Our thoughts . . . 03-03-08

SHHH .... I’VE GOT A SECRET!
THE REAL STORY OF DENTAL PRACTICE FINANCE

It seems this is the time of the year when a large number of "deals" get put on the table for evaluation. Whether it results from students soon to graduate, associates whose contracts are about to terminate or sellers who are ready to spend more time golfing and fishing, springtime seems to stimulate a lot of activity. Since there seems to be considerable mystery about practice valuation and financing, I thought I would share a trade secret with you which might help to establish a baseline about how the people who matter the most in getting a sale closed go about analyzing a practice. I'm referring to the bankers and lenders that ultimately fund the loan for the buyer of the practice. Since neither the seller nor EMA will get paid unless the lender agrees to put their money on the table, their methods of analysis are very important to us. Even those cases of owner financing should abide by the same rules.

We have discussed in considerable detail the methods used to evaluate a dental practice. (See Past Thoughts, June 21, 2007) Terms like Summation of Assets, Capitalization of Earnings, Comparable Sales Date, the Goodwill Registry and Avoided Costs should all be familiar terms. While they are all legitimate valuation methods, they are of little interest to lenders. Lenders don't put much weight on curb appeal or state-of-the-art equipment. They don't dwell on the quality of the staff or how many PPO's the office participates in. They don't necessarily pay much notice to what the Seller believes the practice potential to be or how great and loyal he thinks his patients are. Lenders are concerned about one thing, and that's the secret I'm going to share with you. The Lenders' primary concern is:

               How are they going to get their money back?

Fortunately, their method for determining the answer to this question is relatively simple and can be boiled down to a simple formula based on cash flow:

If there is too much of some of these areas and not enough in others, the deal may be off. Let's break it down a little further to see how it works.

Gross Receipts:

Practices are financed on their past performance. Don't bother talking about potential, because bankers don't usually look at things in that manner. They want to know who produced how much and how consistently the practice has collected that revenue. In this day and age, practices with annual gross receipts of less than $300,000 are difficult to transition, because there simply may not be enough revenue for the buyer to pay their debts and make a living. There are exceptions, but careful analysis is called for.

Normalized Expenses:

I went into considerable detail about normalizing expenses in the September 9, 2007 article now found in the Past Thoughts section of our website. Take out the boats, kids on the payroll and Hawaiian continuing education trips and you get down to what is really takes to run the practice. The lender will look closely at this section to be sure the buyer understands what their obligations will be.

Gross Profit:

Doctors of all ages have to be careful not to fall in love with this number. Although some treat it as such, this is NOT your take home pay. There are a couple of major expenses that have to be subtracted from this number or the business will quickly be in trouble.

Doctor's Salary and Tax Liability:

Prudent lenders will spend considerable time determining how much the buyer will need to cover their living expenses. Present day student loan debts represent a long term liability with payments equal to a modest house payment. The buyer is also frequently in an age group where their family may be growing and one parent may need to be home for extended periods. Can they live reasonably well on the revenues available? Qualified tax consultants should be called in to make sure that adequate revenues are set aside for future tax liabilities or the IRS may become an active partner in the practice.

Excess Earnings:

This is the big one. If there is not adequate revenue left over to pay the lender's debt and any other capital improvements required to maintain an acceptable standard of care then the lender may deny the loan. It's that simple. It’s not about how much the seller feels they need to net from the sale to round out his retirement account or pay off the airplane. It's not about what the guy down the hall told you he sold his practice for or what the Seller believes the practice could do if the doors were open 5-1/2 days per week instead of the current 3 days. It's about proven cash flow, and if there is not enough revenue it probably won't work. Similarly, if the overhead is too high or if the Buyer needs $100,000 to live on and the gross profit is only $75,000, it likely won't work. If the excess earnings are inadequate to pay the debt service, it absolutely won't work because the bank will protect itself by not making the loan. Doctors considering owner financing would do well to do the same.

While the purchase or sale of a dental practice is a major (and often very emotional) event for those involved, rest assured that the lender will generally serve as a check and balance. They do not make emotional decisions; rather, they are highly analytical of the subject practice's cash flow potential. Buyers and Sellers alike should objectively study the numbers and make sure they understand exactly what is on the table. Next time we'll discuss a couple of exceptions to this secret rule along with why some banks will NEVER make these kinds of loans.

Steve Wolff, DDS
UMKC Class of 1977