purchased and make some minor improvements on overhead through better insurance fees, slight decreases in dental supplies, lab, and accounting through group purchasing efficiencies. I have found that their supposed management services are limited and very average in their understanding of a dental office as a small consumer business based primarily on relationships with existing and potential clients. In fact, I can name more practices hurt by the transition than improved.
DSOs will not even consider spending money on expansion or improving technology or capacity. Even in a growing office where the investment would be like shooting dead fish in a barrel with a bazooka, they will not invest money in the practice. Their goal is to buy the best practice they can afford and hope the production and profit do not correct too much. This means it is like real estate in the mid-eighties where people would tie up a property with a down payment and a 3-6 month closing so they hopefully could flip it and make a profit at or before the actual closing. This is not a new strategy. It works – maybe. It rarely works when inflation is rising.
As a whole, DSOs know little to nothing about growing a practice, creating culture, or improving production in a dental office that is run by an absentee owner. They tend to think of dentistry as a factory producing widgets rather than a consumer driven business based on people skills, systems, and relationships.
Betting on the come and the future is kind of like playing craps in Vegas. You roll your number and hope you can roll it again before the house wins. The house pretty much wins most of the time.
There are a few groups that have altered their offering and approach to being a DSO because of a lot of bad press about average DSOs when it comes to patient care, staff turnover, pushing or “selling” deep cleanings, and grey area high end dental treatment. Their approach is to tell you that “We’re not really a DSO, we want to come along beside you and partner with you so everybody wins.” This is driven not by a better offering, but a reduction in the amount it costs them to tie up a practice purchase by only paying 60% for controlling interest. You keep 40 percent but have lost the ability to sell or change your plight unless the corporation wants to do something. You are attached at the hip but only the DSO (corporation) gets a vote. You have lost most if not all the decision-making ability when it comes to your future. Your lot is cast, and you will end up where they want or can go. Make sure you choose wisely.
Going from owner with control, to employee with no control. True, even when “partnering” with someone where you sell controlling interest you are losing all control of the decision making and the value of your stock.
Failure to actually compute the difference in the sale now to a DSO vs continuing to work and grow and selling at a later date. In a sale, the average after tax take home is about 1.5 to 2 times net for the last 12 months. Don’t forget to look at limiting your lifestyle suck and improve your investment potential. Habits are hard to break and very few doctors spend less in retirement than they did while in practice.
Banking ceilings on loans for practices: A loan of 100% might be possible if you have 2-year history of earnings, little debt, practice is worth $400,000-$750,000 in the bank’s opinion. Above that the seller may need to participate (20%), the associate may need to hold another associate job, and/or they will need provide collateral, or co-sign with great credit and ability to pay it. DSOs have no ceiling and that can be good for the seller and a disaster for any buyer in the future. Paying too much for an asset that clearly will depreciate in the marketplace under their ownership in an inflationary, deflationary scenario is crazy.
Goodwill valuation of 60-85%: This tells a lot about the attitude of the DSO buyer.
Once the DSO purchase is finalized, the stopwatch is started. Why would they pay an above average Goodwill percentage if they were in this for the long haul. It makes no sense and hurts their profit potential. Profits will plateau or plumet. Capacity will plateau in facility and employees. In 2-5 years when the original owner is fired or quits, they will never be able to replace the original doctor’s productivity or profitability prior to their purchase. Office Manager training for leadership instead of the original doctor/owner leadership has yet to work. They will try and minimize the need for a strong doctor/owner and strive to counter the drastic drop in productivity and culture when he or she retires. Truly, after 2-3 years, the value will have dropped by 20-40% if sold to an independent buyer, so the search for the mythical greater fool is even more pressing. NOTE: Many sellers to DSOs end up working indefinitely for the DSO. If you were going to do this at a reduced, way reduced, take home, why did you sell it in the first place?
Staff turnover accelerates in DSO purchases every time. You may be able to justify the poor advice, change in culture, and your average take home, because you got paid some up front, and you just know they are going to pay you a basket of money in the near future. Guess what, your team doesn’t care because everything they have grown to love and respect about your practice is now changing.
FOMO (the Fear of Missing Out) may be one of the largest reasons doctors are racing to sell to DSOs. It is the hot topic with the mystical gold at the end of the rainbow. It was, for the most part, an emotional decision and not a well thought out process.
Stop and think about what we have discussed. I remember hearing a professor at dental school saying that dentists, for the most part, are poor at business. Now this was another dentist, and he was teaching in a dental school about practice management. Yep, those who can’t, teach. If our dental schools don’t change their curriculums and train up a group of graduates who can be clinically competent as well as competent business owners, dentistry as we know it will die.
If you are young and considering selling out to a DSO, please take the time to evaluate the offer and the ripple affect of what you are about to do. The complaints from dentists of being burned out, stressed with running a business, and upset at having to deal with patients and employees is a pandemic that will kill the independent practice of dentistry and fuel corporate take over as it has in pharmacy, vision, and medicine. It will relegate care to profit mongers that think dentistry is nothing but a net profit business. While dentistry should continue to grow over the next decade, I’m not sure quality of care and serving our patients will survive. Take the time to learn the business of dentistry, continue to improve your clinical results as well as the range of services you perform and grow 15%-20% a year doing what you want to do without losing control of your business. In corporations, profits go to the shareholders and not to you, the employee.
Michael Abernathy, DDS