Practice Sales: The Role of Escrow

Foreign.

Welcome, everybody, to another episode of the Dental Boardroom podcast. I have one of my good friends and a recurring guest on the show, Matt Odgers. Thank you for joining, Matt.

Yeah, thank you so much for having me back, Wes. I'm looking forward to this.

So, just for those listeners who have not learned or listened to some of our prior podcasts, Matt's been on a couple of our shows. Matt is a dental attorney, and Matt and I sort of kicked off our careers in dental together about going on close to 10, maybe nine years ago. We were starting up in a very small executive suite and ran into each other. I don't know if we had more than a couple dental clients at the time. And we move forward. And so we've just been tight all along the way. And there's a lot of great dental attorneys that we've worked with here in Southern California are the ones who I work with most, and I really enjoy working with all of them. Matt. Just our history together has made it more of a unique relationship, and so we really know each other's backgrounds, our skill sets, our knowledge. So I just love having Matt on the show. It's easy to talk through some of these points that we feel are valuable to our listeners. So, Matt, thanks again for joining. Today we've got a cool subject. We are doing a series on practice transitions. And practice transitions are really kind of a hot topic these days, wouldn't you say, Matt?

Yeah, oh, absolutely. They're moving right along. And I know in my world, just the volume of practice transitions that are happening has really increased. I feel like, you know, dealing with a handful of them at any given time, that's been great.

Yeah, we've been on a number of deals together and definitely seeing some in the. In the DSO space. And that's a whole different level of, I will say, detailed knowledge that's needed in order to navigate that transaction. We here at practice CFO primarily work with the private practice, and so we, however, a lot of our clients who are very successful end up getting pitched to by the DSOs out there and DSO brokers. And so we're often evaluating DSO contracts and all the language in that. And so we'll have more podcasts on that subject. And we've already had probably three or four podcasts on DSO deal structures in the past as well. But in this series that you and I are going to be doing together on transitions, it's primarily going to be around the private practice sale. And I want to provide the type of education that if a buyer or a seller were to listen to our podcasts, they would feel extremely informed moving into a practice sale or a practice acquisition. And recently.

Maybe it was a few months back, Matt, we talked about an loi, the importance of a letter of intent, and also what are some of the terms embedded in a good letter of intent. So if you want to go back to the beginning on our transition series, those two would be two good ones to listen to. Today we want to talk about escrow. And you may not get thrilled about the subject, but I think if you're, if you're considering selling or buying a practice, I think this is a good one for you because escrow does play a very valuable role in the transition process. When a deal uses escrow, and not every deal uses escrow, there's reasons why some don't and there's obviously reasons why some do. So we want to talk today about the purpose of escrow, what does escrow do, and why you should consider using escrow in your practice transition. And before we jump into the actual content, one thing I want to say is that this podcast, the Dental Boardroom, is the podcast for Practice cfo, which is my dental CPA and financial advisory business located out of San Diego. We work with clients all over the place as well. We have about 45 employees, we have nine advisors, and work with approaching 400 dentists throughout the country. And so been doing this for about 13, 14 years, which gives just anecdotally a lot of experience to talk about these subjects specifically been in a lot of deals representing buyers and some deals representing sellers as well. But on the side, as Matt and I are sort of joined in building a technology to facilitate a smoother transition or for buyers and sellers. And it's called Practice Orbit. You can check it out@practice orbit.com www.practiceorbit.com and you can always create a free account. What it does is it's sort of a Redfin or a Zillow for dental practice sales. It consolidates the supply of dental practice sales and the demand for dental practice sales in one place. That is the aim or the goal. It is only recently launched and in fact is undergoing a lot of develop right right now to add a lot of great features to it. And then the software will not only help make the market, that is help buyers and sellers find each other, but also provide tools to navigate from NDA to letter of intent to closing and the buyer and seller's respective teams to all work in a common transaction flow or what we oftentimes is called a transaction management Room. So we're very excited about that. And a practice Orbit has its own podcast called the Dental Practice Sale. So this and these transition series will be posted to both of those podcasts. But if you're interested in the Dental Practice Sale or are thinking about selling your dental practice, check out the Dental Practice Sale podcast. We got a lot more content over there. And its own content separate from the dental boardroom. Excited about that, too. We also do talk quite a bit about selling to a DSO over on the Dental Practice Sale podcast, if you're interested in that.

Yeah. And let me jump in on the Practice Orbit side. One of the key concerns I get from buyers when they come to me is that this whole transaction process, there's so many different people involved and there's so many moving parts, and it's not something that's common knowledge or common sense. And so part of what Practice Orbit, through the technology, is designed to kind of help make a smooth transition process. And whether that be the escrow, like we're talking about today, the letter of intent, discussions between the attorneys, the broker being involved, and being able to collect information in one place, all of those things. Practice Orbit is geared towards simplifying that process and making it easier. So as a dental buyer, you don't feel like you need to take this all on yourself and study and be an expert in this. Our role as advisors is to help you kind of get through the transaction in a clean and easy manner where you can focus on the terms that are most important to you.

Yep. And if you are a practice owner and you want to determine the value of your practice, you can go in there and within minutes, if you have your tax return, you can put in about seven or eight numbers, and it will tell you with some pretty good approximation what is the estimated value of your practice. And it provides a low, medium, and a high, and then what you would take home after paying any debt you have on the practice, any taxes, and any transaction costs. So it's a really cool little tool, sort of like a. Like a zestimate, except for it's related to dental practice sales. All right, let's jump into this subject today. Matt, you ready? Yeah.

Let's get after it.

Okay. Escrow. Now, in my experience, I would say around maybe a third to a half of the practices practice transitions that I've been in use escrow services. Matt, you can share with me your experience. What is the benefit you kick us off? What is the reason to use an escrow when selling your digital dental Practice.

So there's a handful of benefits, but the primary one is financial security. Anytime that there's a transaction that happens and one person has to deliver compensation for goods or services, it's difficult. When do you hand the money over, how all of that is coordinated. And escrow ultimately acts as a neutral third party that holds funds securely until all of the terms of the sale are met. Are met. And this reduces the risk of any financial loss due to fraud or any breach of contract. And so escrow kind of has ultimately a checklist of things that they go through to make sure that all of the boxes are checked before they release the funds to the seller. And because they're a neutral third party, they don't have a conflict of interest in representing either the buyer or the seller. Their primary responsibility is to the terms of the escrow instructions. So it really is a security apparatus to make for a successful sale.

Yeah. Let me comment on that last comment you made about representing the buyer and the seller. Most deals, who Matt is more represented, the buyer or the seller.

So the buyer usually has a bigger team. I would say now, attorney wise, both the buyer and the seller each have their own. Have their own attorney. But on the buyer side, the buyer needs to go through the due diligence process and make sure that they're getting what they're paying for. So there's a whole list of due diligence that needs to happen. And some of the stuff is going to be handled by a practice consultant or by a cpa. Some of the stuff is handled by an attorney. But there's a handful of record searches and lien searches and things like that that escrow steps in and takes care of, which protects the buyer to make sure that there's nothing that was overlooked on the seller side.

Yeah. And I think that's what I want to drive at for a moment in. I will say in broker deals. In broker deals, it has felt to me that the seller generally gets more attention because they are. They're supposed to be brokering between a buyer and a seller, but really they end up representing the seller because they're paid by the seller. And so they want the price to be higher, they want it to move faster. They don't want to. They don't want due diligence to drag it out. They just want the deal to close, they get paid and they move on to the next deal. Now, that's not a, it's not a criticism of brokers. That's the nature of any brokerage. Whether that's Real estate or stock or dental practice sales. That's that model. But in that case, brokers aren't necessarily looking out for the best interest of the buyer because if they do and something slows it up or causes the buyer to back out, well, now that broker doesn't get paid because guess what, the broker's only paid if it sales. So there's a huge conflict of interest there between the broker and the buyer due diligence. So the escrow, on the other hand, gets paid a fixed fee. And whether or not the deal closes, they may not get their full fee, but they're getting a fee whether the deal closes or not. And so the model is built in to try to remove some of that conflict of interest. So why do. One of the, one of the purposes for escrow is they do a title search to verify that this is a legitimate company. It's on the records of the government, in the government records, in the department of the. On the, at the state level. And also they review all public records to understand what obligations this and claims are attached to this company. They don't do that for the seller. The seller doesn't really care about that. The buyer does. Now, most transitions are asset sales, which means we can do a whole podcast on this, but it just means that the seller is selling their assets like a garage door. They open it up and their seller dental chairs and they sell their equipment and they sell their furniture. And anything above the market value of the tangible assets is called an intangible asset or goodwill and that gets shifted over and bought by the buyers. Corporation, which is a separate tax id, a separate entity and will operate separately. There are some claims on the seller's corporation that could move to the buyer's corporation. And tax ID sales tax is a, is, is a big one, I believe payroll taxes is a big one. And so the escrow agent needs to make sure that there's not a claim that could transfer over to the buyer in that search. So what am I saying in all this? The escrow does an important due diligence service for the buyer and the buyer therefore has a larger representation. You could view it that way when an escrow is involved.

Yeah, absolutely. So a lot of times you look at what teeth either the government or banks have into the assets of the practice. And because the. Like you, like you mentioned earlier that most practice transitions are through an asset sale. A lot of times the assets are used as collateral on outstanding loans or potentially as collateral if a tax payment was missed by the seller. So escrow goes through and makes sure that there's none of that outstanding to where after the purchase, that no other third party can come in and lay claim to the assets that were purchased by the buyer. And that saves the buyer because the buyer, through the purchase agreement, will have remedies against the seller. If the seller misrepresented something, they could have a breach of contract, but that doesn't protect them. If somebody comes in and makes a claim to the assets that they just purchased. And while they may be able to dispute that, just the process of disputing it, you're already losing. So escrow is going to make sure that the assets are being transferred free and clear of all liens and any third party claims so that when the buyer steps into the practice, they're the sole owner.

Yep. I also think you mentioned that they help protect funds. So there's really two points when funds are being transferred to escrow or out of escrow. The first, and you don't see it very often. I've seen it a few times, but it's something that I think should happen more often in Practice Orbit. This is a part of the Practice Orbit process for transitions going through practiceOrbit.com is the buyer will provide earnest money when the letter of intent is signed, and that earnest money will go into a newly opened escrow account that the escrow company can protect, meaning that the seller doesn't have access to it and the escrow only releases it either back to the buyer or to the seller, depending on what happens in that transaction. Let's talk for a sec about earnest money in the escrow process. Why? Why? You and I are probably advocates of this. Now, you can differ in your opinion, but I want to hear it. But here's why I'm an advocate for it is.

We want to be serious about this. When the letter of intent goes in, people are starting to pay money for teams. You now hired your account, put some money in your cpa, you hire an attorney, some money's going on there. There's a lot of time that people are putting into this now, collecting documents, getting loan approvals, setting up escrow, maybe some money going to the escrow company. In the beginning, there's a lot of flurry of activity going on once that letter of intent goes in. And if you back out, if the buyer, the seller backs out, then there's a lot of wasted effort and a lot of wasted money. Now the seller has a natural incentive to not back out because the seller is about to land a big chunk of money. When it closes. So there's a built in incentive for the seller to move forward to close on the deal. The buyer, if the buyer backs out, they don't lose anything, they just back out and move on to the next. And letters of intent in most states are not binding, so it doesn't force the buyer into the close. And so a lot of buyers can take for granted that or they will leverage that benefit at the expense of a lot of people who put in a lot of time and including the seller who took it off market during that period of time. So what this does is it puts skin in the game and forces the buyer when they sign that loi to say, I'm very serious about this enough to where I'm going to invest myself in a team and I know the seller's going to do the same during the due diligence period. They can back out and get that money back is usually how the language is. And the letter of intent, because something uncovered in the due diligence, something says, you know what, now that I've looked under the hood, this isn't the practice I want and they can back out. But once the due diligence is done, at that point that money is forfeited if the buyer backs out and it reverts over to the seller for at least slightly mitigating what was their cost and their time lost from that deal. Matt, any comments? And do you think escrow money is a good idea in a dental practice sale?

Yeah, absolutely. I completely agree with your analysis. And it does go to show that it shows the seriousness of the buyer to kind of start the transaction outside of just signing the letter of intent. But I wanted to jump back to the concept of the letter of intent and the terms. And I believe we touched on this in the last podcast. But within the letter of intent, if you're going to be using escrow number one, the letter of intent should say that escrow is going to be used, that the parties agree to that. Number two, it should say that the escrow fees are going to be split between the buyer and the seller. And number three, if you have a earnest money deposit, it should state how much that's going to be. And then last.

The letter of intent should talk about at what point that money becomes non refundable to the buyer. And in having all that in your letter of intent, that goes to escrow and that's going to protect both the buyer and the seller with regards to the earnest money deposit that we're talking about. So escrow is going to use the letter of intent initially as their initial instructions with how to hold that money and when and who to release it to in the event that either the transaction succeeds or the transaction is derailed and not completed.

Yep, all great points. I think the, I think the details of that earnest money in the escrow need to be very clear. Otherwise it could easily be disputed whether or not that money should revert back to the buyer or or not. So thanks for clarification on that. In the Practice Orbit built in letter of intent, which we have one built into the system that Matt has helped to draft up and we recommend all sellers and buyers who transact through Practice Orbit's technology platform using use the built in letter of intent because it does have that level of detail.

Yeah, absolutely. But going back to your initial question, I think I got a little off task there. Wes is I do agree that.

Parties should use escrow and should use the earnest money more for the skin in the game that I guess other than the skin in the game, it also is a way to reimburse the seller for their expenses outside of time. And when coming up with the amount of money that you want to put down, usually we talk about, okay, how much is the seller invested at this point and will that deposit amount cover their investment if the buyer backs out without cause?

Yeah, great. Great comment there. If I were a seller, I am going to want to use escrow and earnest money, even if that's going to cost me. Let's say escrow costs maybe $4,000 and that's usually split, by the way, equally between the buyer and the seller. And Matt, you can comment here in a bit about fees if you want to. That's my understanding. It's usually around 35, 3,000 to $4,000 split equally. If I'm the seller, I will be happy to pay that 1500, $2,000 if I can significantly increase the probability of this deal closing. Because I find that most sellers, once they decide to sell and they start mentally pivoting, they want it to go quickly. And it's a huge kind of blow to the seller. When a buyer takes a month and a half, two months, and then backs out, it's really discouraging because you're thinking, I got to go through this process again, I got to find a buyer that's going to take a month or two and then we got to go through this process. Then what if I lose that one as well? So with Practice Orbit and just in general we're trying to create with escrow we're trying to increase the odds of that deal moving forward and closing for the seller. This is why I tell all sellers, recommend you use escrow and we should do a earnest money deposit. Now, when escrow isn't done, I will say that banks do some elements of what escrow companies will do. And the reason why is the bank's about to hand over a million bucks or whatever for the practice. That's a lot of money. So the bank is going to do their own title search, they're going to do some of their own due diligence to make sure that if they lend to this buyer, there's nothing going to come up later that's going to force that buyer to go bankrupt or have to sell the business and putting the lender at risk of not getting repaid. I just think the escrow does it earlier on in the process. And the escrow I think probably does it a little more thoroughly as well, maybe.

Yeah, exactly. And like you said, Wes, the bank's motivation is they're doing just enough due diligence to protect their loan. And so escrow goes above and beyond that. So the bank's due diligence is. There's a bit of self interest there. And while it also benefits the buyer, escrow usually is going to go and do quite a bit of a deeper dive, which is excellent.

Yep. Here's one more aspect. We'll. We'll name maybe one or two more points here. Matt. I think on, on escrow. Here's the. The final big one for me with escrow is that these practice sales can be a. A chaotic transaction. And I'm going to say that very literally, it can feel like total chaos because you have all these elements that need to get lined up in order for the practice to close. You've got the purchase and sale agreement, you've got the lease document. You've got to have due diligence done, both financial due diligence and what I call operational due diligence. There's a lot of language in the contract. There's insurance that banks generally require for the buyer to take out the loan, depending on the size of the loan, life and disability insurance. There's the buyer having to set up his or her corporation, get getting ready with bank accounts and payroll. There's just a lot going on. And one of the most challenging aspects with a deal is just knowing who is doing what and where are we in the process. And what happens is, I find is attorneys and accountants get extremely busy, really busy. And if somebody Isn't tapping on their shoulder. Sometimes it can be weeks before they pick up that baton to do their part in the process. And so this is why in the past sometimes I've said this is one of the functions that a good broker can handle is making sure that the plays are being run and you're moving down the field. Now, practice orbit, we have what's called a transition facilitator. And right now her name is Erin. She does a great job at this and uses a tool to make sure everything moves forward. But the escrow also plays a valuable role in, in.

The management of the process and the timeline and moving it forward. Now I wouldn't say that.

That'S their primary job. It will still get stalled with an escrow agent. But they do have a software, all of them have a software. And the software will kind of have a timeline. And if they're good, it's going to help drive it forward. But that would be one of the other big value points to Having an escrow is just helping to keep a workflow moving in the transaction.

Yeah, absolutely. And also the record keeping, having a centralized place. Escrow services generally provide detailed records of all of the transactions and communication that can be referenced when it comes time to file taxes or if there's legal questions after the fact. So that's another big benefit going back to the. To the earnest money deposit. Escrow can also help in regards to dispute resolution because they're a neutral third party. If there's any disagreements or misunderstanding, the escrow agent is a neutral third party and can kind of come in and help with the resolution. And because they're holding the money.

It'S a lot more fair to both parties than if as a buyer you were to pay your deposit directly to the seller. That's going to be a tough one to get them to release it back to you.

Yep. And speaking of releasing money, so one thing I said earlier, Matt, was there's two, there's two sort of junctures where money is being released upon conditions being met. The first one is the escrow money that the buyer puts in. And we've seen anywhere from 5,000 bucks. I think the most I see is probably 3% of the sale price. So if it's a million dollar sale price that the buyer puts in $30,000, oftentimes buyer ain't got $30,000. We in that practice orbit say $10,000 is a reasonable amount. Most associates can do it and 10,000 bucks is significant enough to them that it is skin in the Game for them to be committed to that letter of intent and moving forward with the deal. But the second juncture in the escrow process where funds are released is when, of course, the sale proceeds are released to the seller. And this is obviously one of the most important things that escrow company does is the bank will release the funds to the escrow company account first, not to the seller. And then the escrow company will make sure that all of the legal requirements for that deal to consummate are done, including a signed purchase and sale agreement, a clearing of the title search, things like that, so that when the buyer takes over ownership and the seller gets the money, it is a clean handoff legally between the two parties. So that is a conditional release of the funds. And then they prepare this escrow statement. If you ever bought or sold a house, you know what an escrow statement looks like. Let me just tell you that for me, as a cpa, escrow statements are like gold. These transactions are complicated from an accounting standpoint. They're asset sales, and there's depreciation involved, there's depreciation recapture. There's a lot of tax implications to these things and accounting implications to these things. The employees are terminated from the seller and they're hired onto the new company. There are some payments for a vendor that are made that are prorated between the buyer and the seller during the month. And so when I get an escrow statement from the escrow company and they have already sifted through all of that and they give me this ledger that shows all of the. All of the. The transaction minutiae, it is so much easier to get accurately the accounting and the tax done. So for that, that's maybe selfishly said, but that's one reason why I love using escrow is getting that escrow statement when the deal is done well.

And from the legal perspective, I feel the exact same way with regulatory compliance, especially in California, probably more so in California than a lot of other states, there's a lot of specific legal requirements for the sale of a dental practice. And escrow is familiar with all of these regulations and tracks all of it to make sure that the transaction complies with California law. These are things like facilitating the IRS form. What is it, Wes? The 8594. The asset acquisition statement.

That's right.

Filing the. Filing the release from the Employment Development Department and Franchise Tax Board, which usually has to happen after the sale. It's not something that is released prior to the sale being completed. So escrow doesn't Always stop right on the sale date. They make sure all of these things are done. A lot of times the escrow instructions in the purchase agreement will say these forms need to be filed within 30 days after the close. And escrow makes sure that that happens. Another big benefit which when you're negotiating the purchase agreement, if there's something that say the buyer is not comfortable with or a risk, escrow can hold back a portion of the funds and release them at a future date to make sure that. And so escrow would be paid the full purchase price from the buyer. But they may hold, you know, a percentage of that and release it to the seller after a certain condition is made and it makes sure that everybody's protected.

Yeah, Matt, that is valuable information. I didn't even think about that yet. We had a deal about a couple of years ago that that was. That's exactly what happened. It was a $50,000 holdback and it was eventually released to the seller based on the seller meeting certain production goals. So that you don't see that very often. Generally because sellers are sort of fading out, you know, and they don't. They're not selling to ramp up, you know, unless it's maybe a dso, but they're selling to ramp down. But there are situations where having holdback like that makes a lot of sense.

Yeah. And where I see it come up is when there's a loan payment that needs to be made or the seller has a potential dispute that they've come to a resolution but the final payment hasn't been made that, you know, the parties just want to make sure that it's not going to impact the buyer. And so as soon as whatever is outstanding is resolved, then the money's released.

Yep, Matt, this has been productive. Those are all the benefits that I can think of. Again, I recommend escrow. I like it. It's a little bit of a cost, but I think it saves all around in time and in sell it buyers backing out and just creates a lot more organization. Any final comments, Matt?

No, I think we kind of covered most of it at the very beginning. We talked about how, you know, a portion of deals that we do do not have escrow. And I wanted to quickly touch on situations where escrow may be able to be avoided. And I don't necessarily recommend it in any case, but some scenarios where you might be able to avoid using escrow is when there's a direct transaction between two parties that have long standing relationship and they've got a high level of trust or if it's a very small transaction of assets. If it's a chart sale for, I don't know, $30,000 or something like that, you might be able to avoid escrow if the cost of it's going to be prohibitive. But outside of that, I think it's always a good thing. I think it keeps everybody protected and it gives both the buyer and seller peace of mind that the transaction is being handled professionally and that there's somebody overseeing to make sure that all the boxes are checked.

Cool. Cool. Matt, thank you for the final comments there. Just want to give everybody a heads up into our next two episodes. The first one will be on what the Heck does an Attorney do in a Dental Practice Sale? And then the next one is what the Heck Does a CPA do in a Dental Practice Sale? Our job isn't to make you attorneys or make you CPAs or make you an escrow company, but it's my strong opinion, working with dentists, that to be a great CEO of your own business and really your own financial ecosystem, you do need to speak the language enough to be educated as you're working with your team so that collectively you are ultimately the decision maker and making good, smart decisions around your money. So, Matt, we will see you soon. Thanks for joining. And thanks everybody for listening in to another edition of the Dental Boardroom and the Practice the Dental Practice Sale podcast.

Yeah, thanks so much, Wesley.