“Corporate dentistry” has been a hot topic in the industry recently. Corporations, private investors, venture capital groups, and the like have seemed to develop a strong appetite for dental practices, which begs the question, “Why is Wall Street interested in dental practices?”

Dental service organizations (“DSOs”), or “corporate dentistry” as they are sometimes called, are companies generally owned and managed by non-dentist, private investors that seek to own, co-own or manage dental practices, usually large groups of multi-doctor dental practices. The presence of these companies in the industry was first noticeable in the mid 1990’s. As a general rule, their initial track record was bumpy as they sought to figure out how to own and operate dental practices without running afoul of applicable state dental licensing laws governing the ownership of dental practices and sought to convince dentists to work for them, making less than they were ostensibly otherwise making as practice owners. But they soon figured out how to address both of those issues, as well as other challenges, and they have been growing and gobbling up market share ever since. There was a key point in the evolution of the DSO as a player in the dental industry, though. That came when Wall Street, (i.e., private equity groups, venture capitalists, investment bankers, and other investors), “discovered” dental practices as the next industry they could churn and burn to make a buck.

Investment bankers generally see dental practices as undervalued assets. Through the volume created by acquiring many practices, they can create substantial equity and strong dividends for less than the cost of other investments. 

In order to understand how this works, it is important to consider the process employed for valuing a dental practice. The value of any professional practice can be summarized as its capacity to generate cash flow. That capacity is made of two essential elements: tangible and intangible assets. The tangible assets consist primarily of clinical equipment, office equipment, furniture, fixtures, instruments, supplies on hand, and so forth. The intangible assets consist primarily of goodwill, or essentially the relationships existing with patients and referral sources that have been cultured and nurtured over the years, as well as the relationships between the doctor(s) and staff members. 

The combination of tangible and intangible assets, when efficiently utilized in tandem, generates a “going concern” that possesses value. That “going-concern” value is best demonstrated by a track record of generating a certain level of cash flow and profit.  The method and means by which the cash flow and resulting profits are generated–and in what amounts–determines, in part, the price a practice will likely command in the marketplace. Moreover, by utilizing an income-based valuation approach, a reasonable rate of return to the investor can be determined in relation to the risk incurred.

As a general rule, business investors use income-based valuation methods to evaluate investment opportunities. These methods are also widely used when valuing professional practices primarily due to their accuracy in assessing the value of the cash flow of the practice.  An income-based approach is not limited simply to an analysis of the historical financial information of a practice but also takes into consideration many other elements of the practice that contribute or detract from value, such as the type, age, amount, and condition of clinical and office equipment and furniture; strength of financial policy; fee schedules; supplies inventory on hand; management systems; patient profiles and demographics; active patient count; new patient flow figures; participation in discount insurance plans; practice location (both generally and specifically); office lease arrangements; facility size and condition, including tenant finishings; practice type and philosophy; production by treatment class analyses; status and employment history of staff and/or associate doctors; market and economic factors affecting the practice, et. al.

As evidenced by this list, there are a number of elements that can and will influence the value of a professional practice; however, as a rule of thumb, a general dental practice will typically sell at a price in the range of 3 to 6 times its excess earnings or profits. By definition, excess earnings in a dental practice equate to the net income after operating overhead expenses and a reasonable, going-market-rate doctor compensation, but not including specific expenses such as interest, taxes, depreciation, amortization, and certain discretionary items. Investment bankers and business appraisers often refer to excess earnings as “Earnings Before Interest, Taxes, Depreciation and Amortization” or “EBITDA.” The EBITDA of a dental practice gives an indication of the current operational profitability of the business. It shows them how much profit the business makes given its current set of assets and operations and the services it renders to patients.

Using the rule of thumb outlined above, consider the following example: A practice has averaged $1,400,000.00 in gross, collected revenues per year over the past 3 years. It is also averaging net income of about $580,000.00 per year before payment of any compensation to the doctor (which equates to an average operating overhead–exclusive of doctor compensation–of 60%). Let’s say, in this case, the doctor’s compensation (inclusive of benefits and commensurate with market rates) equals $288,000.00. Based on these figures, the adjusted net income or EBITA is $292,000.00 Using the general rule of 6 times EBITA (for a healthy practice with other positive and attractive characteristics), the estimated value of this practice would be approximately $1,752,000.00. 

Investment strategy is not rocket science. It stands to reason that an investment yielding 16.6% ($292K divided by $1,752,000.00=16.6) makes an attractive return. In fact, if the practice were converted into a publicly traded stock with this kind of return, it would most likely sell for 2-4 times more than the traditional, going market value; or in reference to our earlier example, it would likely sell for as much as $3 million in stock. However, most DSOs do not operate with a profit margin of 16.6 percent. Even if the practices they own are yielding higher EBITDA at 20% of gross revenues, the company has other overhead expenses such as officer salaries, corporate operational expenses, and capital improvements for each clinic, among others. These additional expenses usually result in profits, or EBITDA, closer to 10% of gross revenues. Even then, the return is still substantial enough to catch the attention and garner appeal from investment bankers. 

Notwithstanding, in order for most DSOs to attract enough attention from Wall Street to be able to “go public,” they will likely need to have assembled 30 or more clinics. Even then, several DSOs may never go public but will instead continue to be owned privately by individuals, pension funds, investment bankers, and/or venture capitalists. 

So, if a practice like the one in the earlier example could be worth as much as $3 million, why don’t practices generally sell for that much? The answer lies in liquidity and access to the net earnings of the practice. Historically and presently the majority of dental practices are owned by the primary provider of services. They are owner/operator business types. This limits both the liquidity of the equity and access to the earnings since another licensed dentist is usually the only other possible owner/equity holder, making the business an active investment and not a passive one. The pool of potential owners is dramatically diminished. 

Another factor limiting the market value of dental practices is the actual (or perceived) ability to start a practice from scratch. For $3 million a DSO (or a private dentist for that matter) could easily build out and equip 5 to 6 brand-new offices, including soft costs for aggressive marketing campaigns, and soon be generating an income stream well in excess of the $292,000.00 net income used in the example. Consequently, there is little incentive for either a dentist or an investment banker to pay more than 4 to 6 times EBITA to acquire an existing practice.  

Over the past 10 years, those in the business of owning and operating multiple practices and who understand the principles associated with running a successful business will usually prefer to start a new practice from scratch as opposed to acquiring an existing one.  In some instances, they may consider acquiring a well-run, profitable practice in a great location; otherwise, they will usually elect to pursue a de novo. Unfortunately, most practices do not fit that bill, i.e., they do not fall within the parameters most DSOs have set for practices they would be interested in acquiring. So, what are some of those parameters? 

1) The practice should be grossing no less than $800,000.00 per year in collected revenues. It requires essentially the same amount of time to manage a practice grossing $600,000.00 per year as it does to manage one grossing $2 Million per year, from the DSO’s standpoint. 

2) A facility that can accommodate two or more doctors. (Profit margins are higher when utilization of the physical facility can be maximized.) 

3) A highly visible location with easy access (such as retail centers, strip malls, and other locations in high-traffic areas). 

4) A market/area that has the potential and capacity to provide a significant pool of prospective employee dentists. (Generally, this means cities with a population of no less than 25,000 inhabitants.) 

5) A local economy that is stable and growing.

If a practice falls within these basic parameters, it may be appealing enough to a DSO to garner an offer for its purchase, and in some cases, those offers can be quite lucrative.

There is a myriad of arguments both in favor and against corporate dentistry and the changes it is making to the face of dentistry, but whether for or against them, corporate dentistry is here to stay, and it is growing. DSOs are having a significant impact on the dental industry as a whole, as well as the private practitioner specifically. As considered by our rudimentary and cursory look at the numbers above, the rise and growth of corporate dentistry is being fueled by Wall Street’s appetite for consistent, considerable returns on investment.  It can be safe to say, given the current marketplace, that as long as people continue to love and need money, corporate dentistry will continue to grow and flourish. 

If you have been approached by a DSO to buy your practice, and/or you are considering a sale of your practice to a DSO, please call us first. Too often dentists make simple but very costly errors when considering an offer from and selling to a DSO. Do not make the same mistakes or make a decision you may otherwise regret later. The DSO will have skilled, knowledgeable, experienced business personnel representing them. You should too.