Valuation, Sales, and Partnerships in Orthodontic Practices
In a time of many sellers and few buyers, proper planning — well in advance of important practice transitions — produces true-win strategies.
by William C. Sutton
I am the principal partner in a firm specializing in the valuation and transition of orthodontic practices. This business has been my livelihood for 13 years, and I have been involved with orthodontics for 30 years. We'll be looking at an analogy of how the process of transition relates to orthodontic treatment; some common misconceptions regarding valuation and transition; and, some pitfalls that have occurred over the years and how to avoid them.
The role of your personal and legal advisers in a practice transition is pivotal. During the transition process, they should demonstrate synergy and cooperation.
Your practice and transitions
In your daily practice, you take records on new patients, work up plans, and carry them out via successful treatment. Only once or twice during the life of your practice will you carry out some type of transition. Perhaps it'll be a partnership or a sale, and, at some point, you will retire. Taking patient records is similar to the practice evaluation, and the treatment plan relates to the practice-transition plan. They play out similarly. In any acquisition of one company by another, the acquiring company delves into the operations of the company to be acquired. The buyer will look at the seller's history and records, get to know personnel, look at the financial picture, and become totally acquainted with the company in order to put a quantitative number or valuation on the company. This process of discovery is commonly known as due diligence.
The valuation process of an orthodontic practice is no different. It is almost always conducted with an on-site visit to the practice in order for the valuation expert to go beyond the financial paperwork and scrutinize all of the aspects that contribute to the "real value" of the practice — goodwill. Some of the items that must be analyzed include: 1) patient recall — present, and 2) the trend — up or down. Other areas to be evaluated include staff history; an analysis of the patient intake process; new-patient contact trends; consultation trends; conversion ratios of exams-to-treatments; and the all-important profit realization. Additionally, an item called "contracts receivable" must be analyzed. Contracts receivable is an asset not typically booked by other dental specialties or general dental practices. It is a significant factor in orthodontic practice analysis. Analyze the accounts receivable over 60 days and any trends over the past three years. Recall is one of the chief components of the practice value, both in terms of the number of patients in recall and the method of recall administration used to ensure that those patients do begin and ultimately complete treatment.
For example, a practice grossing $1,000,000 and having an active recall of only 150 patients may have a value similar to a practice grossing $600,000 with an excellent active recall of 450 patients. The point is that the old yardstick that says the value of a practice is equal to one year's gross; two times its net; one-and-a-half times its net plus fixed assets; or, any relationship to a percentage of any quantity is simply coincidence.
I've valued practices ranging from 42 percent of one year's gross all the way to 135 percent. The latter case was a practice with a huge recall of approximately 450 patients and an amazingly low overhead of 41 percent. It's obvious that the gross an office generates is one of the least meaningful statistics in determining a practice's value. In reality, valuation boils down to the cash flow the practice generates, and the net.
Evolving trends and cash-flow terms
As previously mentioned, the old paradigms of a practice's worth are purely coincidental as they relate to the value of a practice. They're simply guidelines. The discounted cash flow or capitalized pre-cash analysis is the method most commonly used by larger accounting firms and those firms dealing in the valuation of closely-held health-care practices and businesses.
You own your orthodontic practice; therefore, it is closely held — the stock is owned by you alone. There is no public stock issued or owned outside of the portion you and your partners (if any) own. Since it is a specialty practice, it requires special valuation procedures. In the valuation of an orthodontic practice or any closely held business using the capitalized pre-cash analysis, the "free cash" is capitalized or multiplied. The capitalization rate is determined by many factors, such as the location; the prevailing federal discount rate; the specialty of the practice; the component of risk in the practice; and, the quality and amount of the practice's recall, contracts receivable, profitability, staffing, and management priorities. Excess earnings refers to pure profit flowing after allowing for overhead and paying the orthodontist for the pure orthodontic efforts on the patients and minimal management efforts.
The Journal of Clinical Orthodontics and other periodicals offer that the average overhead of an orthodontic practice today is about 58 percent. The average successful orthodontic practice has an overhead of 48 to 50 percent. Therefore, just as orthodontic technology has changed from Australian wire to stainless steel wire; and from Nitinol wire to heat-sensitive Niti wires — valuation has evolved and become more sophisticated.
Today's valuation techniques are much more realistic than those of only a few years ago that used the "tried and true methods" of comparison to gross, net, etc. Today, if someone made a statement that a practice could never be worth over one year's gross, the speaker would simply be an uninformed valuator.
Let's take a look at the roles of your personal advisers whose expertise are paramount to the success of the valuation and transition of your practice. These include your CPA, CFP, and your attorney, whose advice and collaboration can produce the synergy that makes both parties winners — provided they have experience in mergers, acquisitions, and orthodontic practice valuation enabling them to execute the proper transaction. In reality, orthodontic valuation and transition are not typically part of their day-to-day business. Your practice transition probably will be the most important business transaction of your life. Therefore, you must carefully select an appropriate specialist to help you avoid the pitfalls which can confound uneducated and non-veteran valuation analyst and transition advisers.
The transition company that you select and its ongoing relationship with you and your advisers must forge or "plate" a transition agreement that is solidly fair and a true-win transaction for the buyer and seller.
For example, your CPA should be discussing your practice statistics with you on a monthly or quarterly basis. These reviews should include: the mechanics of new patient exams; patient starts; the need for fee increases; and, the use of phased orthodontics. If not, your CPA's Profit and Loss statement for you may be correct, but the advice given to you will not be extensive enough. That adviser may not be able to go the extra mile and provide the "arm's length transaction" necessary for the successful negotiation and sale to your partner or successor.
This tremendously important transaction usually can only be accomplished by a skilled third party who does not have any emotional ties to the parties involved. Advisers with emotional ties could include those conducting daily asset management, financial advice, or recurring legal transactions. Therefore, if your attorney or CPA has just been advising your orthodontic practice, there is very little chance that he or she can have the "big picture view" of your practice and the way it compares to hundreds of practices across the United States and Canada.
Some of my truly difficult practice valuations have occurred in "family transactions," where emotions run at extremely high levels and sibling relationships must be considered. It is essential that an impartial third party be engaged so that an equitable inheritance to heirs can be arranged.
Components of valuation and transition
Let's focus now on typical transactions and their components. A typical transition transaction has four distinct parts: 1) valuation; 2) the associate, partner, or buyer search; 3) the negotiation and documentation; and, 4) the definitive consummation document of the practice transition. As discussed previously, the practice valuation is best accomplished through a site visit where most of the information is gathered and verified for examination by all parties.
When it comes the buyer search, many doctors are well-networked with orthodontic schools, enabling them to more easily locate a buyer than someone with no current school associations. It is, however, a buyer's market, and older practitioners are becoming frustrated at having underestimated the time and effort involved in finding a suitable buyer. Even the finest practices in less-than-fabulous locations are often difficult to transfer. Your practice valuation and transition specialist should maintain a current database of candidates that can help you in the search process by connecting sellers with buyers.
The ability of a buyer to be a Charlie Tweed or Edward Angle from his or her first day of association or purchase is not essential. What is essential is that the buyer must be the type of person who will be able to form honest and lasting relationships — and to carry forward the legacy and success of the seller's practice. The search process may be lengthy because it may be dependent on the location of the seller's practice; and, to a lesser extent, the practice size. As a rule, the larger the seller's practice and the better the location in terms of recreational, cultural, educational, and social opportunities, the more desirable the practice may be to a potential buyer.
The ideal scenario would be for the seller to have many discussions with numerous candidates and then have the luxury of choosing the best. Reality dictates, however, that many times even one or two viable candidates can take several months to a year or more to locate for a practice off the "beaten path." The law of averages applies here — the more candidates interviewed, the easier it is to catch one! Begin having orthodontic residents visit your practice from the time you are in your mid-40s, so that many potential candidates are looking at your practice all the time. Thus, when you reach age 60 and the time has definitely come for transition, lookers don't unwittingly signal to your patients and staff that something strange is happening in the flow of your practice. The ideal transition in orthodontics is a long-term buyout where the successor enters as an associate while simultaneously proceeding with the buy-in and eventual buy-out over a pre-determined period. This allows a very important action to occur — the seller to exit the practice at the time that was established in the transition documentation. In this way, the "changing of the guard" and its timing is not known to the staff and the community until the buyer and seller choose to let them know.
Negotiation and transaction arrangements
Several key factors which may be unveiled in the negotiation process include: discussion of the selling price; covenants not to compete (both ways) and other protections to both the buyer and seller according to salary structure; perks to the buyer during the selling process; and, whether the sale will be financed through the practice, cashed out by a bank or lending institution, arranged through a transition company, or through another entity. The higher the practice's cash flow, the easier the transition can be accomplished. This is because adequate funding is available to compensate two orthodontists working in one practice during the association of the buyer and the phaseout of the seller. I recommend that the association period rarely exceed one-and-a-half years before the buy-in begins, and that all paperwork should be set in place prior to the onset of the association period.
Moreover, I strongly urge that an initial payment be made by the buyer or associate at the beginning of the association period so that both the buyer and seller share a common financial commitment to the success of the transition. The negotiation is accomplished using a process that always loops the information through the seller and his or her advisers, and then it goes to the buyer and buyer's advisers. Thus, the seller and advisers are always aware of what is being presented to the candidate during the negotiation process. The negotiation is consummated by drafting a definitive letter of intent which lays out in skeletal form the general terms of the purchase and gives specifics about the association. These specifics include when it begins, the length of the association, compensation to the associate, per diem paid to the seller during the transition, and when the closing of the sale will occur.
Whether the sale of a partnership transaction is a stock sale or an asset sale, these issues are determined in advance of the association, as they affect the "workout" of the purchase price and its allocations to stock, assets, deferred compensation, covenants, etc.
The bulk of the information detailed in the transition documents are drawn from the letter of intent. The type of transaction (stock sale or asset sale) will vary according to the wishes of the parties of the sale, the type of business entity that is passing from seller to buyer, and other considerations. The seller's practice entity can be a sole proprietorship, an S-Corporation, C-Corporation, a partnership, an LLP, an LLC, or another type of hybrid entity. As a final bit of discussion regarding definitive documents and the sale of an orthodontic practice, it is my opinion that the passing of a corporation through a 100 percent stock purchase would not be fair regarding tax implications to the buyer. A 100 percent stock purchase would be totally nondeductible as a business expense to him, and would pass as capital gains to the seller.
Very seldom is there a transaction conducted where negotiation, discussion, facilitation, preparation of documents, finalization of documents, and the beginning of the transition itself occur without some amount of consternation, stress, and head-scratching taking place as well. It is for these reasons that I recommend you retain an astute, savvy, and veteran transition specialist — someone who is best-equipped to handle your practice's sale negotiations and documentation.
We've observed in the past 25 years that the number of graduates from orthodontic departments in the United States and Canada have decreased by 25 percent. At the same time, the number of practices for sale has increased by a number which outstrips the current supply of candidates for transition. Consequently, we are in a buyer's market and it will remain that way for at least another 15 years. The good news is that the best-run, best-operated practices in terms of low, appropriate overhead; high profit realization; owning a large recall; having solid staffing; producing great orthodontics; and having good management can expect to receive a fair price for their transition transactions. As we all know, according to our life's experiences, what goes around, comes around, and the number of truly solid practices is much lower than all of the practices that are up for sale. It is truly a time of caveat emptor. The buyer should beware as should the seller.
The buyer has the advantage of having more practices to choose from because there are more sellers than buyers in the marketplace. By the same token, buyers must not allow unknowledgeable advisers to negotiate away a great practice because they are unaware of the importance of substantial recall, collectable accounts over 60 days, contracts receivable, etc. On the other hand, the seller must have a true and realistic grasp of the practice's worth in the marketplace — before any associations or transition arrangements are made.
Therefore, I have made it my mission to help both buyers and sellers, residents, and practitioners with my valuation experience. Through proper valuation, consideration of the facts, and the crafting of pertinent transition documents, the result will be a mutually advantageous and successful transition.
William C. Sutton is principal of Sutton Consulting, a firm specializing in valuations, evaluations, mergers, and sales of orthodontic practices. Sutton cofounded and is the former president of Orthodontic Management Group. His 30 years of experience serving the specialty of orthodontics and his specialized skills have allowed him to develop an industry standard for orthodontic practice analysis. For more than 13 years, Sutton has crisscrossed the United States and Canada presenting seminars at orthodontic graduate programs, AAO and COA Annual Sessions, AAO constituent society meetings, and other forums. He served as a lay director and as president of the American Association of Orthodontists Foundation. Other accomplishments include numerous awards for articles on practice valuation, transition, and management. These articles have been published in orthodontic journals, bulletins, and periodicals. You may contact Bill by phone at (336) 545-1899, by fax at (336) 545-3953, or email at SuttonConsulting@aol.com