73: Partnership Valuations

Welcome, everybody, back to another episode of the show. Continuing on this stream of dental partnerships, I want to take about 20 minutes here and talk about valuing a dental partnership. So just valuations in general, dental practices do have a fairly good valuation aspect.

To them because it's a consistent cash.

Flow, especially if it's a GP with a hygiene department, which essentially this recall creates predictability of income stream and a recurring patient visit that has a good, a good value to it. And so dental practices sell every day, as you know, just like houses sell every day. They're not based on the asset value, the tangible asset value. They're really based on the reputation of the practice. That's called goodwill. And dental partnership is same thing, just you have two or more doctors in that dental practice. And so how are they valued? I will say if. I will start off by saying if you have two dentists in the practice, it's going to be valued the same way as a doctor with a single doctor practice. It's usually going to be somewhere around on the very low end, 65% of collections, up to 90% of annual collections, with exceptions here or there. That's usually what banks are willing to lend. They'll lend up to usually 85, 90% of annual collections. However, what they'll actually lend is really a function of cash flow. What's left after paying all of your overhead? A practice that has a 50% overhead is going to be worth a lot more than a practice that has 80% overhead. So at the end of the day, it's cash flow. What's left? That's what drives valuations. Now, what I want to emphasize here, talk about here on this episode, is when you have an associate who's going to buy into an existing practice, what should that associate pay to own whatever percent ownership they buy? I'm going to keep it simple and say it's going to be a 50, 50 dental partnership. So how much should the associate buy? How much do they pay to get that 50% ownership? There's a number of things I want to consider here.

The first one is I'm going to assume in my scenario that.

Let's run through two scenarios. One, the dentist is not working in the practice and is going to join and right off the bat by 50%. The second one is they are associating in the practice and we'll do an associate to owner model. Now, for the first one, calculating the value of that practice is fairly standard. And if you want to get a quick valuation, you can go on to my technology company practiceOrbit.com where a doctor can, with their tax return in a couple minutes, get a free valuation of about what the practice is worth in a general range. Now, the buyer will essentially take that and pay for 50% of whatever that is. So if it's worth 1.5 million, the buyer needs to come up with a loan for $750,000 to pay the seller, and the buyer now has 50% of the practice. Now, in a scenario where the associate is already in the practice as a producer, as a dentist, and a lot of the production is coming off of the hands of that associate, how does that affect the value of that dental practice? Well, here's how it affects the value of the dental practice, assuming that when the associate buys in to the practice, the seller is remaining on as well. And this is essentially a two doctor practice going from an owner with an associate to two owners. Normally or often, what you do is you will take what was paid to the associate, whether that's a W2 or an independent contractor pay, and you may add some of it back. If the associate is essentially replicating or going to take over the seller's production, you'll oftentimes try to arrive at what is the cash flow before paying the new owner. Now, if it's a two doctor practice, if it's a two doctor practice, then the associate, when they become an owner, is going to get paid for their production, even as an owner. Now, it may not be as, it won't be as a W2. Most likely it'll be as what's called a guaranteed payment to a partner, but it's essentially still a simulated expense to the partnership. And so you don't want to add that associate's pay back to profits when calculating the value of the practice. Now this is getting a little bit technical here, but when a partner, when a dental practice is valued, you will take the profits and you will add back to the profits certain expenses that will not be applicable to a buyer. Let me give you a nice simple clearance example. A doctor selling a practice is running $50,000 of personal travel costs through the business. It's not really a business expense. And when the buyer takes over the practice, they're not going to pay for the seller's trip to Hawaii in Europe. And so let's say the profits were 300,000. After deducting that $50,000, you're going to add that $50,000 back to get to what really is the true business profits at 350,000. That's the true business Profit. So these things called add backs, affect dramatically what is the value of the practice. And the seller wants the more add backs, the better because the more you add back to profit, the higher the profits, the higher the valuation. And so sometimes there's this contention and associated in the practice, the seller wants to add back the associate's pay because the associate is going to go from being an employee to being an owner. So do you add back that employee expense? Since theoretically the employee will not be there afterward, they're going to be an owner. And so you would add it back and the profits would go up. The problem with that is, is even though they're not a literal employee, the associate is now a partner. They're still going to be paid for the amount of production that they do, and the seller is going to be paid for the amount of production that they do as one of the two ways that they are paid. One is generally going to be a function of production and the other one is going to be a function of profits. Whatever's left after paying everybody, including the doctor's production pay. And so you don't want to add that back. So be very careful about that. Because dental practices can be overvalued to a buyer, they the buyer overpays if their compensation is added back to the profits when calculating the value of the dental practice. All right, maybe a little heavy there. Maybe rewind, listen to it once or twice. Try to understand that concept.

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So what I recommend is an associate that's coming into a single doctor practice. And the associate's going to want to. They're planning for the associate to buy, buy 50% of this practice in a year or two years, sometime down the road. And the associate saying, well, if I'm going to put a lot of blood, sweat and tears in this thing, I'm going to, I'm going to try to grow it as if it were my own. For me, as a seller, I love that. I want an associate who's going to come in and not just think of it like a job, clock in, clock out. But they're going to start thinking of it like a business, and they're going to put a lot of heart and soul in that. And a lot of that heart and soul is going to display itself outside of the operatory. How are they working with the team? How are they thinking through the business, kind of the business planning? How are they helping grow your reputation? Are they going to study clubs? Are they helping to drive new patients? Are they involved in marketing conversations? Are they referring friends and family? I want an associate who's doing that stuff. But they're not really getting paid for that yet. But they could be adding to the value of your dental practice. And so a lot of times there's this contention between the associate and the seller. The associates feeling like, I'm going to pay for this added value that I'm bringing to the practice. And the seller's thinking, okay, that's great, you brought in the added value. But guess what? I was here first. I created the platform. I did all the heavy lifting to get this thing rolling. So we have a, we have a seamless operation. I, I am, I'm the founder of the reputation of this practice. And so, no, I'm not going to, I'm not going to lower my price based on the valuation because you feel like you've contributed something to it. The truth is, it's probably going to be somewhere in between. I mean, if you really have an associate who's really rolling up their sleeves and doing more than just clocking in.

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Clocking out so to speak. Then the truth is is that they are creating an additional value that's coming from their own sweat work. And I think in fairness to them that should be considered when calculating the price. So what I like to do is say all right, if you're really planning on an associate to owner buy in model, do evaluation at the onset on day one or shortly before the associate comes in. What is the practice valued at? And then let's say you have a year or two year program whenever the buy in actually occurs, value it. But value it using the same methodology. Use the same what are called multiples of profits to arrive at that price, that valuation at the point of buy in. Take the Difference, split it equally. So let's say the value of the Practice on day one is $2 million. $2 million practice before the associate comes in. Associate now comes in and, and over a two year period it goes to a $2.5 million practice you could take and then you value it at 2.5 million. You would take 50% of that increase and give it as a reduction, as a discount to the buyer. So the, so the value is now at 2.25 million. Take 2.25 million divided by 50% and now you've got what is the buy in price for the associate? That is what I found to be a reasonable approach. It's not perfect because every partnership is different. How much that associate actually contribute to that additional 500,000 is questionable. How much did the seller contribute? It's questionable. You, you'll never be perfect on that. But at least if you have something to say, hey, I'm going to, I'm going to reward you for having really helped grow the practice and given it a good faith effort. I'm going to reward you with that. And we're therefore not going to make you pay for 100% of the increase in the value of the practice since you came on board. Associate. So that's a model that I really like. All right. One thing I want to add or talk about briefly is, is 50, 50 the right arrangement between two partners? Where do you go 51, 49, do you go 60, 40? What about if the buyer buys in 50, buys in 10% over each year over a five year period? There's a lot of ways to do this. Let me just comment though on a couple of these. Number one is if you are not 50, 50, there will always be a perceived sense of authority. There will always be a perceived sense of control. And it's not only perceived. Assuming that the partnership agreement gives the decision making power or attaches that to equity ratios, then it is true. And depending on the type of relationship you want.

You want to be very careful about that because I'll tell you what, if I'm a 49% partner, I'm not going to put in the same equity, blood and sweat and soul as if I were a 50% partner. Now you may reverse that and say, well, if I'm a 51% partner, I'm going to put in more than if I'm a 50% partner. And maybe there's some truth to that. But if I'm bringing in an associate, I want them to treat this thing fully as if it's their own. I want them to be motivated to grow this thing and I want them to feel like they are. They are in the yoke with decision making. I want to empower them to feel as a true business owner. Not just someone I'm throwing them an equity bone, but really a 50% owner. So I have found in my experience, those tend to be the best scenario. 50, 50, we're in this thing together, doesn't mean it's not risky. And you definitely want to set up parameters about how you make decisions in the practice. This is why I think having those quarterly meetings as partner partners I think is a great idea with the standing agenda, talking about decisions that need to be made around the business functions of the practice and how profit is allocated. Now, one thing to consider that is even if a dentist is a 10% owner, they're still 100% liable. So the liability is not tethered proportionately to the equity of the practice. If one partner owns 99% but they're bankruptcy, the other partner who owns 1% can be fully exposed on certain lawsuits that may pierce this sort of veil of corporate protection or liability protection back to themselves personally. Now you're going to want to talk to an attorney about that. When you form the partnership, really make sure you understand the liability exposure you have. But that's my understanding is even if you're a minority owner, you're still 100% liable. So that's why 50, 50 is probably the better arrangement for most dental partnerships. Now, I'm not a fan of the whole 10% buy in per year thing, 20% per year, whatever that is. I'm just not a fan of that because there's a lot of work in calculating what's the value now, changing the profit allocation calculations. When you buy in every year, it's literally a purchase of partnership interest or assets within the practice. And now you have this taxable event to the seller and the buyer. You have a new tranche of assets that have to be depreciated. There's a lot of accounting and tax work that goes into that a lot. And I would never form a partnership unless that partnership is going to be together for five years. This is really important because partnerships are cumbersome from a tax and accounting administration point of view. So I don't like having all of these events where equity is changing because every one of those events comes with a whole new analysis and set of work that could get pretty costly. So I'm personally just not a huge fan of the equity buy in model, little by little. All right, let me talk about the buyer for a sec. There was a scenario I had where a dentist bought from a seller and the seller.

Sold 50% of the practice but did not share 50% of the patients, nor had 50% of the new patients routed to the buyer. The seller communicated with the staff that they still wanted to get the majority of the new patients, at least the bigger cases coming in. And what happened was this. The buyer did not have sufficient income to pay for the loan, the loan payments. That is not the scenario you want to be in. And that was, in my opinion it was an incredibly inequitable approach by the seller and was predatorial. Now they didn't think it, they didn't think it at all. And they fought it legally and it went on for many years and it cost them a lot of money. But at the end of the day, the buyer won because ultimately that's sort of what what happened. Now there were, I'm sure, other opinions and viewpoints on what happened on the inside. For sure. This is where I talked about in my last episode about our perception of value of ourselves is going to be very different than the perception of input value that other people have. This is why partnerships are so delicate is because of that imbalance in perception or that misalignment of our own self view versus our view of others and or what they think of of us. So in this case, when you're buying into a partnership, it's really important that the buyer runs a cash flow and says if I pay for this and I now have a loan of say $8,000 a month to pay the bank who paid the seller for my 50% ownership, am I going to be better off or worse off than as an associate? Because now I'm exposed to more liability and I'm going to have to take over some business functions. I'm hoping that I'm getting paid more. Doesn't always happen. But in theory, if the associate that bought in gets paid an associate pay, sort of a production pay, that's equal to what was the associate pay before buying it. If that's about the same, their profits, their share of profits should exceed the loan payment. If the share of profits exceeds the loan payment, then you're good, you're good, you're taking home the same amount and now you're building equity in the practice. Because every loan payment you make is building equity in the practice. Just like every loan payment on a house, you're building equity in the house. It's the same thing with the dental practice.

And so one way to look at this would be to say, okay, I, as an associate, I'm now going to get 50% of the profits from the non owner producers. That is hygiene. And maybe if there's other associates or some specialists who come into the office, you now get 50% of those profits. And that 50% should be adequate to cover your loan payment. So very, very important that you run a little modeling with an accountant or professional who knows this, who can take the partnership, the proposed partnership agreement, run it through some numbers, use actual sort of historical production numbers and P and L expenses to say what is going to be my take home profits if we replicate last year into this new year with me as an owner, and are those profits going to be sufficient for me to take home the same and to pay my debt? And if the answer is yes, then you're probably good to go. Just make sure you have an agreement with the seller that you're buying the goodwill. The goodwill is the cash flow, which means you have a right to 50% of the cash flow from existing and new patients, which means the seller needs to be willing to share existing patients and new patients to you in a way that's commensurate with what you are buying. Cash flow equals goodwill. Goodwill is by and large what you are paying for when you buy into a dental practice. All right? That is partnership valuations. I hope that was helpful. Be sure to get that right. Consult with good counsel attorney, accountant who understands dental partnerships. There's a lot of them out there. Practice CFO is open for conversations on this subject. They are delicate, so they do need to be done right. In our next episode, we'll talk about associate to partner buying timelines. We'll get into legal structures for dental partnerships. And then lastly, partnership allocation models get a lot more deep in how to allocate the money in the bank account. Until then.