41: The EBITDA Fascination

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You have this natural talent, this unique ability. Hello everyone, and welcome to another episode of DSO Secrets. I am Ken Kaufman, your guest host today, filling in for Emmett Scott. Now I get a chance to work with Emmett on an everyday basis in my role as the CFO of Community Dental Partners. And in discussing what topic I should address in this episode, we decided I should tackle ebitda. And with a little bit of brainstorming, we quickly realized it would take far more than one episode to cover the topic comprehensively. And so we've broken it up into three. Today I'm going to address why is everyone so fascinated and or obsessed with this concept of ibadah? In the future episodes, I'll then talk about what exactly is ebitda, and I'll also address what is not ebitda, what EBITDA should not be used for, and how it should not be applied in your business. Sometimes it's as important to understand that as to understand what it is and how to use it. So jumping right in. Many of you on this podcast are familiar with the Nomad, the handheld X ray device. I was the CFO and president of that business several years back. And in my role in working with the board, the decision was made that we would run a process to see if there was a potential partner that we could merge with or even potentially sell to that could help take this startup business and really help it get to the next level on an international level and continue from a go to market standpoint to penetrate into the dental practices as well as other verticals. So through this process, we talked with several potential buyers and then it came down to one where we got several Lois. We went under LOI with Danaher Corporation. It's now known, or at least the dental division has been spun off and it's referred to as the Cavo Kerr Group. But at the time, it was the $18 billion conglomerate of Danaher Corporation. And I found that my Saturday afternoons during due diligence Became consumed with phone calls and conference calls and video Skype with their finance team trying to understand this one thing, ebitda. They wanted to know what was happening inside of the business with this ebitda. And as we went through and understood it and built out the model for where the company could go post acquisition or merger with them and how all that would look, everything came back to, what is this ebitda? Now, why is that so important? Why is it so critical? Well, in the finance world, they needed a way to rip out the effects of financing and capital expenditures and investments to come up with a way to project the earnings, or I'll even loosely use the term cash flow that the business produces. And the thought process is, if this business was owned completely by equity and there was no debt on the capital stack at all, so no interest or nothing accruing from a debt perspective, and the business did not have or need in the future any additional capital to grow or to invest in capital expenditures, what would the cash flow of the business be? So it's a nice, interesting thing to think about. It's not how the business actually runs, but it's the way finance created this nominal platform to be able to say, what is the EBITDA of this business versus this one versus this one? And even compare across industries to some degree. And so there is this emphasis on what is the real ebitda? And after a merger acquisition, what would it be in year one and year two and year three? And in essence, that becomes one of the two factors of how a business is valued. Now, the second factor has to do with the repeatability, scalability, predictability, growth trajectory and risk mitigation within the business. And I'll go into each of those in just a second. But the second piece is this EBITDA multiple that says, how much do I believe in where this business is going? And I'm going to take that, I'm going to multiply it by today's EBITDA to come up with what the valuation is. Now, that's how we think the formula is done. Let me tell you how the formula is really done. This model is created that says next year, the year after, the year after, what is really going to happen to this business and how is it going to grow or shrink or stay flat? And they're looking at several items to come up with this. How repeatable is the model of the business? Meaning can, if you're a DSO that's doing de novos, is how repeatable is your process of launching a new de novo or launching five next year or 10 the year after that, or if you've got an acquisition process and funnel that you're working through, how repeatable is that process? If that's repeatable, then they're going to get excited and build in some nice growth into that EBITDA in the future. How scalable is the business? This means at what stage of growth does the company break? That might be. That's the opposite of scalable, right? But if your business is scalable today, at what stage does it break? And then what cost or what infrastructure needs to change in order to become scalable again? Where you add new things without having to add a lot of new costs. So you see that new margin start flow down to the bottom line and make the business more profitable or in essence build up that EBITDA over time. They also want to understand how predictable is the business. So if I invest X amount of dollars to build the de novo, how predictable is the model and that it will generate X results. They also want to look at what the overall growth trajectory of the industry of dental in general and what we see currently happening with this consolidation process and all of the estimates about the CAGR or the assumed capital growth rate over the next several decades being in double digits. They get excited about those things and that goes up versus if it's an industry that's shrinking or dying. For example, think about the difference between growth in digital sensors when those came out and what that did to the business of film and phosphor plates. That was obviously an industry that was going down. So they take that growth trajectory element and then they also want to look at risks. What risks exist in the business? Concentration risk is very or is one of the highest items on the list. If you have any payer that represents 15 or 20% or more of your total income coming in, then they're going to start to discount that EBITDA and say, well, what happens if that payer lowers their prices? Or what happens if they take their business elsewhere or do something different in the world? Now, in dental, the largest payer is the government. And so those businesses that are built around government payers and building a profitable model around that, understand that finance people may look at that and say, wow, that's a high concentration of a payer. 20, 30, 40, maybe 50%. And they might start to think, well, that's the business is at risk. However, there's lots of things you can do to mitigate any of the risks around concentration risk. They also look at regulatory risks. Anything that could ultimately hurt that EBITDA or that nominalized cash flow somewhere in the future. All of that, they model out and say, okay, what is the cash flow going to be for this business? And then they figure out and come back and say, what is that worth to me today? And that ultimately is what the EBITDA multiple is. So if you hear somebody getting a 5 multiple on their EBITDA, that's a business saying, hey, I think that, you know, based on where I see this going, this is what it's worth. If you're somebody getting a 10 or a 12 or a 14 EBITDA multiple, that means the buyer sees some of this repeatability, scalability, predictability. They like the growth trajectory. They feel like the risks have been properly mitigated to the extent that they really see this big growth opportunity to take what the current EBITDA is and to build it and grow it. So that really identifies why there's so much fascination around ebitda. Because everything from modeling and thinking about what is the business going to be in the future is driven by it. And then it's all discounted back into today's dollars. And the multiple that's applied, it just reflects what is the confidence, what is, what is the repeatability, scalability, predictability, growth trajectory, and the risk mitigation that's happening inside the business, inside this dental practice or your multi practices or your dso, however you're organized. And it all comes back and says that that's why the EBITDA multiples are lower for a single practice. Because the repeatability, scalability, predictability, those are things that just haven't been built out yet, or even if it's just a few practices. And that's why the bigger the EBITDA number is. Usually you start to see higher EBITDA multiples because there's some of these scalability and predictability and risk mitigation. There are things that are built in and around that that are making those future cash flows look more sure and more like they can grow for the long term. So that's it. That's ebitda. That's why there's this fascination around it. You've got the two factors, what is your EBITDA today and what is the multiple that's applied by that and that comes up with the valuation to some degree. It feels like we almost bow down to this multiple. We hope that it's high against our ebitda. Ultimately, the way you drive that up is by building a business that repeats scales. You can predict it it's in an industry that's growing. That's you're listening to this podcast, you're in a very high growth industry and you've learned to mitigate the potential risks that could hurt that ebitda, that nominalized cash flow over time. So I hope this has been helpful. Don't forget, just a reminder, the DSO Secrets Facebook group page is out there and we encourage you to join that. This is a place where you can ask questions. You can also jump in and help answer questions. Really, Emmett's vision there was let's build a community where people can help each other as they come across questions and challenges and their efforts to build a dso. And I would be remiss to say as I sign off here, I would be remiss to not include what Emmett always says. Until next time, keep smiling.

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