What Dentists Need to Know Before Selling to a DSO
By Selling your practice is a major decision you face. You must decide when is the right time to sell? At what price will you sell? To whom do you want to sell your practice? And how will you transition out? These last couple of years haven’t helped any with Covid not going away anytime soon, the economy during a recession, and potential tax increases at the state and federal levels. To add to all of that, now corporate buyers, called Dental Service Organizations, or DSOs, are becoming more and more prominent. I would like to talk about DSOs and make sure you know who they are, what their goals are, and what you may be getting yourselves into.
There are many shapes and sizes of DSOs. Some start out as a small group, owned by a dentist or a group of dentists and backed by a local or national bank. These small groups grow and eventually outgrow their bank, then look to other forms of financing to grow into a DSO. That’s when they reach out to private equity groups that have billions of dollars of cash from investors to provide to the DSOs. The private equity groups invest in the DSOs in exchange for ownership. That can come in many forms, but they usually take the majority ownership in the group. I won’t get into how they structure the ownership too much since private equity groups are not dentists and some states require someone to be a dentist to own a practice, but just know that they typically have a dentist own a piece of the DSO in order to tread in the grey area of legally owning a practice. Some attorneys will argue that this isn’t even legal, but they get away with it.
The DSOs look for practices that are well run with annual collections above $1 million. Some DSOs will buy practices that are doing less and merge them into a practice nearby. Or they buy a practice because it is in a great location, and it will help fill their footprint. They also like to buy a practice that has six to eight operatories. They love it if it has more than eight ops. They also do not want to go in and update the practice. They will do it but expect to receive a lower price.
One of the major requirements of the DSOs is that the selling doctor and any longtime associates stay after the sale is complete and work back in the practice. Most want the seller to stay a minimum of three years. That can be negotiable for a shorter or longer period. You might find a small group or associate who will let you leave shortly after the sale, but those are few and far between. For the most part, if you do not want to stay on and work, they do not want your practice. The employment salary is typically market. Some will pay more; some will pay less. Several DSOs have benefits that the seller will be able to participate in as well. If you have a great benefits package that you are currently providing your staff, there is a pretty good chance that will be reduced to the benefits package the DSOs offer their other practices.
When DSOs look at a practice, expect to run a lot of reports, both from the practice management system and from your accountant. They also will want to know what you’re paying your staff, benefits, sick time, holiday pay and any other compensation or days off you may provide them. Again, if you give your staff a few extra personal holidays, extra bonuses, or any other perks, you can expect those to be eliminated. If you have special payments or provide free dental work or discounts, there’s a chance those will be cut as well.
When DSOs write up an offer, they need to be read very carefully. Even though these are non-binding, the DSOs will refer to them during the entire process. Once the offer, called a Letter of Intent or LOI, is signed off on by both parties, it will be handed over to the attorneys to draft up an agreement. After it’s handed over to the attorneys, the purchase and sale agreement will be written according to the LOI.
The DSOs make their offers challenging to understand. Some will give you a purchase price that includes accounts receivable in the price. You might read the offer and say, “Wow, they’re offering me 100% of last year’s collections.” No, they’re not. They’re offering you 70% of last year’s collections and they will pay the market rate for the accounts receivable. The offer will pay you a percentage of the purchase price upfront. It’s typically around 70% of the purchase price at closing. They will have you carry a note or finance the last 30% and pay you a market interest rate. You may receive a lump sum payment each year while you work back. If you have a three-year work back employment agreement, you may get one-third of the 30% paid the first year, one-third the second year, and one-third the third year. However! You are typically required to keep the production level or net income of your practice up to a certain level. If you do not, you will either get a pro-rated amount, or you may not get paid that portion at all! Go back and read that again, as it is important. If you are counting on that last 30%, there is a bit of a gamble. What happens if they change the culture and the entire staff, and many patients leave? What happens if you have health problems? What happens if there’s a pandemic (we know that happens)? What happens during a recession? There are so many things that can happen in those three years.
Another thing to watch out for is how do they make the calculation for net income. Most will charge the practice a 5% – 15% management fee. They require you to make a net income number, but now they added a management fee on top. I’ve seen this in place where they added staff to the practice as well as an associate. The doctor didn’t make his net income number to no fault of his own.
I have heard stories of DSOs offering practices above-market prices. We have been involved in several DSO sales lately and we have not seen a DSO pay above market for a practice. They have typically paid the market price. If your friend tells you they received 120% of collections, ask them to prove it. DSOs will quote prices on occasion based on EBITDA. That’s “Earnings Before Interest, Tax, Depreciation, and Amortization”. It’s a term used in the investment world for private equity as well as Wall Street. There are different ways to calculate EBITDA that private equity groups can manipulate, so don’t get caught up in quoting prices based on a fancy word. I’ve heard doctors say they sold their practice for 5 or 6 times EBITDA only to find out they input that management fee and the note payment into the EBITDA calculation. It truly wasn’t anywhere 6 times EBITDA.
There are good DSOs and not-so-good DSOs out there. Some will completely change the culture of your practice. They will scare staff away with benefit and salary changes. Some will keep everything the same to the best of their abilities. But the staff knows you will eventually leave, so they may more readily look at other opportunities.
The best advice I can give you is that if you are looking at an offer from a DSO, be sure and have an expert review the offer. Many of the local attorneys and brokers have worked with the DSOs. They know who are good and who may be a bit challenging. They also know the inside secrets the DSOs have where they may try to sneak something by you. I’ve seen doctors sell to DSOs and quite a few months later leaving the final 30% on the table. They just couldn’t take working for someone else in a different manner than they were used to. Know what you’re getting yourself into before you take that leap.