35: The 3 Income Streams of a DSO

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Hello, everyone, and welcome to another episode of DSO Secrets. I'm your fearless host, Emmett Scott, and today we're going to take on a topic that I am getting, for some reason in the last two months, a lot of questions around. I think the questions are all different, but they've centered on one topic. And I'm going to see how much I can take on in one podcast. I may have to divide this up, but I'll try to keep it simple. And it really centers around income and the different types of income that can be structured within an agreement and a partnership in an arrangement. So let me just dive right in. The first part that I think there's a lot of mistakes made around is that equity and ownership income gets mixed with contribution working tactical type income. Let me give you an example that I see often. So two dentists decide to partner together. They are going in on a practice together and it's going to be their first practice. And they say, hey, this is how it's going to work. We're just going to go in there, we're going to do our best. We won't pay ourselves a percentage as clinicians, but we're going to split 50, 50, whatever the practice makes, whatever the net income is. And at the beginning, that sounds really aligned, right? Because now everybody's working towards bottom line income. No one is really taking off the top, so to speak. And so it feels very much like a partnership, more so than maybe if you were getting paid as an associate and then taking a percentage of the income. But here's where the problem starts going sideways really fast in this example. And some of you are going, I already know that this is dumb, but many of you are saying, whoa, I'm in that partnership right now. And I'm going to extrapolate this out because there's a lot of situations where you, you might be doing the same thing in other relationships or may not be thinking about it this way. So now I've got two partners. They're both working towards the net income. They're splitting that 50, 50. Then one of them, because of personal situations, because of motivations, it might happen a week later, it might happen five years, 10 years later, one of them decides that they don't want to work as many days as the other partner. Now what do you do? Is 50, 50 the right amount? Maybe that person's just starting to take more. Initially, each of them were kind of doing that. Maybe that other partner started something else. Maybe that other partner doesn't want to work as a clinician anymore and just wants to live off of the net income. It gets messy really quickly when you haven't distinguished the difference between working wage and the net income of the business or the equity portion of the business. So I get a call that's something like this, hey, my partner isn't really working in the business anymore, and so I want to take his equity. I don't think he deserves it anymore. And the problem with that question isn't that that's necessarily wrong based on how they started the arrangement. It's just wrong based on how the principles of equity actually work. Equity is given for an initial contribution, something that's foundational, either through actual capital or sweat equity, where you actually own a portion of the business. You don't take that away because you stop working in the business. It's not like when I buy Apple shares that they call me and say, hey, listen, we haven't seen you at Apple. You know, you haven't been clocking in some hours. I need to take your shares away from you. Which seems really obvious to us. But in a lot of other relationships, when we're closer to it, when it's a smaller business, we ask that question all the time. So what's really important to me is to designate income types and make sure that they're correct right from the beginning. So if I have two dentists who are going to partner together right from the beginning, they should have clinical employment contracts that, that say that they would get X percentage of the work that they perform. And, you know, they may not take all of that in the beginning because maybe the practice can't afford that, but you need to accrue that then on the balance sheet that it is money owed at some future point. Here's why that's so helpful. Now, let's suppose that you and I are 50, 50 partners. We're both getting a percentage of work that we're doing, and then you Decide that you know you can't work as often or you don't want to work as often, and let's say that the practice is extremely profitable. So I'm now able to bring in another associate to cover the days that you can't work and you're able to live off of the equity percentage down at the bottom. You actually own a business now. Now, dentists get sloppy with this all the time. Part of it starts with maybe they started the business, they're the only owner, so why create a line item to pay them for associate pay? But they feel that pain as soon as they go to try to bring in a partner or they try to sell the business, especially if it's to a DSO who's going to operate off of ebitda. So the sooner you can get this type of thing cleaned up, the better, and the better it makes partnerships. Now, let's kind of build on that concept, because this is about DSOs and the secrets of building a DSO. So if I've established clinical income and I've established what equity ownership is, I can now introduce a third type of activity or income, which is management income. So what. What may happen is that one of the clinicians realizes that somebody's gotta start running the business portion. Maybe they're at 3, 4, 5, 10 practices, and so they peel off. Now how are they going to get paid for the management activity that they're doing? And so it creates this real transparent conversation of, okay, I'm getting clinical income for my clinical activity, but maybe one day a week, two days, three days, up to the full week, I'm working to work on the management side of the business. Well, that's going to be a separate wage appropriate for the management activities that they're doing. Now, from the business's perspective, thinking of it as its own entity, it loves this from an accounting because it's so much cleaner to see what's going on and what the realities of the business are. And as the practices start to grow and you can pay more for management. And if that clinician, you know, has an interest, passion and capability and talent around some management business, management component operations, CEO, cfo, whatever that might be, then you can start replacing their clinical income that's already been designated with a new associate without the business actually seeing anything different. See, the business doesn't care whether you're paying a clinical partner who also has equity, or if you're paying a clinical associate, especially if the percentages are consistent or even better, if the percentages goes down a little Bit with an associate role versus maybe what the owner was demanding initially. So now I've got two clinicians. Let's say one of them is starting to move into the management role and they're starting to replace their days with an associate. It's been really clean because as they've stopped being a clinician, let's say that I'm the one who's staying as a clinician. Well, I'm not losing anything, right? Just another clinician might be taking that. Or if I'm picking up that extra work, well, that's okay, because I'm getting paid a percentage of all the work I'm doing. I still have my equity income on the other side. So whatever the net income of the business is, and if we've both agreed that this management responsibility needs to be taken on, that there's a fair market value for that. And if my clinical partner wasn't doing it, I'd have to hire somebody else to do it. And we're paying them a wage that's consistent with that. Well, at the end of the day, where can there really be a lot of dispute? The business has to pay somebody around this. And I've got these very clean buckets because clinical income, I've got management fees and income that have to be paid, and then I've got my equity income. Now, just as a side note, which of those incomes would you say is the most valuable? Is it the clinical income, the management income, or the equity income, the passive income coming from the business? I think this is obvious, but it's not. Sometimes we don't talk about it this clearly or cleanly, but passive income is tremendously more valuable than clinical or management income. Let me explain what I mean by that, because when you go to the grocery store, they don't ask you, now, were these dollars, you know, created by your clinical work, your management work, or are they passive equity income? But my philosophy around that is because time is the one thing I can't create more of as an entrepreneur. I have not figured out how to develop more time. Somebody's got to get that time machine built. So whenever I bring in the factor of time, passive income and equity income is something that can overcome time. See, clinical work and even management work requires my time. But passive income by something that I built does not require my time. And anytime it does require time from me, then I should be getting a wage for that. So ultimately, kind of in Maslow's hierarchy of entrepreneurship, we are working towards creating passive income for ourselves. Ourselves, Our ultimate goal Right. Would be to have clinicians and management team members that were handling the day to day work and that we were able to retire from the activities that we don't want to do and that we are receiving passive income for what we've built and it's requiring no time for us. That's what we're all working towards. When someone says that they have a practice that's kicking off, let's say $20,000 of passive income to them that they don't have to work in directly, that's extremely valuable. Now you may want to have 50 of those eventually because 50 times 20,000 might be more of the income that you're targeting towards. But still the fact that you've done that one time is extremely valued. Means you have an infrastructure that can handle that. Now most of us, it's not binary. We're in, in kind of some kind of spectrum in between. Partly because that's building out a business. And it takes a long time to get all the infrastructure and org chart in place to truly be completely passive in a business. And there's a second reason which is there's a lot within a DSO that we actually enjoy doing. And so those things we should keep doing. And as we build our dso, we should start retiring from the activities we don't want to do. Now think about the clarity this would give you on your financials and in your partnership and associate relationships. If you more clearly distinguished what is clinical income? What do we pay for that? What am I getting paid for doing that activity? What is management income? What is the expectations for that? What am I getting paid to do that activity? And what's passive income? What's coming to me simply because I am the owner of the business? Now we talked about passive income kind of being the ultimate goal. What about clinical versus management? Is one of these you know, better than the other from a kind of a utilitarian perspective, is one the of one a better ideal to get to? And the short answer is no, not at all. They're completely equal because these should be driven by the passion and interest of you personally. If you are more interested in being chair side and interacting with patients and interacting with staff and having that, yeah, having those interactions, you love that technical work. Then you should get the relationships and partnerships in place so that all the business and management piece is taken off of your shoulders and you can be your highest and best self. If that's not where your core passion is and you have an interest in the management side, then you got to really dive into that and make it your passion. Now, one of the places I have a lot of sense sensitivity for DSO owners, clinical DSO owners, is the number of steps they've been going through to truly get to passive equity income. Because many of them go from being a clinician and went through all the training and study and passion and mistakes that go with becoming a clinician. And then they decide that they really want to do the entrepreneurship and the management and just all the learning. You know, that's, that's not singular too. I mean, you've got everything from finance to marketing to ops to compliance, billing, et cetera, et cetera, HR hiring. So it's, it's really like five or six clinical studies that you, that you have to do. So if you're passionate about that too, I mean, these are each big mountains to climb. And if ultimately your goal is to get to passive income or to find some role in there, there's just a lot to be done. So you should be proud of yourself. Whatever stage you're at. You should also be empathetic with the number of things you really have to juggle. So take a minute and think about how this might apply to your business. How could your financials get a little bit more cleaned up to represent the different activities that you're doing in the business? And what would be the value in that, especially if you have a partner? Would this create more transparency if you started to divide out your income into your clinical activities, your business and management activities, and then have the remaining amount be your distributions, passive income activities. And would you be able to better measure how the business is doing if you more clearly represented that? Now, some of you don't want to pay yourself on the clinical side because it can be a little bit depressing. I mean, there's various stages, definitely at the beginning and a lot of steps in between, sometimes at that 2, 3, 4 practices where if your clinical income was really being paid to you, there is no passive income. You realize that you're just doing a lot of hard work and keeping things afloat by your clinical activity. And same with management. If you were really paying yourself for your time, there really wouldn't be any passive income. Now, for tax purposes, whatever, I'm not addressing those. Maybe that has a reason why you do that. But for your management financials, I think you want to have clarity on what is the real health of your business because you just don't want to deceive yourself and thinking you have a lot of net income when really it's just you not paying yourself as an associate or not paying yourself for management activity. But the reverse side is that if you pay yourself for those things and you have any passive income at the end, it can feel magical. I don't care how much it is, but just knowing that tomorrow you could hire someone to take on those clinical and management activities if you're paying yourself a fair market wage for those and that there's something left at the end. Now you start thinking to yourself, so how do I scale this? How do I take it to the next level? I think having this conversation with your partners might clean up some future roadblocks you may run into and just overall just give you more excitement and clarity on how to grow and run the business. All right, so I hope these three income buckets you start to clarify on your financials or at least mentally start thinking through them. If you have any further questions, please join us on our Facebook page at DSO Secrets. And until next time, keep smiling. Thank you for listening to DSO Secrets. Join our community on Facebook at DSO Secrets and get answers and resources to some of your most challenging questions. If you want to get a copy of the seven secrets of any DSO, go to our website at dsosecrets.com and we will get that emailed to you. Remember, don't go at this alone. Let us be your team while you build your team.