Financial Due Diligence

Here you will see the first page of our trusty Dr. Devlin's bank statement. And hopefully you all got to know Dr. Devlin during the initial analysis example presented by Wes earlier in the program. In our effort to verify collections, we must first understand the risk involved with collections. The risk for a buyer is that tax returns and profit and loss statements report more collections than were actually collected by the seller. If this risk proves true and you didn't catch it, you will ultimately pay more for the practice because collections directly impact the practice valuation. And also your estimated cash flows from this practice as the future owner will also be overstated. So now you have less cash flow to service your debt and your debt is higher. But because the practice loan you got is the practice loan that you received to buy, the practice is much more than it should have been based on a reasonable valuation. So now that we have the why, let's look at why we analyze or how we analyze, I should say the bank statements. And starting on page one of the bank statements, we're going to focus on deposits and other credit section because this is the total collections number that that we expect to be included on the tax returns and the profit and loss statements of the seller. And next we'll skip down to the deposits and other credit section of the bank statement to get a closer look at the transactions that actually make up this summarized balance.

Now to someone that may not look like.

To some of you guys, it may not look like this is telling us that much, but to a dental CPA that works with hundreds of dentists, you become very familiar with the type of bank transaction codes that listed on a dentist bank statement. For example, let's look at the transactions that have been outlined in red. First you'll see ach merch bank card which indicates that this transaction is the total amount collected in the dental office through the use of a practice's merchant processor or their credit and debit card terminal, a fairly non risky transaction code. And next you will see transactions from a host of popular achievements dental insurance transactions, which indicate that these transactions are insurance reimbursements from actual patient collections, which also is fairly non risky. Okay, now looking at the transactions with the arrow pointing to the even $20,000. The transaction code reads deposit, bank, store, branch, store. And it could represent anything. Anything. That's just someone going in with a $20,000 in cash and giving it to the teller and telling the teller to deposit it into the business checking account. It could be patient collections, it could be disability insurance benefits that the seller is incurring. It could be personal contributions that the seller is infusing into the business checking account that could mask itself as actual practice collections, when in fact it's not related to the practice production at all.

And so not too many deposits. There are also not too many deposits that are even dollar like the 20, like 20,000 or 5,000 even without any decimal places or you know, factoring in taxes that would be taken out or sales taxes. So it's quite rare to even see an amount that actually is even to be patient collections in general, it's not impossible, but definitely something that we would want to investigate further.

And next you will see how we account for this initially before requesting any corroborating evidence to support the inclusion of this transaction in collections. As you saw previously, January collections were $112,500 and we found a $20,000 deposit that on the surface doesn't appear to be collections. So we are adjusting our collections in January to remove this $20,000. And we will repeat this process for every month until we get to what we call total adjusted collections, which in our example here you can see is $1,330,000. We then compare our total adjusted collections to to the accounting records, AKA the profit and loss statement. And we also compare it to the tax returns. And what we're seeing here, evidenced by the accounting and tax records, is that the seller is including the $20,000 we identified earlier in their collections number. Now that we know there's a potential overstatement in collections, we are going to request supporting documentation to verify that 20,000 was in fact true patient collections. If not, then we'll have to assess whether or not the difference warrants a price reduction or simply does it mean that we have to walk away from this deal altogether because the difference has too great of an impact on the success and future of this practice as a new owner. And next we're going to look at the steps involved in verifying the tax returns. Verifying tax returns is an exercise of corroborating partners profit and loss statements to their tax return counterparts. A lot of times we will find that the dentist will maintain their own set of financial records, typically through QuickBooks or another some other user friendly accounting platform. And then at the end of the year, they will submit these financial records to their CPA who will then use them to prepare their tax returns. Now the CPA should be doing some due diligence of his own, of their own to verify the accounting accuracy. But not always, and not always to the extent that they should with that said, during due diligence we want to compare the major overhead items such as labor, dental supplies, labs, rent, advertising, doctor wages and all of the other pro forma adjustments or simply add backs that are listed on the profit and loss statement to the tax return. These add backs and pro forma adjustments are going to be something that you will find as you are looking for practices and getting these broker prospectuses that will list back these pro forma adjustments. And as a quick refresher, pro forma adjustments or add backs were introduced during our Dr. Devlin example in which we identified items that were unusual in nature, non recurring or relating specifically to the seller with no impact to the future earnings of of the buyer. We then remove those identified items as pro forma adjustments to arrive at true operating income. That should be a representation hopefully of the earnings a buyer will experience in the future. And on line 19 you will find a summarization of the other deductions and next we will look at these other deductions to continue our due diligence.

On statement two of the seller's tax returns, you will find an itemized list of all expenses making up the other deductions line item. And here we will continue to cross reference expenses from the tax return to their corresponding accounting records. In summary, we spend a lot of time on this step during financial due diligence because major overhead items and add backs impact valuation and they impact your future cash flow projections. And given the importance of both to you as a new practice owner, we want to make sure that we can corroborate all financial records pertaining to these line items. And if we find discrepancies, we will start requesting supporting documentation and either tracing or vouching the accuracy of those supporting documents to uncover any items that will truly impact the financial health of the practice. Next, we're going to look at labor costs and how we approach that overhead category to due diligence. Okay, first let's start off with an explanation of the boxes. Box one reports your total taxable wages or salary for federal income tax purposes. The number includes your wages, salary tips that you reported. It also includes bonuses and other taxable compensation. For example, taxable fringe benefits such as group term life insurance will also be included here. However, box 1 does not include any pre tax benefits such as savings contributions to a 401 plan or a 403 plan for health insurance for 401k for retirement savings. And it will also not include subsidized health insurance premiums that are paid through payroll and the amount from box one is reported on line seven of your form 1040. Box three reports the total amount of your wages that are subject to Social Security tax. And then box five reports the amount of wages subject to Medicare tax. There is no maximum wage base for Medicare. So the amount showing in box 5 typically, or can be, I should say, the larger amount, or at least larger than the Box one amount. It's quite common for boxes three and five to be higher than Box one. And here's an example of why. Your wages for the year, say, are 30,000. You had $5,500 taken from your pay to go into your employer's 401k sponsored retirement plan. So box one would show 24,500. Since 5,500 is not being taxed, it's a tax deduction. And boxes three and five will show the full 30,000 since your total wages are subject to Social Security and Medicare taxes. And box one can be lower than box three and five. And because box one can be lower, we typically focus on box five, which is a better representation of the true cash outflow of the practice owner to pay for the staff. And additionally, box 5 is the total amount eligible to be deducted by the employer on their corporate tax return.

So next, we're going to aggregate all the employee W2s and record their total amount from box five. And we're going to record their total, their position, their hourly rate, and the number of hours they work per week. And after we've aggregated all of the staff's W2s, we're going to take a look at the W3. The W3 is just a summarization of every W2 issued by the seller in a given tax year. Thus, we would expect that the sum of every box 1 and box 5 across all W2s would equal box 1 and box 5 on the corresponding W3, respectively. And any variances found here are investigated further by requesting supporting documents like payroll reports, employee timesheets, etc. And now that we have all of our financial records aggregated, let's look at all of this in one harmonized view. In this view, you will see that we are bringing in all of the data that we aggregated earlier to compare against all sources. We look at the total W2s compared to the W3, and then we look at the total W2s compared to THE accounting records and the tax return. And ultimately, the biggest risk here is an understatement of labor expenses. An understatement of labor expenses would increase the valuation, which would also Increase the loan that would take to get to purchase the practice. And it would also decrease your future cash flow projections because you're paying labor costs in excess of what was actually reported to you. And now that we're, now that we've looked at labor, we're going to move on to facility costs and all the nuances that go into a facility due diligence. And what you're seeing here is an excerpt of a lease agreement that shows the key terms of the agreement affect the cost of the lease over the life of the lease. Each lease agreement will have a base rent amount, which is the amount that will be paid at the start of the lease agreement. And most leases also provide how that rent will be escalated over the life of the lease and when those rent escalations will occur.

In particular.

The lease agreement is increasing at an amount equal to 5%. In this particular example, the lease agreement is calling for a rent escalation every 12 months to be equal to 5% or the consumer price index, whichever is less. Typically, the consumer price index runs about 3% annually. It's usually a good gauge also for inflation. So 3 to 5% is what you were going to see in this particular lease year over year in escalations. And in order to actually track and report and compare what the lease agreement was relative to the historical financials, which is part of what we're doing here in due diligence, we have to go back and look at the consumer price index in those years to make sure that we are escalating the rent properly so that we're comparing it properly and we're not having a variance or discrepancy that's unwarranted. And after we've become familiar with the lease provisions, we'll aggregate each key provision here as it's shown.

Key lease provisions are very important for you guys to pull out of the lease contract so that not only you understand what you're walking into, but what provisions potentially will become your future if you have to do any sort of lease renegotiations with that landlord. So let's look at some key ones. Here we want to look at the type of lease. And here we either have a. We want to look at the type of ownership, I should say, so you either own the building or the suite or condo that your practice is in, or you lease it from a landlord or a third party that you have no actual ownership. You're just paying rent. So those are the two different types, two main different types. And so we'll record that Here will also record the type of property. Is it a medical building or is it some sort of general use commercial real estate building that any sort of business can occupy. And typically what you'll find is medical buildings are more expensive per square foot just by the way that they're deeded with the county. Next we're going to look is it a shared space, meaning are there a bunch of suites or condos in one building that many different owners occupy or. Or is it a standalone building that you will be working in solely by yourself? And next we're going to look at the total square feet of the space. We're going to look at the original lease start date. We're going to look at the original term of the lease, AKA how many years does the lease agreement span. We're going to look at the first term expiration. In most lease agreements there are provisions that are called options. And these options give the leasee, AKA you the option to extend your lease for a specified number of years. Typically, the bank that you're working with on the lending to buy the practice will require at a minimum 10 years on the lease agreement, either in the form of options or in an actual lease term. And the reason why the bank wants that is they want assurances that over the life of the 10 year loan that they're giving you that you're going to be able to occupy this dental space without any sort of disruption in cash flows to service the debt that they're giving you to buy this practice. And next we're going to record the number of options remaining and how many years each option will allow us to extend the lease. We're going to record the official lease end date. Is there advance notice required to exercise these options to extend the lease? Typically you will have to provide your landlord between 60 days and six months notice that you plan on extending the lease. Is the lease assignable? And also an important question for you, because when you go to sell your practice, you will need to assign the lease to the new owner. Also important, as a brand new owner, you want to make sure that the lease that is currently held by the seller is assignable to you. Because if it's not, you now know that you have to go through extensive lease negotiations with the landlord before you can close on your practice loan and actually become the new owner.

Does the seller remain obligated after assignment? Another important question, as you would prefer to not be liable for someone else's lease in the event that they default on payment, is there an existing security deposit? Is selling Signage allowed Signage being allowed is critical for a dentist because so much of your patient base is local to your practice and having visibility, having visible signage is one of the best marketing efforts you can do as a practice owner for bringing in new patients. You got people that drive by your practice every day. The more that they see that sign, if it's allowed, the more likely they're going to come through that door and become a new patient of yours. And and after aggregating these important components to the lease, we need to compare the costs recorded on the profit and loss statement and the tax returns with the amounts implied in the language of the lease and investigating any material differences. And equally as important.

In the facility cost due diligence is understanding the changes that will be applied to your lease as a new owner. For example, if the lease isn't assignable and there isn't enough options to cover the bank requirements, a new lease has to be drafted. And when this new lease has to be drafted, as I mentioned earlier, the potential for that these facility costs are likely to increase almost every time a new lease has to be drafted, you're going to see a much higher lease increase than would have been called for in the lease agreement itself. And for that reason we need to understand what that lease escalation is going to be like in year one for you. So so that we can build that into the valuation as a decreasing adjustment to the valuation because it is a decreasing cash flow factor for you in the future and most valuations are based on the future cash flows that you're going to receive. I also see adjustments needing to be made when the owner of the building is also the owner of the practice and the owner of the practice is paying themselves rent in an amount that is.

Typically not representative of what an owner would charge a third party leasee, AKA you, the person that will be leasing the building and the owner will usually charge or pay themselves rent in excess of what they're going to charge you. And the reason that they're doing that is there's some certain tax advantages involved of having a self rental and paying more rent to your self rental llc. A little bit beyond the scope of this conversation, but nonetheless it is important to find those factors. And especially in that regard, we would actually increase the valuation to factor in the fact that your rent would be lower in comparison to the profit and loss and tax returns that the seller had because they were paying themselves rent in excess of what they're going to actually charge you. And so that is our facility cost part of Our, that's the part of our financial due diligence as it relates to facility costs. And now we're going to go take a look at production reports. In review of your production reports, we want to make sure that after insurance, after insurance adjustments, net production is equal to or at least has a minimal difference from collections. If net production is lower than collections by an amount that is above a normal accounts receivable balance, then we want to understand why. And if we didn't already uncover that in the verification of the bank statements, we want to make another pass through the bank statements to find any potential reasons there that we might have missed. And if there's no missing information, that's usually a good sign that collections have been manipulated to be higher than, than they otherwise should be. And I should mention that if a doctor is willing to artificially inflate their collections to get a higher valuation, most of that benefit for doing that is going to be wiped out in the form of additional income taxes. Higher income equals higher taxes. So usually the tax burden implications mixed with the uncertainty of when they're actually going to sell the practice results in an equalizer of sorts, which tends to keep inflationary tactics from occurring or at least to a large extent.

You'll see sometimes that net production numbers are much higher than the collection reports. And the difference can be that collections are running through the practice.

So meaning when net production numbers are much higher than collections, the difference can sometimes be that there are a lot of cash collections that are running through the practice and the seller is simply taking the cash collections and not depositing them in the bank statement, in the bank accounts and more or less just stuffing it under a mattress and avoiding income taxes. Not something that, you know, not something that the practice owners that I work with will be doing, but it's nonetheless something that I see when I'm working with buyers and evaluating and analyzing seller financials and something that you potentially will see in your acquisition process as well. And finally, we're going to take a look at Delta Premier and the potential impact that it can have on your practice as you move into ownership. Over the last eight to 10 years, Delta has been eliminating Delta Premiere, eliminating Delta Premier only providers, and they've been doing this gradually. They've been disallowing new dentists and dental practice owners to be credentialed as a Delta Premier only provider. Right now, if you come across a practice that's been under the same ownership since 2009 or earlier, there's a really great chance that that practice Owner is a Delta Premier only provider, which means that regardless of whether a patient that comes into their office has Delta PPO insurance or Delta Premier insurance, that doctor is going to receive Delta Premier reimbursement rates, which from our experience in the GP dental space, equates to roughly a 35% reduction in the fees for those associated Delta patients. And as the new doctor, if you choose to credential with Delta, you will be credentialed as what they deem is called Delta PPO plus Premier provider, which means that if a patient has Delta PPO insurance, you will receive PPO reimbursement rates, and if the patient has Delta Premier insurance, you will still receive Delta Premier rates. It's important to note though, that at or around the same time that Delta began disallowing new Premier only providers, they also stopped issuing Delta Premier insurance policies to patients.

Out of 100 delta patients, you may see one or two that actually have Delta Premier insurance policies. Therefore, almost every dollar from a Delta patient that you inherit as the new owner will have a Delta PPO insurance reimbursement rate. And at those reduced fees relative to the seller, that means less production, or I should say the same level of production but less less collections, which should translate to a lower valuation because you're getting lower cash flows for the same amount of work as the current owner. And a fair market valuation in theory is supposed to be based on the sum of all future cash flows discounted to the present value, AKA today. And the discount rate that is used is the rate of return that you would expect to earn on your investment based on the level of risk involved and thus your future cash flows are reduced because the collections for the same patients are less.

Because of that should have a direct impact on the valuation. However, what you'll often find from brokers and even sometimes from bankers is that they ignore this fact altogether and they list the practice as if Delta Premiere implications are not going to have an impact to you as a future owner and during due diligence. What we're trying to do for you is quantify the actual collections impact that this Delta downgrade is going to have on your practice. And what we do is we start by getting a detailed Delta insurance report by procedure code for the historical period. If the owner has Dentrix, the report name is the utilization of insurance, which you're going to then want to filter for Delta in most practice management softwares will have a form of this report. I just know this one offhand. And we then request a copy of the Delta PPO fee schedule that you're going to inherit as the new owner. And then we also request the Delta Premier fee schedule that's utilized by the seller or also the current owner. And from there, we are going to aggregate the quantity of every procedure code produced in the historical period and quantify the difference between the rates. And after aggregating and computing the difference, what we're going to arrive at is a weighted average reduction in collections, because that weighted average is based on the procedural code mix that the seller doctor was using most often. Every procedure code has a different reduction rate. And depending on the utilization of those different procedure codes, we're going to arrive at a weighted average which we have found typically to be between 30 and 35%.

In the GP space. And what you're also seeing now is oral surgeons, for example, are also getting delta downgrades. In fact, I believe in 2020 because of COVID they have pushed these downgrades for oral surgeons into January of 2021. And based on what I can see from the differences in fee schedules, oral surgery practices and other specialty practices are looking at about a 19 to 21% effective weighted average decline in reimbursements. And so after finding this weighted average decline, we're going to look at the true impact on the collections in total. Here we are summarizing the impact that delta had on collections and quantifying the percentage reduction that the buyer will experience after business overhead is met. We're going to quantify the percentage reduction that the buyer will experience. And after a business's overhead is met, which hopefully in any strong practice worth purchasing is.

Will do, you will find that any reduction in collections is virtually a dollar for dollar reduction in the cash flows that the buyer will receive. In this example in particular, the buyer has $83,198 less in collections, and therefore $83,000 less in net profits. And we know that collections feeds the ego, but net profits feed the family, and it also funds your retirement and your future self. So that $83,000 in a practice like Dr. Devlin's is roughly the same amount that it would cost you to fund your entire 401k plan for not only you and your family, but also for your staff. That's quite a big impact as a new owner walking into day one. And with that, we have wrapped up financial due diligence. We've covered a lot of important areas. And if you're still feeling overwhelmed or a little lost there, that's okay. If you want to go back and re watch our modules, or that's perfectly fine. You can also explore other resources on this topic. Feel free to leave comments or questions on any of the sections throughout, and hopefully myself or a team member of mine, or maybe even another associate that's following along in the videos, will be able to provide some additional help and get you to the answer that you're seeking. And next we're going to look at in our next module, we're going to look at clinical due diligence and the important nuances to look for when completing that section.