Purchase price negotiations: Maximizing your sale proceeds
The most important aspect of selling your dental practice is negotiating the purchase price.
S. Nathan Gordon, Esq.
The most important aspectof selling your dental practice is negotiating the purchase price. I frequently encounter clients who believe they have agreed on a purchase price, but after understanding the payment terms and after-tax implications, they're disappointed to learn the deal is not what it seems. In many instances, the purchase price is negotiated (perhaps over a beer at the golf course) by the buyer and seller without attorneys, accountants, or other advisors present. Sometimes negotiations even break off because the parties do not understand or are unaware of what needs to be discussed when they determine the purchase price. By understanding how to negotiate the price, you can maximize the amount of money you receive when it comes time to sell your dental practice. Here are five key areas in the process that deserve special attention.
1. Payment terms
Negotiating the payment terms for the purchase price are just as important as the purchase price itself. As the seller, your negotiations should revolve around obtaining as much cash at closing as possible. The buyer will likely try to defer a portion of the purchase price through an earn-out, escrow, holdback, or promissory note (as discussed below). If the buyer insists on deferring a portion of the purchase price, you should insist on a higher purchase price to compensate for the delay in receiving your money.
2. After-tax proceeds: Asset sale versus equity sale
As a seller, focus on the after-tax amount that ends up in your pocket after the dust settles. Most transactions are structured as the sale of all assets of the dental practice. When the transaction is structured as an asset sale, the buyer is purchasing each separate asset of the practice (including goodwill), which allows the buyer to receive certain depreciation deductions and a step up in basis. These tax benefits are not available to the buyer if the transaction is structured as an equity sale (i.e., a stock sale). Thus, an asset sale is more advantageous to the buyer.
In contrast, an equity sale is more advantageous to the seller because the seller will receive long-term capital gain treatment for the sale of the equity interest. This long-term capital gain treatment most likely results in lower taxes to the seller than if the transaction were structured as an asset sale. Also, in an equity sale, the buyer assumes all of the liabilities of the practice (such as potential lawsuits). The buyer rarely assumes any liabilities in an asset sale.
Because an equity sale is generally less advantageous to the buyer and more advantageous to the seller, it makes sense in most cases for the seller to accept a reduction in the purchase price compared to what he or she would have received if the transaction had been structured as an asset sale.
Therefore, as the seller, you can "do the buyer a favor" by agreeing to a smaller purchase price when the deal is structured as an equity sale. In reality, you as the seller are in a better position with an equity sale because of the tax implications and the fact that all liabilities of the business are being transferred to the buyer. It never hurts to remind the buyer of this "concession" you made in the purchase price when the negotiations got tough and the buyer refused to budge on issues that arose during negotiations. Also, it is usually a good idea to enlist your accountant to help crunch the numbers to make sure you maximize your after-tax cash when negotiating your purchase price.
3. After-tax proceeds: Purchase price allocations
Another negotiating tip that affects your after-tax proceeds is the purchase price allocation. Assuming the sale of your practice is structured as an asset sale (like most dental practice sales), the purchase price must be allocated among the assets of the business for the purpose of determining the tax treatment. The buyer and the seller agree to this allocation in the asset purchase agreement.
When negotiating the purchase price allocation, you as the seller should push to allocate as much of the purchase price to goodwill as possible. Treating the purchase price as goodwill allows you to receive long-term capital gain rates instead of ordinary income rates. The buyer will attempt to allocate as much of the purchase price to equipment as possible so that he or she can depreciate the assets faster (instead of the 15-year period allowed for goodwill). Again, lean on your accountant to make sure you understand the after-tax sales proceeds.
If negotiations stall, the solution may be an "earn-out." Although you as the seller would rather have the entire purchase price payable at closing, in many instances an earn-out may be the only way that you and the buyer can agree on a purchase price.
In an earn-out, the seller must "earn" part of the purchase price over a period of time. The earn-out would be payable when and if certain milestones are met. For example, the parties may agree that the purchase price for the practice is $900,000, with $700,000 payable immediately and $200,000 payable as an earn-out one year later. The earn-out would be payable only if the practice has gross revenue of $600,000 for the year following the purchase. By tying the purchase price to the actual performance of the practice, the buyer is able to reduce the risk of overpaying for the practice if the practice turns out to be less profitable than he or she thought.
However, from your perspective as the seller, an earn-out period delays your proceeds from the sale. Also, you're risking that you may not receive the final $200,000 of the purchase price (if the milestones are not met). Further, you may be inclined to work in the practice with the buyer to make sure the practice meets the earn-out milestones.
As the seller, you should make sure the buyer understands the inconvenience that the earn-out causes you. Because of the delay in receiving your purchase price, the added inconvenience, and the risk that you may never receive the earn-out, you should demand the buyer increase the purchase price accordingly to compensate you. The buyer should be willing to pay a little more for an earn-out in exchange for the reduction in his or her risk.
If the earn-out provision is properly negotiated and drafted, the results can be a win-win for both the buyer and seller. If the earn-out milestones are achieved, the seller is happy because he or she gets the earn-out money, and the buyer is happy because the practice was successful during the earn-out period. One caveat is to make sure you have a competent attorney designing and drafting the earn-out provision. If the earn-out provision is not drafted well, the buyer may attempt to wiggle out of the earn-out payments by manipulating the practice's financials.
5. Escrows and holdbacks
Also critical to understanding and negotiating the purchase price is an escrow or holdback provision. An escrow provision states that a portion of the purchase price will be held in escrow by a third-party escrow agent for a certain period of time after the closing. Any claims made by the buyer for indemnification under the purchase agreement will be paid from the amount held in escrow.
A holdback provision is the same as an escrow provision, except that the funds are held by the buyer instead of an independent escrow agent. In many cases, the holdback provision is part of the earn-out, so if there is an indemnification claim, the earn-out is reduced by the amount of that claim. Similarly, if the buyer agreed to pay part of the purchase price pursuant to a promissory note, a holdback provision may be part of the promissory note so that indemnification claims are offset against the principal of the note.
An example of an indemnification claim is if a third party sues the buyer for something that occurred prior to the sale of the practice while the seller was still the owner. In this case, the buyer might seek indemnification from the seller.
As the seller, you should argue against any holdback or escrow because, again, any delay in payment delays your sales proceeds. However, the buyer wants to be assured that there is money available to pay for any indemnification claims and that you have not blown all your money on an exotic retirement destination.
Negotiating the purchase price involves more than simply agreeing on a value for your practice. Payment terms and tax implications can dramatically affect the amount of money that ends up in your pocket. Understanding the terms discussed here and how to negotiate them will go a long way toward maximizing the amount of money you receive when the dust settles and your practice has been sold.
S. Nathan Gordon, ESQ., is an attorney in the Birmingham, Alabama, office of Baker, Donelson, Bearman, Caldwell & Berkowitz, PC. His practice includes a variety of transactional matters, including all aspects of entity formation, mergers and acquisitions, securities law, corporate finance, taxation, and tax planning.