What’s Your Equity In A DSO Really Worth?
May 2022 ISSUE May 1, 2022Transitions Buying/Selling and Mergers
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Recently, a long-time client called excitedly sharing that he had received an unsolicited offer from a DSO that was unbelievably good. While he wanted to share the details with Wade Coleman, JD* of our transition team, he made it clear he didn’t want to be “confused by the facts,” but simply wanted our blessing before signing the Letter of Intent (LOI).
He forwarded the proposal, explaining that the broker offered him over $11,400,000 for his practice, which represented more than 20 times EBITDA and over 8 times his prior-year collections ($1,400,000), broken down as follows:
|Cash at Closing||$2,015,000|
|Stock (Equity) Value||$1,350,000|
|Potential Earnout (based on growth)||$145,000|
|Post-Closing Compensation (5 years at 25% of collections)||$4,245,269|
|Forecasted Stock Appreciation||$3,645,000|
|Total Deal Value||$11,400,269|
Post-Closing Compensation Not Part Of Deal Value
The deal value was misrepresented (inflated) for several reasons. Most importantly, because it erroneously included the post-closing compensation to be paid to the seller over the next five years. This was fraudulent since the doctor would have to perform services for which he was previously paid 40% of collections but would receive only 25% of collections for those same services after closing. In reality, the post-closing compensation should have been considered as a reduction in the deal value, rather than as an addition, since his compensation percentage was going down, not up!
Earnout Not Guaranteed Or Prorated
Furthermore, the earnout payment shown ($145,000) was not guaranteed but was contingent on performance. Moreover, these earnouts are often structured as an “all or nothing” contingent payment. For example, if the collection goal to receive the earnout is $1.7 million at the end of two years, what happens if the practice collections increase to only $1,650,000? In most cases, the seller receives nothing ($0). Rather, the earnout should be prorated ($250,000 increase divided by $300,000 = 83% x $145,000 = $120,833), says Blake Hassan**, a tax attorney and CPA who has successfully negotiated hundreds of these deals.
Equity Value Overstated
When structuring the payment for the practice, the seller and DSO buyer have conflicting goals. The DSO wants to maximize the amount of stock or equity (up to 40-50% of the deal value) and minimize the amount of cash paid. Since the DSO has a finite amount of cash to work with, this approach allows them to maximize the number of practices they can buy. That’s why they hype the potential stock appreciation to make it more attractive to sellers. Conversely, the seller typically wants more cash to ensure they have the funds needed for a financially secure retirement.
While the forecasted stock appreciation (more than tripling in value over five years) is tantalizing, it’s far from certain. As doctors have learned thus far in 2022, the stock market can go DOWN as well as UP! Moreover, in the event of a stock market crash, your stock could be worthless, as dozens of orthodontists painfully learned in 2000, when the publicly traded Orthodontic Centers of America (OCA) stock value cratered to zero!
Even the current value of the DSO equity received in the deal is likely inflated since the seller is giving up a practice he can control, in exchange for equity in a DSO where he has only a small minority ownership interest, and no control. Also, the seller is giving up a practice whose value he can liquidate at any time for full value, in exchange for DSO equity that has substantial restrictions on liquidating. Discounts of 25-40% commonly apply when valuing these ownership interests due to the lack of marketability and control. So, what you’re getting (DSO equity) is worth less than what you’re giving up (practice value) as soon as you get up from the closing table!
The fact is you can’t sell your DSO equity at the original valuation anytime you’d like. Rather, the DSO operating agreement determines when you can sell, and how much you’ll receive! In some cases, the DSO retains the option to buy back your stock at a discount (loss for you) in the event you sell within five years of closing, whether due to death, disability, or retirement.
Even if the practice successfully hits all of the DSO’s performance goals so that it substantially appreciates, you may not be able to cash it out and receive all of the gain. In some cases, the DSOs allow you to cash out only 40% of the gain when it recapitalizes, with the balance rolled over.
The dental marketplace is being flooded with deceptive and misleading offers such as the one described above, designed to entice you into selling. Since this will likely be the biggest and most important financial decision of your life, make sure you have advisors with the proper experience and expertise negotiating on your behalf. It may save you hundreds of thousands of dollars and provide the peace of mind that comes from knowing you have a financially secure retirement!
*For more information on dental practice transition services offered through Roger K. Hill & Company, Inc., a member of The McGill & Hill Group LLC, call 704.424.5626 or connect online.
**For more information on legal transition services, offered through the law firm of McGill and Hassan, P.A. call 704.424.5450 or connect online.
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The McGill Advisory content Is provided For informational purposes only And does Not constitute legal, accounting, Or other professional advice.
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