The majority of DSOs have never increased the production, profit, or lowered the overhead in any office they have purchased if we consider inflation and market values. Never a net gain, and usually a 5-15% drop if we include inflation and the additional debt of their purchase and subsequent management fees from the DSO. 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 capital expansion of a facility. DSOs grow on paper from mergers and acquisitions, not from increasing the profits of their acquisitions. Their goal is to maintain what they purchased and make some minor improvements on overhead through better insurance fee reimbursement, a slight decrease in dental supply cost, lab costs, 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 potential clients. One fact that you can always bet on is that staff turnover accelerates once a DSO takes over. NOTE: If they tell you they are a “hands-off” company and their lips are moving, they are lying. They will always have a regional director/consultant who has never done this before, and who is guaranteed to want to change a bunch of systems, while simultaneously upsetting most of your team and you. These regional directors tend to be an ex-assistant, hygienist, front desk, or dental coach that couldn’t make it in private practice. A real gem in the rough. Get ready to thicken your skin and hold your tongue as the DSO works its magic.
Most DSOs will not even consider spending money on expansion or improving technology or capacity blockages. 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. Maybe I am a little harsh in throwing all DSOs into this past statement. Let me rephrase the word “all” to just 95%. Their goal is to buy the best practice they can afford and hope the production and profit do not vary 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 can hopefully flip it quickly and make a profit at, or even before, the actual closing. This is not a new strategy. It works maybe, sometimes, and sometimes not, but in our current inflationary season of high interest rates, it is destined to stumble and perhaps fail.
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. If you really think about it, every practice works at capacity. With the doctor and employees that they currently have, they are getting the results they are currently getting, and that will be the best they can do. If it weren’t, they would be doing different numbers. Everything you do is designed to give you the results you are getting. A DSOs only hope is to keep the office engaged enough to keep up with inflation and not become a huge problem for the group. By maintaining the same team and doctor, DSOs have a huge headwind in order to increase profitability and increase value, especially with the debt service on the buyout amount. They tend to think of dentistry as a factory producing widgets rather than a consumer driven business based on people skills, systems, and relationships.
Timeline contention: Every doctor enters a sale to a DSO with some preconceived timeline where they would finish their employment to the DSO and the timeline of when there would be a recapitalization or sale and the big enterprise payoff for the original owner. Your timeline to cash out vs that of the new owner to maximize a profitable sale can be in complete contrast with you thinking it will be 2-3 years, and the reality that many will be 10 years or possibly never. If it were never to happen, at what point would you get upset? Most doctors swallow the sales pitch of recapitalization in the next 2-3 years, hook, line, and sinker. In an inflationary economy with elevated interest rates and a higher but unstable inflation rate, it could take 10 years or more; maybe never. There will always be a point where your expectations of what you thought would happen are not fulfilled and you will get upset. They say that happiness occurs when life exceeds your expectations. Be realistically cautious about the promised timelines in any DSO buy out. When your expectations exceed reality, this is the point that many doctors become part of the problem and not part of a solution. Keep in mind that your big pay day was contingent on you being an employee at the time of the next recap or sale. If they let you go, your myth of a big payday leaves, too. If you get fired, all bets are off. If you don’t increase the collection numbers each year, and that includes an inflationary increase, you don’t get the earn out money. They say time will heal all wounds. In this case, the longer it takes the more most doctors have sellers’ remorse and realize that three quarters of what they promised you as a huge payoff may never come.
Betting on the come and the future. A large portion of your potential future earnings from this sale is based on nothing more than speculation and hope. It should come as no surprise to learn that 90% of DSOs today have never survived an entire economic cycle. They just have not been around long enough for that to happen, and that’s a huge problem. They don’t know what to do when the sunny blue skies of 2% interest rates turn to cloudy with a chance of storms. One might even say from blue skies to a pretty good chance of a tsunami. I’m betting they won’t weather the storm any better than you or I would in an economic meltdown. That is why private equity in the dental marketplace is drying up. DSOs were founded on the Greater Fool Theory of Business where they promise to pay you 30% more than your practice is worth, give you a small percentage at closing, tie you to the office for several years through an earn out strategy, while forcing you to invest in the DSO’s worthless stock, and tell you that they will be able to sell it to another buyer for 7 times what they paid you in about 2-3 years. I don’t know who the greater fool is, but this is starting to look like musical chairs. The music plays and everyone is having fun until the music stops. When the music ends, everyone rushes to find a seat, but someone has removed some of the seats. Those without seats are done, finished, caput. It will likely be the original owner of the practice who believed the over-inflated value of the stock they were forced to purchase or the idea that someone would be foolish enough to pay 7 times what the practice is really worth in the near future or the next buyer, if they really exist. There is not any statistical or historical precedent that says there will be a “greater fool” that is willing to pay multiples of what you sold your practice for in the first place. Consider the definition of “fair market value (FMV)” according to the IRS: FMV is defined as the price at which the property or asset would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all of the relevant facts. It is not what an appraisal says it is worth, or what the seller is asking, and it’s certainly not what a DSO projects in a recapitalization. It sometimes comes down to what a bank would lend on the sale based on their evaluation, the buyers credit profile, and their opinion of whether the buyer will be able to service the note. What happens when equity partners find that their return on investment no longer equals what they need to get in order to attract investors?
Do you really want to become an employee? Going from owner with complete control to an employee with no control is a huge change in operating systems and protocols. Especially when you realize that as an employee, there is no longer profit coming in from other providers that boosts your take-home income, and that your current pay scale is 20%-40% less than it was when you were an owner. This is true even when “partnering” with someone (DSO) where you only sell controlling interest (51%-60%) to a DSO yet lose all control of the decision making and the value of your stock. This is a common ploy with some DSOs to minimize their payout and debt by only purchasing about 60% of the practice and they refer to this as “partnering with you so we all make a lot of money”. The real reason that this is done is to minimize the amount of money the DSO has to pay interest on. It also gives them complete control but spreads much of the risk in the transaction back to you, the seller. Don’t be deceived, there is no guarantee that this will pay off and, once you sell, you are now holding 40% of the sale price in worthless stock in a company you don’t control, can’t sell, and don’t even want to be there anymore. You got in the boat with these people and now you have to ride it out, regardless of the outcome or timing. On a wing and a prayer, your only hope is that you got together with the right people. Hope you bet your money and your future on the right player, because with economic and financial shifts, they may pull away two or three chairs when the music stops instead of just one.
Once you consummate your DSO contract, the dust settles, and reality sinks in, you will realize that you are either part of a solution or part of a problem. Remember that being fired by the new owners happens more often than one might think. Yep, your heard right. If you become part of a problem, they have the right to free up your future.
In this game of musical chairs and DSOs, cash at closing (actual money in your pocket as opposed to some future promise) is your only certain outcome. The rest is just some hope with a 50/50 chance or lower of actually occurring. Cash at closing versus the promise from a stranger with a questionable track record and promising a nirvana within the next 2-3 years should give you pause. It’s all about your timeline and reality. The big unknown is how well you will do with a DSO and how predictive their anticipated recapitalization will be. Every economy tends to shift. Shift happens. That’s why years ago with an artificially propped up 2% inflation rate anyone could make money any time with that type of economy. Shift happens and welcome to the new dental climate change.
Income and profit analysis in selling your practice. There is a common mistake that most dentists selling to a DSO make. It is failure to actually compute the net difference in the sale now to a DSO versus continuing to work and grow and selling at a later date. Average valuation from a DSO of a general dental practice is about to 2 times net or 90% to 120% of the last 12 months collections. That amount would not be given to you unless they recapitalize, or your contract demands that over the next 3-5 years that you exceed the collections each year above what they were at the time of the sale to get your “earn out”. Most contracts have an inflation percentage added to that target amount you must hit to get more of your own money back. Don’t forget to look at limiting your “lifestyle suck” and your investment potential due to the years you owe them as an employee without the benefit of ownership and control in your now sold practice. There will definitely be a 20-40% decrease in what you take home after the sale.
Lies, myths, and exaggerations. Here are a few other things that you might not have thought of in a DSO sale. I like to refer to these as lies, myths, and exaggerations. My attorney calls them borderline fraud approaching the framework of a Ponzi scheme. If you have already spoken to a DSO representative then you have heard the sales closing line of: “If you don’t sell now, there will be no one to buy your practice later”. This automatically triggers the lizard brain of a practice owner. It is called FOMO: Fear of Missing Out. It’s fooled a lot of us. The long hard truth is that not every DSO is the same. In fact, many doctors actually choose the wrong DSO for their practice. They sell too soon, don’t ask the right questions, and don’t seek professional help in evaluating any offers from a DSO. Let’s look at just a few myths and exaggerations that approach outright lies as we pursue a DSO to buy the practice and create financial freedom for our future.
- What you are initially promised is not always what you will get. The unrealistic promises are made in order to entice you to consider selling. I have seen initial offers lowered by 20%-40% after they have done their final evaluation. Keep in mind that you will be talking to a professional “closer”. They sell and are paid on their success of closing. They are not interested in you. Their entire world revolves around a commission on closing. Once the deal is done and the papers are signed, you will likely never see or hear from this person again. I have had doctors select one DSO over another because the closer seemed nicer on the phone.
- RED FLAG – Fireworks should go off when you hear these words coming from a DSO: Expected, hoped for, forecasted, anticipated recapitalization multiples and timeline, equity projections, and total enterprise value because the only thing factual will be the money given to you at closing. These are a salesman’s vocabulary whether you sell a used car or whole life insurance.
- Misrepresented (inflated) deal values are sometimes truly fraudulent when you consider that you now earn 40% less than prior to the sale. I cringe every time I read some of these deal values and wonder how they get away with the language and implied payout numbers.
- Earn out payments are not guaranteed and are always contingent on performance that may leave you short and create another loss in this contract. Most DSO sales are initiated for one of three reasons. The first is a doctor that is getting to the end of their career and finds that the practice is worth too much for a single buyer, so the DSO is the logical choice. The second is someone who foolishly thinks that a DSO will take away all their staffing challenges, accounting, marketing, lack of patients, etc. These are doctors burned out and just looking for a way out of all of the stress. DSOs are not the answer. YOU will always be responsible for the results in the practice. The only difference will be that you will make less after the sale and still have to work another 3-5 years.
- Equity value is always overstated: The DSO wants to maximize the amount kept in stock by the seller (30%-40% plus) to minimize the amount of cash paid to you. There is no equity value in stock that cannot be sold, has no buyers, and has no real value in the first place.
- Stock appreciation is overstated: Their projections of 4-7 times sounds great but is far from certain. I take that back. It is worthless. No asset has a fixed value. The value is established by a buyer and what they are ultimately willing to pay. Until the DSO sells, there is no real price or solid projection that can be made.
- Even the current value of stock is always overstated: There are no buyers, you can’t sell it without permission that will never come, and the only value would be realized in some future sale that may never occur. DSOs live in the land of unicorns and tooth fairies. Lollipops grow on trees and every day is 70 degrees and sunny. Take the time to discuss any DSO purchase with a knowledgeable CPA and attorney.
- DSOs will retain the option to buy back your stock at a discount which creates another loss for you. Read the small print and have someone that does this every day review these details. It is easy to assume that there is never a poor outcome, but DSO contracts are one sided, so make sure you understand the downside if something doesn’t work out.
- Due to the shrinking supply of venture capital and increases in interest rates, DSOs are pushing hard to get seller financing, called “preferred equity”. Kind of like the term “military intelligence”. It has no real meaning.
- I could go on but there seems like there is no limit to the deceptive and misleading offers DSOs can come up with.
The DSO contracts: Money at closing, money tied to performance, diminished pay, limited control, no money to expand or increase marketing, change of insurance to the DSO and in the case of Premier Delta, loss of that income when demoted to a PPO status, debt payoff before the sale and taxes after the sale can all create a situation where you end up getting far less than you anticipated in the final tally of the sale. At that point, you are desperate for them to “recapitalize or sell” in order for this to work. Your requirement to either partner with or invest in the stock of a worthless company creates a captured investment with the inability for you to exit your practice without crippling the payoff you thought you would get. Your non-compete, benefits, work schedule, lease (if you own the building), all need to be reviewed and negotiated to ensure a safe and profitable sale to a DSO.
Recapitalization in an inflation/stagflation economy makes no sense. Nothing more to say. Why would anyone recapitalize with an increase of 400% in interest rates in an uncertain economy. Banks won’t. Personal equity partners won’t, and DSOs shouldn’t, even if they could.
Financing individual sales of a practice with banking ceilings on loans for practices: In comparison to DSO purchases, an individual buying your practice would need to approach a bank for a loan, but it is unlikely that the bank would finance 100%. The reason for this is that banks have an artificial ceiling on what they will loan on a dental practice. Once you go over a million dollars, few banks will finance the sale due to this artificial ceiling. DSOs, on the other hand, 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. Chisel this into your memory: Debt is the tax on future income. Someone has to pay the bill and it’s going to be you if you or any company continues to abuse borrowed money. With DSOs, it is like buying run down homes and fixing them up. A flip or flop strategy. DSOs are in it for the flip in a 2-3-year period, but our economy has put the brakes on their simple strategy that tends to bog down in the reality of an up and down economy.
The greater fool theory of business success: You have to admit that every DSO has the strategy to buy and pay top dollar for a practice and then, in a few years, sell that same overvalued practice to someone else at 5-7 times what they paid for it 3 years ago. Who in their right mind would purchase a group of practices knowing this. The Greater Fool. When will we run out of fools and equity partners with the money to fund this iteration of a Ponzi/multilevel business model? Timing for DSOs and large multi-office practices when looking at a cash-out and consolidation is at best uncertain, and very probably unlikely. With an economy in a recession, increased interest rates, and uncertain inflation rates, it is only natural that it would create jitters with lenders and investors. This does not bode well for a greater fool coming around to pay you a pot full of gold any time soon.
You can tell the real strategy of a DSO by how they negotiate and construct a buyout. In every sale (asset sale), the IRS requires the buyer and seller to agree on the allocation of the sale price. In other words, if the practice sells for $1,000,000, we must allocate each and every dollar to one of four categories: Goodwill, Non-compete, Supplies and Equipment, and Accounts Receivable. Each of these categories are taxed differently and present a different concern for a buyer and seller. So, even after negotiating the sales price, you must sit down and do the same with the allocation of the sale. This allocation can make a huge difference in what the seller really nets out of the sale, and what the buyer actually ends up paying. Most sellers want as much Goodwill as possible because it will be taxed as Capital Gains at about 20% or so. The other three categories for the seller are taxed as “Ordinary Income” which could be almost twice Capital Gains. So, you could see, if we had two identical practices, both of which sold for $1,000,000 but one had an allocation of 70% Goodwill and the other had it at 50%, there is going to be a huge difference in what each doctor actually gets out of the sale. The doctor with 70% Goodwill or $700,000 taxed at 20% or $140,000, and the remaining $300,000 is taxed at 37% or $111,000 would total $251,000 netting out $749,000. If everything was the same for the other doctor except having a 50% Goodwill, then the net for this doctor would be $715,000. The perspective from a buyer is that they want as much as possible in Supplies & Equipment, because they can depreciate the entire amount over the effective life of the equipment or all at once with a maximum of $1,220,000 as of 2024. Pay attention here. If the buyer could get $300,000 allocated to Supplies & Equipment in this example of a $1,000,000 sale, it would mean that they could get a dollar-for-dollar tax credit for the $300,000 which would mean that effectively, they only paid $700,000 for the practice because they get that $300,000 back. All of these numbers, so far, are an example of an individual buying a single practice from another dentist. When we look at DSO purchases, it is not unusual to see a Goodwill valuation of 80-90%: This tells a lot about the attitude of the DSO buyer. Every buyer wants that Goodwill to be low. They want the percentage to Supplies and Equipment as high as possible to take advantage of section 179 of the IRS code to depreciate that amount over the effective life of the equipment on an annual basis for 5-7 years. It seems that DSOs don’t care if they leave money on the table. The takeaway is that if they construct deals where they don’t take advantage of depreciation, they make it somewhere else, and they are betting on a short ownership of the practice. The “make it up somewhere else” is that no matter what or how they evaluate your practice, they are not going to give you that money. There will be some money at closing (they want this to be as low as they can get away with) and the rest will be in a yearly earn-out and/or in as much DSO stock as they can coerce you into.
Once the DSO purchase is made the stopwatch starts running. Profits will plateau or plumet, capacity will plateau in facility and employees, and it is 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. If the opposite occurs and the production goes up, or by some miracle the team members stay, you will reach a capacity issue on staffing and facility blockage that the DSO will not be interested in funding or making a cash outlay.
Office Manager training for leadership has yet to work. They will try and minimize the need for a strong previous owner doctor, to counter the drastic drop in productivity and culture when he or she retires. Truly, after 2-3 years, the value will have dropped 5%-15% if sold to DSO, so the search for the mythical greater fool becomes even more pressing. The clock is ticking.
Staff turnover accelerates in DSO purchases every time. Maintaining a consistent, highly committed team is very difficult. Change stimulates a lack of control, trust, and satisfaction when a DSO takes over. The clock is ticking.
Recapitalization in an inflationary economy with interest rates climbing seems unlikely. The clock continues to tick.
DSOs create a false impression of a profitable business through mergers and acquisitions when the actual cash flow and GAAP documents tell a far different story. No real profit when we consider hard times or call on what they owe. One of the largest DSOs in the US is a C minus rated company with almost eight times debt to earnings.
If you have made it this far, let me give you a word of caution. There is a common ailment in dentists and their investments and strategies. It’s called Normalcy Bias. This Normalcy Bias is a cognitive bias which leads people to disbelieve or minimize threat warnings. Consequently, they underestimate the likelihood of a disaster, when it might affect them, and its potential adverse effects. DSO leadership and control are constantly challenged to create the culture that would make their practices profitable and attractive in a sale. At any moment the threat of poor outcomes can happen. As I’m writing this, I have seen 4 DSOs cut and cover and dozens find themselves without equity partners. Dare I say, DSOs of the future may actually have to learn how to make a profit in dentistry when the magic greater fool doesn’t show up for the next round of hoped for recapitalization. I define this as The Greater Fool Theory: the idea that during a market bubble, one can make money by buying multiple overvalued assets and selling them for a profit later, because it will always be possible to find someone who is willing to pay a higher price.
Recapitalization is a rearrangement of a company’s capital structure. You do this by issuing new equity, taking on debt, or a combination of the two. The goal is to improve the company’s financial position. If they issued new equity, existing shareholders may see their ownership stake diluted. Debt refinancing is the most common form of recapitalization. It can do so through issuing new debt or taking out loans. Not being an economist, I took the time to look up a couple of financial fraud titles that I had heard of in the news. The first was the Ponzi scheme where investors make an up-front investment in what appears to be a legitimate security or other investment product, but the business does not work in the way it is described. Sounds a little like the deal’s DSOs put together. The second was the Pyramid scheme which involves getting investors to help recruit new victims in what closely resembles a Ponzi scheme.
To me, it comes down to a few options for Owners today:
- Remain an owner and take your practice to another level of profitability and production. You could even cut back hours and still make more.
- Retire in practice with associates and be an absentee owner. You keep your asset.
- Sell to an individual for about 75%-80% of your last 12 months collections or about 2.5 times net for the last 12 months.
- Sell to a DSO.
- Sell fractional shares of your practice to multiple partners while retaining the real estate and continuing to work if you want to.
Why do dentists sell to a DSO?
- The dream of an exit from dentistry with a huge financial win.
- They fail to actually do the math on the price at closing, minus debt, minus taxes, and possibly no future check.
- They fail to have a “next”. What do you do after the sale? What do you do for income? What really inspires you and your family? What is possible?
- Failure to do the math on your earnings and autonomy while getting nothing from associates or hygienist production. The actual pay after being an owner can be a 30% to 50% decrease in take home. Don’t forget all of the perks you had as an owner that disappear now.
- The allure of big brother dealing with all of those silly staff issues, insurance crap, marketing, etc.
- Burn out: Tired of perpetual striving, tired of being tired of going to work.
- FOMO: The fear of missing out. Everyone else is making millions working for DSOs.
As we finish up with the last few thoughts on DSOs, I would have to say that sellers are not usually motivated employees. In a corporation, profits go to the shareholders and not the employees. If you are considering a DSO sale, educate yourself to the point of being an expert at understanding your options and the likely outcome of this transaction. Not all DSOs are bad, most are average, and a rare few can deliver on all of their projections and promises.
Michael Abernathy DDS
972.523.4660 cell
[email protected]