It is imperative that dentists ask three financial questions to ensure a deal is advantageous to them: how much is being paid to the seller; where is the money to pay the seller coming from; and when will the seller receive payment? To determine the answers to these questions dentists looking to buy or sell a practice must first understand certain financial terminology, and the types of dental transactions that are possible. We will discuss each of these below.
Cash Deals and Bank Financing
When an outright sale occurs, the buyer pays the agreed-upon price in cash at the closing without making future payments. The funding for a cash deal will stem from a buyer’s cash savings or bank financing. Since the dental industry’s low default rate encourages lenders to pursue a business relationship with dentists, qualified buyers will likely receive the necessary financing for the transactions they wish to pursue.
This type of transaction, known as a “cash deal,” is an excellent option for retiring dentists. However, dealing with any post-closing disputes in connection with a cash deal can be challenging since the seller already has all of the money from the transaction, therefore the buyer has very little. Nevertheless, cash deals can still run smoothly for all parties when executed properly with contractual safeguards in place.
Another option for paying the purchase price is “seller financing.” Under this scenario, the seller will lend money to the buyer directly rather than the buyer seeking financing through a bank. However, this is less advantageous for a seller as payouts can often take years. On the other hand, this type of transaction incentivizes the seller to help the buyer succeed after closing because the seller has “skin in the game” and does not want to lose money on the deal if the buyer were to fail post-closing. These transactions are less common than they once were, but some sellers will agree to self-finance a deal because of the potential tax benefits. The potential tax benefit in seller-financed “installment sales,” is the deferral of recognizing the profits of a sale over several years instead of in one tax year. Seller financing is also appealing for the parties that wish to avoid having a lender place a lien on the practice. If an associate or outsider is becoming a partner and only buying a portion of a practice, lenders frequently require a corporate guarantee to ensure they can retrieve payment from the practice if the buyer defaults on the loan. For this reason, the seller will sometimes hold a note instead of a bank to prevent the bank from placing a lien on the practice, and from pursuing payment from the practice if a buyer defaults on a loan. Instead if a buyer defaults on monies owed the seller on a note, The Seller can take back the ownership in the practice.
A third type of transaction is known as an earn-out. This is a transaction in which the buyer pays the seller a percentage, often 10%-20%, of the practice’s gross receipts for a specified period of time. After the closing, the buyer makes installment payments to the seller based on the practice’s performance. Consequently, earn-outs also provide an incentive for the seller to help the buyer grow and succeed post-closing as they will financially benefit from the practice’s growth in revenue. The payment term will vary from deal to deal. If earn-outs are executed correctly, everyone wins: the seller potentially gains more money than they would from a cash deal, and the buyer does not assume the risk of a loan.
Associate Discount Programs
Next, the parties may consider an associate discount transaction. Associate discount programs, or “sweat equity” discount programs, can be applicable if a junior associate joins a practice but is not yet ready to buy into it. In this situation, the practice can offer a performance-based discount on a future buy-in. This incentivizes practice growth and the associate’s direct benefit from improving their productivity. Further, these programs facilitate associate retention because they reward the associate’s longevity with the practice, by discounting their ultimate buy-in.
Practices can determine the associate’s sweat equity discount by calculating a percentage of their gross collections on a monthly basis, often between 2% and 5%. The sweat equity discount accumulates each month until the associate is ready to buy into the practice, at which time the purchase price is reduced by this discount. This type of program is beneficial to all parties and the practice’s future because it gives quality dentists time to grow, which in turn prevents high turnover rates and maintains stability within the practice.
DSO Payment Terms
Sellers are often lured into a sale to a dental support organization (DSO) because these private equity backed groups frequently pay a significant cash purchase price upfront. However, DSOs protect themselves through the services of strategies including but not limited to rollover equity, seller promissory notes, or by requesting that an earn-out be incorporated into the terms of the sale. The value of those concepts and seller’s realization of the economic benefit are generally linked to future success and performance. In the case of equity rollover, the DSO will pay 60%-80% of the purchase price in cash, and then provide the remaining consideration in the form of equity or ownership in the DSO or a related parent company. This incentivizes dentists, who remain as employees with the DSO for three to five years, to help boost the DSO’s success after closing because it benefits their future potential investment in the DSO by increasing the value of the company. Navigating the distinct types of dental transactions and the financial implications of each can be challenging for both parties. However, with the right legal and financial guidance, transactions can run smoothly and successfully. Therefore, if you are considering a dental transaction, it is important to collaborate with attorneys and tax advisors that are specialized in this industry so you can be fully informed of the legal structure, as well as the tax implications of your deal.
For personalized guidance regarding your dental practice transaction and how to best navigate the legal and financial terms of your transaction, contact the National Dental Law Group at Mandelbaum Barrett PC. For further insight into dental transactions, see Pain Free Dental Deals: An Entrepreneurial Dentist’s Guide To Buying, Selling, and Merging Practices, or The DSO Decision by Bill Barrett and Casey Gocel.