October 21, 2022
Key Terms Dentists Should Know Before a Private Equity Sale
A growing number of clinics in the health care industry are being purchased in a less traditional manner—through agreements with private equity firms. In the dental industry, these are often called dental support organizations (DSOs). For a dentist who has invested years in building and managing their own practice, the eventual sale is a big moment they have been planning for to support their retirement years. But is selling to a private equity buyer—even if the offer makes you feel like you’ve won the lottery—the best path?
First, it’s important to understand the basics of a private equity sale and how it differs from the most traditional option for selling a practice. In a traditional transition strategy, the sale price of the practice is based on its current profitability, and the owner generally has limited ongoing liability for the practice’s performance once sold. In a private equity transaction, the goal of the buyer is to maximize the practice’s profits before eventually selling to another buyer. Unlike a traditional sale, when you sell to a private equity firm, you are also selling future profitability that you will need to maintain once you become an employee of the firm. You’ll also likely become a partner to the firm as an ongoing investor.
Second, it’s important to understand the assumptions underlying a private equity deal offer. Each deal will contain unique elements, and they are subject to the notion of caveat emptor, a phrase used in legal settings that means “buyer beware.” As a result, the buyer will do their due diligence to assess the true value of the practice, and if the owner misunderstands a deal assumption, this will not be a reason to unwind a deal. Here are explanations of the most common terms a practice owner should understand when assessing a deal offer:
- EBITDA: This is an acronym that stands for earnings before interest, taxes, depreciation, and amortization. Because clinician-owned practices rarely have a profit-and-loss statement that conforms to Generally Accepted Accounting Principles (GAAP), the private equity firm will take the practice through a process to “normalize” its financials. Because financing decisions are up to the owner’s discretion, in the process of a sale the buyer will recapitalize the practice and exclude interest expenses when analyzing its cash flow. Also, before the deal, profits are generally taxed as ordinary income, but under a corporate structure, the taxation may change.
- Assumed second sale: Private equity groups are focused on financial—not clinical—outcomes. Their goal is to package revenue and improve group-level cash flow to sell the now-larger entity to another group of investors. As private equity groups bundle more practices, both the revenue and profit grow as well. Investors view these larger organizations as safer investments than individual practices alone.
- Assumed market multiple: Along with presuming there will be a second sale, a private equity group will assume the future sales price, usually represented as a multiple of future cash flows or as a multiple of the owner’s investment. It is generally based on observed deals in the market and historical transactions, though these are not guarantees of future deals. Often the second sale is assumed to be five to seven years in the future and may well happen under quite different market and economic conditions.
- Assumed group growth rates: As part of estimating the second sale value, the private equity group will need to assume what that future cash flow will be. As such, there is a group collections growth rate assumption.
- Tax assumptions: Private equity deals are structured to maximize capital gains. A traditional practice sale is broken down between goodwill, which is taxed at the capital gains rate, and equipment and inventory, which is generally taxed as ordinary income. While the taxation of the sale is unique to each practice, what is most important to a business owner will be the post-tax proceeds. An accountant or tax professional should be consulted to ensure the seller understands the specifics based on their practice.
- Time value of money: All else equal, if invested, a dollar today is worth more than a dollar in the future. When some deals are presented, there is an assumption that the proceeds will be invested for the seller’s future benefit. While the concept of time value of money is appropriate, the seller should understand this element and make sure it aligns with their personal financial plan and investment objectives.
- Deferred cash: For the deal to work, private equity will need continuity of care and revenue. Most deals contain a deferred cash element. The practice owner may forfeit this deferred compensation if they do not stay for the contractual term. The deferred cash can be a benefit to the seller as it spreads proceeds across multiple tax years, though there is the risk of losing it if they decide working under the private equity ownership is not ideal.
- Earnout note/preferred equity: As part of the deal, the seller may be presented with preferred equity or a note in the private equity group, or both. This is a debt investment on the seller’s behalf with a portion of the “practice purchase price.” This investment pays a contractual rate of return for a specified period. This is like making a loan investment in the private equity group. Based on current rates, this rate should appropriately reflect the risk of the presenting organization. If this is presented as “preferred equity” the investment will act as an earnout note by prioritizing the seller’s share of cash flow.
- Add-on EBITDA: The value of the deal is heavily tied to its scope. The larger the entity, the more secure the forward-looking cash flow assumptions are to investors. Some deals incentivize clinicians to recruit others through acquisition targets. An add-on EBITDA provides financial incentive for this activity, putting a premium multiple on the deal if additional practices become a part of the deal as it heads toward closing.
- Rollover equity or PIK: Commonly, a portion of the presented proceeds will be reinvested as equity into the deal in one of two ways. First, it may be noted as a rollover equity position in the term sheet, which clearly identifies as a holdback investment versus cash at closing. It can also be presented as a payment in kind (PIK), which is essentially the same investment from the seller’s perspective, but it can be rolled into the cash at closing figure.
- Incentive units: A private equity buyer desires a positive financial outcome, which is in the seller’s best interest as well. Many of these deals include incentive units, which either grant or allow a discounted equity purchase in the future if certain financial targets are met.
Wealth advisors have experience in reviewing these deal assumptions to make sure they align with the dentist’s overall financial picture and lifestyle. Due to a lack of dealmaking experience, practice owners may look at the bottom-line number with limited understanding of the terms and their impact on the transaction. These deals can be a great opportunity, but you only have one chance to sell your practice, so it is critical to fully understand the terms of the agreement before signing on the dotted line.
This blog is the first in a three-part series intended to educate medical and dental practice owners about private equity transactions. The first explores the basics of a private equity sale and explains the key terms you need to know. The second gives an overview of the different types of risks associated with a private equity sale. The third explains how to assess if the deal fits into your financial plan with a hypothetical example. This blog series is for informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Individuals should speak with qualified professionals based upon their own circumstances. R-22-4481