Selling to a DSO: Key Considerations – With Brannon Moncrief

Welcome everybody to another episode of the Dental Sail podcast. I'm your host, Wes Reed. Coming at you, excited for our first episode on the concept of DSOs. Now, if you're a dentist, you know that DSO is a very common theme. It's a big subject today in the landscape of dental transitions. Really, you can't escape the interesting concepts and someone discussing or even proposing the concept of a DSO as a potential way to exit or sell your practice. So I wanted to dedicate a full episode to this and likely we'll have others on various aspects of a DSO sale because it can get very involved in different areas. And today we're going to cover sort of high level. We're going to start high level and move our way down. And to help me do this, I have Brandon Moncrief on the show. Welcome, Brandon.

Hey, Wes, good to see you.

Thanks for doing this, Brandon. Brandon, I want you to just give the listeners who ideally are sellers of a dental practice or practice owners considering a sell, whether now or later, give them a little bit of your background. Why are you an expert and spend all of your days, every day right now on this concept of DSOS?

Absolutely. So I've got about 22 years of experience in the dental industry. The first 12 years, 1012 years, I was a banker, so I have a finance banking background. And for the past decade I've owned McLaren and Associates. So I'm the principal and CEO of McLaren and we specialize in doing sell side advisory for large practice owners and emerging DSOs who are looking to sell or affiliate with a DSO or bring on a private equity partner. So in my 22 years in the industry, been involved exclusively in practice sales and transitions. With the past, I'd say five years solely focused on DSO private equity transactions. So I've seen everything that can go right and wrong in one of these transactions. Been involved in well over almost a billion, I would say, in practice sales volume in that period of time. So love talking about the subject and love being in the space.

Yeah, I came across McLaren and Associates, which is your firm, about a month or two ago as I was just sort of searching the space of dental transitions. You look like you have a solid team there. I know one or two of your colleagues who I've always respected in the space. So I think you come at this with a really good background and knowledge set to be able to help dentists decide if a DSO is going to be a good option for them to to sale because it's, it's more layered than a It's more complicated than a sale to a private practice. And I think it requires more information, more explanation, more education for these sellers so they can feel comfortable with this type of sale. You mentioned earlier partnering with PE or private equity. Private equity, as we know, is institutional money that's looking for a place to invest and get a return on that investment. And there are many PE companies out there looking for a good investment. And right now, PE is hot and has been hot on dental and the industry of dental. Now, many states don't allow a non dentist to own a dental practice. However, there have been many creative ways to essentially allow for non dentists to have some level of ownership over a practice through what are called management agreements and other arrangements. And I don't know if we'll get too detailed in how they sort of work around those laws in those states. I want to keep it a little bit higher level, but bottom line is that they have figured out a way to do this and to invest their private equity funds into dental. So why don't you explain, Brandon, why do you think they're so bullish, which means they're so optimistic about the industry of dental as a place to invest money.

Sure. Private equity loves healthcare verticals in general. So the consolidation that's happening in the dental industry is not unique to healthcare, is happening across all aspects of healthcare. You know, dermatology, med, spa, cosmetic surgery. I mean, obviously it's happened in the general medicine space. It was the hospital systems that were consolidating the space. So private equity has a ton of dry powder to deploy and they're looking for typically highly profitable businesses. They love dental because it's proven to be recession proof, pandemic proof. It's a very profitable fragmented business. It's still kind of a mom and pop boutique business. And it can benefit therefore from organization in the sense that by becoming larger than a single practice or a handful of practices, you can leverage economies of scale. You can negotiate better reimbursement rates from payers, you can negotiate better pricing from vendors, you can implement business systems across a platform that will create synergies and efficiencies at the localized level. So because private equity is in the lane of supporting health care businesses, dental businesses, from an administrative standpoint, you know, they know that most doctors are not incredible business people and they can benefit from offloading a lot of the administrative and management burden to business people that have created an ecosystem to support practices from that standpoint. So for all of those reasons, private equity loves dental and pre Covid I mean, we saw huge private equity interest in the space. Post Covid, after dentistry rebounded really faster than any other healthcare vertical, even more private equity came into the space. So now across the country, we've got about 300 DSOs operating nationally and as much private equity, space, investment and interest as we've ever seen.

And I know historically bank financing has been around for a long time in healthcare and been around for a long time in dental as well. And if you take a kind of a Business 101 class or Finance 101 class, you know that businesses generally derive their income to grow, or they're sort of financing money to grow is through either bank financing, they call it debt financing, or equity financing, or you get neither of those and you just use your profits and you reinvest it to grow that way, which is usually a lot slower. And if obviously in the space of dental, dental students don't have big pockets because they're coming out of dental school with a negative net worth with their student loans. And so historically they've gone to bank financing in order to get the money to buy a dental practice. Well, over the past decade or so, you've now seen the emergence of equity financing as an option in dental practices, or equity, I would say equity financing making its place in dental transitions. Right now. I'm curious how in time associates buying a practice might pair up with a equity sort of PE fund or a DPO or dso. And we're going to get into that in order to sort of come at it together with a private buyer and also with the institutional money. I think there's a lot evolving there. But it almost seems to me like where banks have a tight. They have a tight underwriting process and they don't like to take excessive risks in debt financing. They want their money back. That's the way banks are successful. But when equity financing comes in, equity is different because equity says not only are we going to give you money, and yes, we want that money back in the form of a return on investment, but we're willing to take on a little bit more risk and even pay perhaps more than the bank is willing to lend, because we're going to step in and help out at some level as an operator of your business, and we're going to help bring aspects of business operations in your practice that don't currently exist. Banks don't do that. And so banks are. They just look at the cash flow today and want to make sure that that cash flow today can be replicated by the buyer and will be enough to pay back the bank over time. Usually a 10 year loan for a private loan, where the equity or the PE money, the institutional money as I'll call it that comes in, has a complete different approach and angle to it. So one of my questions for you is, do you find generally that a DSO sale or a sale to a DSO is offering a higher price tag? And if so, about how much higher is that price tag than what sellers are able to get from a private buyer?

Yeah, I think you made some interesting points there that I want to touch on. So from a banking perspective, their upside when they lend money to a doctor to buy a practice or grow a practice is finite, right? It's determined by the interest rate. Whereas private equity's upside is limitless, based upon growth economies of scale, and then selling the organization once it becomes large and well diversified for a much higher multiple than the practice is initially worth. So for that reason, private equity is more aggressive when it comes to.

Valuing a practice than a bank will be. So private equity got heavily involved in the industry. We talked about why they love the industry, but the reason it's become so prevalent is because banks have limited exposure limits. So if I've got five, six, seven locations, I've probably borrowed the last dollar, I can borrow from a conventional lender. If I want to continue to grow and acquire practices, I either have to do it with my own equity or take on institutional capital. And the other reason private equity has gotten so involved in the industry is because the question you just asked, they're paying premiums compared to what private buyers can pay, often limited by what a bank will lend a private buyer. Conventional lenders in the dental space are typically maxed out at lending 90 to 100% of revenue. Private equity doesn't care. DSOs don't care about revenue, they care about EBITDA. Value in the private equity world is a function of determining what the EBITDA of a practice is. Essentially the absentee owner profit revenue minus real overhead minus doctor Compensation equals ebitda and then applying an appropriate multiple to that EBITDA to derive value. So we'll see practices with revenue of, let's say three or four million dollars, that in the private buyer world, one are somewhat hard to sell because you've got to find a very sophisticated doctor that has access to capital and the confidence and the skill set to take on an enterprise of that size and they're going to pay maybe 80% of revenue for that business. Whereas in the private equity DSO space, that practice may trade for 7 to 8 times EBITDA, which could equate to 2 to 300% of revenue. So that practice in the private buyer world, worth 80% of revenue, DSO private equity space, 2 to 300% of revenue, a massive delta in valuation. And that's caused a lot of successful practice owners to look at going the DSO private equity route rather than the more traditional private buyer path.

Yeah, there is this really interesting concept in finance or finance. If you take finance classes, you learn about this. But a return on an investment is a function of risk. And if you're a single practice, and I lend money to a single practice, I've got a lot of risk because it all rides on the success of that single practice. But if that practice merges into 100 other practices, if that one practice fails, the risk of my investment, if I'm invested in the hundred practices, even with the same dollar amount, just a much smaller slice, my risk goes way down. And when risk goes down, then if the risk goes down, what's how? I'm willing to invest more money in that investment because it's a lower risk. So I'm willing to invest more money in that. And there's a little bit of that concept of what I call an EBITDA multiple that's taking place here, which is a private seller will sell to a DSO at a multiple of, let's say five or six, meaning that as you define what EBITDA is, and I'll just delineate out it's earnings before interest, taxes, depreciation and accounting. And all that is is if I simplify that as a cpa, it's just the net cash flow after all of your expenses, but before taxes and debt. Now, one of the things that doctors forget when they calculate their EBITDA is that if you sell to somebody, they're going to have to pay for a doctor production as an employee to reproduce what you're doing. That's an overhead where if you're an S Corp owner right now and you're a doctor, you're usually paying yourself something that your CPA might tell you to pay to save in taxes. It really nothing to do with your production, might have to do more with your 401k than it has to do with your actual production. So an institutional buyer is going to want to calculate what am I going to have to pay as a salary to a doctor to replicate the production of the seller. Now, a lot of times the seller will stay on and they sort of will agree on a compensation package. And then that will affect what is the EBITDA after the sale. In other words, what's that sort of free cash flow to the DSO buying the practice, after all the overhead and after paying the doctor, they want to know what that number is. And then they might pay five or six times that number to the seller as a price. Then they could, theoretically, if they have, let's say, 50 other practices, turn around the next day and sell their collective group of practices with an ebitda multiple of 12. So just in one day they're more than doubling their investment on that investment. I call that in my own sort of made up term, the EBITDA multiplier. There's a little bit of a game, there's, there's a little bit of a, of a momentum that takes place in different industries with these kinds of finance concepts. And I think that's taking place right now with dental. At the same time, it's not just a game. I don't mean to make it sound like it's just a game, because if you take that one practice and you get it plugged in operationally with the other practices inside of that structure, that DSO or that dpo, and you get them, theoretically you get them all in the same practice management software, the same billing, their order supply from the same sort of central person or process, you start to create significant economies of scale there that the small dental office doesn't have. And that is a real true economic benefit to that business. And so you combine this sort of finance concept of risk and return and the EBITDA multiplier I was talking about and the return on just a better, well run business with lower costs and better billing and revenue structures, and you get for what is a really good healthier cash flow to that dental office than before to that dental practice. So there's a lot of economic substance behind these, but at the same time, it does have to feel right and be right. Now I want to pivot into that a little bit. What is a doctor giving up when they sell to a dso?

Brandon, I think the question always starts with all of our clients is you got to find your why, right? You got to define what you're trying to accomplish through pursuing a DSO affiliation. Is it purely economic? Are you looking for management support, infrastructure, better quality of life, better balance? What's your Runway to exit? Are you using this as an exit strategy? You're planning to retire in three to five years. Are you going to move out of the area or are you 40 and you plan on living in the area for the next 25 years. And this is your baby and this is where you want to work. Depending on your individual situation and your why is going to determine whether pursuing a DSO affiliation makes sense for your particular practice and for your particular life plan. So once we define the why, then we can really dial in on what are the DSOs that are positioned to help you accomplish that why. Some are infrastructure light, some have no infrastructure, some have very robust infrastructure and a heavy hand from a managerial perspective. So it's always a balance between economics, autonomy and support. So economically, you're going to have liquidity event when you sell your practice to a dso, hopefully at a great multiple, and you're going to be able to put away a significant nest egg that you can then invest and enjoy compound returns. You're going to have an equity component, whether that's joint venture, retained equity or holding company equity. That should have a significant return as well when that DSO recapitalizes and sells to the next institutional investor. And you're going to have hopefully infrastructure and support so you can offload the administrative crap that you don't enjoy doing on a daily basis. When we talk about hr, benefits, compliance, legal things of that nature, that the DSO is immediately going to take off your plate. And when we talk about autonomy, most of our doctors want to retain pure clinical Autonomy and today's DSOs allow for that. From an operational autonomy perspective. Some of our doctors are like, hey, give me that liquidity event, I'll affiliate with the dso, but leave me alone, right? Maybe take a few things off my plate. But from a day to day perspective, operationally I want to still be captain of the ship and make those decisions, while others are of the mindset that, hey, I want to go back to being a dentist, focusing on patients. I want to clock in at 8, clock out at 5. I don't want to worry about the administrative part of the practice. You're going to look for a DSO with heavy managerial pedigree and strong infrastructure. So it's that balance between defining the why and finding the right fit to accomplish your goals and balancing all those factors, autonomy.

Support and economics.

I think this might be the most important concept we're talking about in the podcast today is one thing that I've learned in being in dental now for about 14 years or so, and being in a lot of dental transitions and seeing a lot of the rise of institutional, a lot of different formats of DSOs and this concept of DPOs or dental partnership organization, which, which is kind of a newer emerging term originally and at some level associated with MB2, which is one of the bigger, bigger ones out there as well, is that there are a lot of nuances between these. A lot of differences, a lot of what they expect out of you if you join that dso, and a lot of even differences in what they're willing to pay for it. And they have variations in deal structures depending on the DSO and what they're looking for. I just want to make a few comments, if you don't mind, on these three. Economic support and autonomy. I have dentists, some dentists who I can barely drag into my office to talk about their financials and their cash flow and that. I mean, it's like it is so difficult to rally them into the office because they don't want to talk about it. And then I have some dentists who literally pull up the general ledger every month and look at the way we've categorized every single transaction in their bank account and credit card account and they want to talk about all of the details. And then I have everything in between and where a doctor lies on that sort of spectrum. That personality as a business owner spectrum I think is an important factor on the type of DSO that they sell to. Now this is for a doctor who doesn't have an immediate exit plan. If you have an immediate exit plan, it probably doesn't matter as much. You're going to stay on for maybe a couple years and then you're out and you might just be looking for the highest payer period. But if you're mid career and you're wanting to partner up with something bigger than your practice and get benefits of scale or maybe be part of this larger organization that sort of breathes new life into your, into your professional experience, you really got to look closely at your personality as a business owner. How much autonomy do you want? How involved do you want to be? And some DSOs are going to make you, in time, switch your practice management software, which is a big hurdle. But when that happens, think about how much centralization you can create around marketing and billing and claims and other processes in the offices where it's my understanding, Brandon, correct me if I'm wrong, other DSOs and DPOs don't require you to switch over your practice management software. They say, hey, you run that internally how you want, we're here for whatever you need and we're in this economically together, but operationally it's entirely up to, to you. And, and so assessing those goals, assessing your personality, assessing what your economic Intentions are, are all relevant factors. One more comment on the economic side of this is I had a doctor who sold to a DSO about four years ago and the, the price was insane. It was probably three and a half times what they could sell to a private buyer. And that, that's an anomaly right there. I'm usually seeing like 20% to maybe 50% markup on the price to institutional. Now you can tell me if I'm, if you're seeing different than that, but this was three and a half times what they would have got to a private buyer. Now I ran the numbers and the doctor had an adjusted gross income on their tax return, a take home income pre tax of about 1,200,000, a little bit more, maybe 1.3. And afterward they were going to make about $750,000 as an employee. And they were in their early 40s when they did this. And so I just ran out a 20 year projection and I said, okay, if you were making your 1.2 as a private owner versus the 800 as an employee, but as the employee, you're getting that 3.5 now versus getting maybe something less when you sell later as a private practice in net present value terms, which means if you sort of factored out inflation, which one is going to have the most value to you in today's dollar? And the answer was sticking as a private practice in that scenario. And it opened my eyes to think that, okay, if you're going to sell out early and give up a good portion of your cash flow to a management fee to that organization, there's got to be two benefits. Number one, the value of a dollar to you is worth more today than then. And for him, he had four kids at home, five kids I think, and wanted to use that money now to accomplish these sort of family and life goals now, more travel, more time off, things like that. That, that was a huge value to that doctor. That was number one. And then number two is he really wanted to be a part of this sort of growing organization and now he has partners because he had an equity swap in there. And the equity swap ended up getting about a 300% rate of return over the next three years. It was incredible. So he ended up getting over $5.5 million on what would have been about a $1.4 million private sale during those three years. So it was a phenomenal return. Now again, I think that's an anomaly, but the concept still applies here. But now he's actually part of that organization, really enjoying the partnership with Other doctors who have joined feels like he's part of something bigger. The camaraderie, all that stuff is also a factor to be considered. I would maybe put that under the support. You could almost create a fourth category called camaraderie. You know, because some of these emerging DPOs and DSOs, they're smaller. They might have four or five practices or 15 or 20 practices. They do things like going to, I don't know, a lake together on Saturdays or they do a quarterly event together and they just have a lot of fun together and build camaraderie that way. So that, that's another area where this doctor found some good benefit. So even with the apparent economic gain to sell at a higher rate, there's always a lot factors to consider here. Which now comes back to you, Brandon, which is why I wanted you to have on the show. Because I think Practice Orbit right now isn't a broker. And I've started Practice Orbit. I'm really excited about it. I think there's a great need for it in the space of dental. But a lot of DSOs don't want the million dollar practice or the $500,000 practice. They want the $2,002.5457,000,000 practices. And some of those more million dollar practices can go through a fairly traditional sell without too much complication. When you start to get up to 2 million, 3, 4 million, it gets complicated. This is where I think your company McLaren comes into place. In that you have a group of DSOs that you know, you know the nuances and the kind, the sort of, as they call it, strike zone that they're looking for. What's a good fit? Tell me how you work with a dentist who's got, say, two and a half to $3 million practice in identifying a good DSO based on that doctor's personality and goals.

Yeah, you know, I think you, you just got done talking about the fact that every DSO is unique, right? If you've met one dso, you've met one dso. And oftentimes the reason we got involved in this DSO private equity ecosystem when we built our company doing doctor to doctor transactions initially is because we found that doctors weren't clearly defining their, why they didn't understand how private equity and DSOs approach valuation. They weren't creating optionality and they weren't taking into consideration a lot of what you just got done. Speaking about, you know, Runway economics, the intangibles, defining what matters to them and then going to market, creating a highly competitive environment and making sure that they have as much optionality and as much leverage as possible to find the right fit and negotiate the most favorable outcome. And that's really where we come in first and foremost. We start with doing an EBIT analysis and evaluation and getting to know our client, defining their why and running through. We actually run a cash flow model very similar to what you just explained. We do a no sale scenario. What does it look like on a 5, 10 year window? And then what does it look like 5, 10 year window on a joint venture structure, on a hybrid structure, on a holding company structure? Define economically all the different scenarios and situations, define the why and then determine is now the right time to go to market? Is a DSO transaction affiliation appropriate for this particular doctor? If the answer to that question is no, great. It's been a great learning exercise. We now have built a relationship and trust along the way. Call us if you're thinking about making a big decision with your practice and we can talk about how is that going to impact value and marketability in the future, whether you look to sell to a private buyer or a dso. If it does make sense to go to market now and pursue a DSO affiliation, let's put it out to bid to all the DSOs that we think would be a good fit, aggressive economically, and able to provide the support and infrastructure you need to accomplish that. Why leverage that competition to find the best fit and then get the best outcome economically. Valuation matters to everybody, but your why is going to play into how important deal structure and those intangibles are as well. So trying to align all of that with a single buyer means that you've got to date around, you've got to talk to a lot of different DSOs. And all too often, unfortunately, doctors respond to a solicitation from a dso. They do a tremendous amount of direct mail, they knock doors, they pay the doctors that they're affiliated with to refer their colleagues into the fold with the hope of getting a proprietary lead and doing a deal in the dark. They don't want somebody like me at the table educating the doctor, protecting the doctor, and providing optionality. So that's really what we do on a daily basis, is make sure we educate and empower doctors to make good decisions with their practice. That's kind of our M.O. and we've accomplished some amazing results for doctors that would have left millions on the table and likely probably sold to the wrong DSO if we weren't involved.

The way that I would look at a doctor hiring you to help sell their practice as a DSO. Specific broker is that because DSOs are, are, there's so many varieties of these DSOs and also the amount they're willing to pay is in many ways a function of whether you fit their model. Where a private bank like bank of America who does great lending, provide Citibank for citizens. A lot, a lot of these banks that do that, do the lending. They're all going to come in around the same place. They all essentially use the same underwriting measurement called a global debt coverage ratio. But it's not, it's not like that when it comes to DSOs. There's much more variability there. And so if you're able to bring to a doctor and say here are the ones you mentioned, that economics is your biggest driver here because you've got a three, three year Runway, four year Runway and you want to be out. These are the three that given your practice size, are going to pay the most. That right there could easily make up your fee and then some just by that one item alone. So I think that there is a win, win value proposition in this relatively nascent space of DSO acquisitions because of just the inherent complexities associated with these types of transactions. Not like somebody selling their car. You know, this is way more complicated than that.

Yeah. And that's why we take all practices to market in a bid process. We don't price the practice because it's very situational. And you'll see sometimes when you take a practice to market, put it in front of you mentioned three. We normally put our practices in front of at least 10 DSOs on every single opportunity. Now we kind of know out of those 10 who are probably going to land in the top three spots based on fit because we know the client and we know the practice, we know the appetite of each of these DSOs. But it's critical that you don't leave money on the table. And we found that if you price the practice like your traditional broker would, you're going to leave a tremendous amount of value on the table. Because one or two particular DSOs, it may be a perfect fit. They may fall in love with the doc and bid two, three, four million dollars higher, you know, than, than the other offers. That's critically important.

Can I comment on that real quick?

Yeah, yeah.

When a broker of a private sale occurs, usually what I find is they have a good idea what the banks are going to be willing to lend on this, which is what drives a lot of the ultimately what the sale price will migrate to be. Then they'll tell the seller, here's what you could probably get out of this, if you want to list it for higher, you know, you can list it for higher. Now some brokers will inflate in the seller's mind what they could actually get out of it so that they can get the exclusivity of that listing. And some brokers, I think are more honest about that at the same time. But that is, you sort of know what that price range is going to be and then you just go to market with that price because you know it's going to end up being somewhere around there where you're different. You're saying you don't necessarily go to the DSOs and say, here's the, here's a practice we're selling for three and a half million. You say, here's a practice that's collecting four million. It's located here, it has two locations. What do you want to pay for it and let them bid on it? That's your process, Brandon.

That is our process. During the valuation process, we do set an economic expectation with the client, but it's a baseline economic expectation. Like recently we took a practice to market in Tampa with about a million dollars in ebitda. We knew the client was very dynamic, high growth opportunity in a great marketplace and that a lot of DSOs were going to be interested. We set the valuation at 7 times EBITDA, so around 7 million is the expectation we set with the client. Behind the veil, right? That's between us and the client. We only represent sellers, we don't represent buyers. We ultimately got nine offers and the practice traded for $10 million.

Oh my gosh.

The client was thrilled. We try to be conservative when we do valuations so that we're almost certain that we can meet or exceed our valuation when we go to market. In a lot of cases, we do exceed the expectation that we set with the client by a million, 2 million, $3 million depending on who the bidders are at the table and finding somebody that's willing to be ultra aggressive.

I think that pe, whereas banks all have a relatively similar risk tolerance. I mean, don't get me wrong, they have some variability there. I'll credit the banks for being really good at doing their underwriting and coming out with their sort of nuanced advantages which are very, very valuable. When it comes to PE, though, I think the DSOs and the PE behind the DSOs have varying levels, like significant different levels of appetites for risk and that's going to be a function of how much they're willing to pay. So one DSO in that scenario might have only been willing to pay 6 million and another one 10 million. These are dramatically different offerings. Do you oftentimes see a large spread across the DSOs that you go to bid for?

Yeah, I mean, we've seen spreads as high as 5, $6 million between bids. And obviously as the practice gets larger, as the economics get larger, the delta can be more and more significant. When you're dealing with, you know, a two or $3 million top line revenue practice, the Delta could be as high as a million or 2 million between offers. But when you're dealing with a 9 or 10 million dollar top line practice, the delta could be, you know, five, six, seven million dollars. So it is very situational, but it's why a bid process is utilized and why it makes a ton of sense to do so.

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Here's a really important question I believe is there are small DSOs. I'm going to use the term DPO for a second dental partnership organization and I think on a separate podcast might be good to talk about this concept of partnering. What does that mean? Which is essentially you're. You're selling some of your practice in the form of equity. You're receiving as a seller equity of the DSO itself. So you become a very small partner in that management entity in the DSO itself and you're swapping some of your equity for that. So you might sell 20% of your practice as an equity swap and the other 80% you're getting cash. Since equity swap seems to be so prevalent now in a lot of these DSO purchasers, or I'll say DPO because now it's a partnership thing. So a dental partnership organization, there's DPOs that have three or four offices and they're just getting started. And then there's DPOs who have hundreds of offices. MB2 is large, one of the early ones in the game. They have hundreds of offices. Just speaking economically, not talking about support, not talking about autonomy, I'm just talking about the economics for a second. Seems to me like the upside is so much higher if you're that fourth practice as opposed to the 404th practice. However, you're going to run into a lot more risk if you're the fourth practice. Does this DSO have what it takes to operationally and from a business standpoint get off the ground to become 100 practice DSO? Is that a part of the conversation when you're talking to a seller? Is how much risk do you want to take on? Do you want to be early on in a DPO where you might actually take on some. Some more involvement in that DPO and have more benefit of the upside of that EBITDA multiplier that I was talking about earlier? Is that a factor at all?

Absolutely. So it can get. It should be a relatively complicated conversation when you start to compare offers. Right, because each DSO has a risk reward component. So we talk about where are they at in the recapitalization cycle. Most of the time they're on a five year recap window. So when is the next liquidity event going to be and what is the projected return and depending on their size, what will it look like in the future? At recap number two and three Post Affiliation so we're constantly comparing not only just the valuation, the cash at closing, but talking a lot about the equity component where each DSO at the table is at in the recap cycle, how big they are and what the risk reward looks like. So typically, just generally speaking, the smaller the organization, the higher the upside on the equity component. But the more risk and the less infrastructure and support you're going to have until they're a more developed company and have the time, the bandwidth and the money to fully build out an infrastructure and be able to support you from an operational perspective. Now I will say this. When you're looking at a joint venture, a DPO type deal structure, typically the size of the entity doesn't necessarily define the potential return on equity. The return on equity is about the same regardless of the size of the entity. When you're talking about joint venture equity, but when you're talking about holding company equity equity in the parent company, DSO.

Size matters significantly. The smaller the organization, the much higher typically return potential you're going to have and the higher risk. But when you're talking about that joint venture deal structure, if you're comparing a very small joint venture buyer to a very large joint venture buyer, I would say the risk adjusted return is probably better with the larger buyer than the smaller buyer. And it's because the ceiling on your equity component on the joint venture structure where you own your equity at the localized level, in that scenario it's relatively finite because your returns related to the performance of your own practice, not the parent company. Whereas at the holding company level, the return is related to the performance of the entire entity. Therefore, the smaller the entity, the quicker they can grow, the higher the return they're typically going to generate at recap.

So let me make sure I understand when a doctor Sells in a DPO or joint venture structure where there's an equity swap and now that Dr. Gains some small ownership in the DSO, is that what you mean by joint venture arrangement?

No. So there's a couple of distinctions between the DSO deal structures and the biggest distinction is where your equity lies and in a joint venture, a DPO type model, you're going to sell, let's say 60% of your practice cash at close and the other 20 to 40%, you're actually retaining equity, joint venture equity in your own office.

You got it.

You only own equity in the parent company. In that model, the upside on your equity is somewhat finite because at recap, your return is going to be predicated upon the EBITDA of your practice times the EBITDA multiple of the parent company. Whereas in a holding company model, let's say you sell 100% of your practice in that model and then you roll 20 to 40% of the value of your business into stock in the holding company of the dso, you no longer own equity at the practice level. You own that equity in stock at the parent company level, you're going to get the full arbitrage that private equity is going to recognize from that stock at recap. So your return potential could be higher depending upon the size of the company in the holding company model and where you enter the recap cycle. Okay, so in the joint venture model where you own the equity at the practice level, it doesn't matter where you enter the recap cycle, you're going to get the full lift, the full arbitrage at recap on your joint venture equity predicated upon the performance of your individual practice in the holding company model. It depends where you enter the recap cycle. So are you entering in year one of a five year recap cycle? Then you would expect your return to be higher. You're gonna purchase the stock in the DSO for a lower value than somebody that enters in year four of a five year recap cycle. They're gonna buy the stock at a higher value and the return's gonna be muted because they only have to wait a year to a liquidity of that. So you can see how complicated these conversations get when you're comparing seven offers. Every DSO has a different level of infrastructure. They have a different culture, they're at a different stage in the recap cycle. Some might have a joint venture structure, some might have a holding company structure, some might be a hybrid structure where they bifurcate the equity into, you know, half of it being joint venture equity and half of it being holding company equity. It's a really, really dynamic conversation. And that's where our cash flow model comes in, where we plug it in and show you economically, typically on a five year window. Here's how each of these models, each of these offers is going to play out based on, you know, a number of assumptions.

That makes a lot of sense. So the holding equity model, the holding company model, I should say, is that what it was Called.

Yep.

The holding company model. That's where you're selling in, I would think a lot of cases, if not most cases, you're essentially selling all of your practice.

Correct.

And in the holding and in that scenario, you can get more equity of the DSO because you're selling more of your practice. You're sort of giving up all of its net cash flows, all of its EBITDA into that holding company. And then you might get some cash for that. But because you're selling more of your practice, you could also get more equity in the DSO from the holding company model. Now, I think I created some confusion in you. I can tell by your face. Where did I go wrong on that one?

No, you're right.

You can I get so far, you.

Can potentially create a higher return on holding company equity if the DSO does really, really well.

Does well, exactly.

And what I'm seeing a lot right now is I'm seeing a lot of the joint venture model. Whereas a doctor says I'm going to sell 60% of my net cash flow through this management agreement, which then we pay the dso as if you would pay a practice management consultant in a way, you would pay them usually a monthly amount consistent with the management agreement. And that's just a way to sort of sweep out a percentage of the profits and to mimic ownership. Even though ownership may or may not be literal, depending on the state, you may still own 100% of the stock of your S corporation if you're in California. But you enter in a management agreement with that DSO to take 40% of your net cash flows after paying the doctor usually as well into that entity. And then of course, you're only getting 40% of the sale price also in that scenario, which means you might get less equity in that arrangement in that dso, which means that the upside is less.

It can be less, it can be limited. But here's why you're seeing the DPO model, here's why you're seeing the joint venture model become so popular, meaning the.

Less than 50 or you're not selling all of your practice.

When you say joint venture, typically you're always going to sell a majority ownership interest in your practice. So let's say you're going to sell 60% of your practice and retain 40% and you're going to enjoy your pro rata EBITDA distributions ongoing. Right. Because you still own equity at the practice level. Whereas in the holding company model, because all of your equity is rolled into stock in the holding company, you no longer enjoy in the EBITDA distributions on an ongoing basis. You're only earning based on what you produce. Chair side. The reason that the joint venture model has become so popular is, is because the age of the sellers is going down. And if you're a younger seller and you look at a longer Runway, if you sell 100% of the practice up front and do the holding company model and you no longer enjoy any of the ongoing EBITDA distributions on a 20 year time frame, you're typically going to win in the joint venture model economically compared to the holding company model because you have the ongoing income stream associated with that retained equity. So it's a balance, right? You're always trying to talk about Runway economics. How does the equity function? What's your life plan, what's your why? And that's going to oftentimes dictate what deal structure you gravitate to and what dso you gravitate to. And that's why I would argue that deal structure and fit, fit, especially for a younger seller, are far more important than the upfront economics and valuation. I mean, in an ideal world, you have all three right with the same buyer. And that's, that's what we try to create as you, you get further in your career or as your exit is more finite, three to five years versus 10 to 20 years, you're somewhat less sensitive to, you know, where the equity lies and those ongoing EBITDA distributions. Does that make sense?

This makes a lot of sense, yes. And it's almost crystallizing in my own head what I'm seeing a lot, which is this joint venture model where the doctor retains some portion of their net cash flow. They don't, in other words, they don't sell 100% of their practice. And so they get an EBITDA distribution after their, let's say they're 35% of their own production, they will keep, say 40% of the net cash flow in addition to that sort of associate pay. And that way have more income today because there's a give and take between income today and income later at the cap, at the recap events with the DSO and a lot of younger doctors who has student debt. They might have younger families, they just bought a house, they've got higher personal overhead. They sometimes can't afford to lose 100% of the EBITDA right now in exchange for equity because they need that cash flow now to support their, their living expenses. So that would make a lot of sense. And then if you're a few years away from selling, you have a lot less personal overhead. Maybe your home loan is paid off, your practice loan is paid off, whatever, all that stuff is paid off. Maybe you could sell to a holding company and you can do a full exit that way. So a lot of it I'm seeing, what you're saying needs to be attached to your unique circumstances where you are in your own, your own career and your own personal situation too.

Absolutely. You just mentioned one last thing. When it comes to looking at these deal structures, and that's a complete exit of your equity in a holding company model, typically at recap, you're able to liquidate all of your equity, or you have the option to liquidate all of your equity in the parent company. And the joint venture model, by its very nature, that model needs a vested doctor partner at the local level. So there's typically a baseline equity component that you or another doctor has to maintain at that practice level. So there will be typically a portion of your equity that's tied up long term at the practice level. And if you want to step away, you have to sell that joint venture equity to another doctor. You cannot liquidate it at recap. So a lot of docs that have a finite exit plan like the holding company model, because they might have a much higher likelihood of being able to exit their equity in full at recap, as opposed to the joint venture model, where you may be in the position where you can sell part of your equity at recap, but then you have to sell the remainder to another individual doctor. Yep.

I have found that it's sometimes difficult in this joint venture model to decide how you handle when you bring on an associate, because now the associate needs to sort of be on board with this management entity at play, that it's attached to a dso, I find. And then how do you go about bringing them on to buy some of your equity at the local level? Is there a way that you figure out how to maybe sell some of your equity at the DSO level? So you're all sort of joint in your motivation there. That creates a whole nother kind of set of discussion points that might have to be very tailored to that specific practice. And that's where I think the DPOs have this advantage. These emerging DPOs is that they can be really flexible in creating kind of a structure that works. I think my last question for you is this. We've talked a lot about this concept of a recap. Explain what is a recap and how is a doctor who is benefiting from their equity swap and getting a Payout from that recap, who's paying that money that funds the recap that ultimately goes to the doctor and maybe what's the anatomy of that transaction like?

Yeah, so a recap event, recapitalization event essentially means that the private equity investor, the institutional investor that currently backs the dso, typically in a five year window, the goal is to grow the DSO from an acquisition standpoint and from an organic economies of scale, top line revenue standpoint, and then exit the investment, sell that DSO to the next investor, private equity, institutional investor, family office, whoever that may be, and then the cycle is repeated by the next investor. And that's why as a DSO typically grows in size, right, the return is somewhat muted because if the next investor steps into a DSO that's got 200 locations and you know, $50 million in EBITDA and pays 15 times EBITDA, they now have to grow significantly through acquisition and organically to buy down their cost average. Right? They pay 15x on 50 million of EBITDA. They now need to go get 50 million more of EBITDA at 6x to bring their cost average down over a 5 year recap window before they sell it to the next investor and actually create a return, create arbitrage. So as a DSO gets bigger, they can only continue to grow so much through acquisition organically, naturally the return is muted and then the next investor repeats the cycle and requires a little bit lower return than the last investor. So that's how the cycle continues to function. So you would typically, you know, I'll relate it to this. So If I've got.

200 practices and I go by 50 practices, you know I grew by 25%, right? If I've got 10 practices and I go by 50 practicesS, I grew by 5X. So the arbitrage is going to be a lot higher. That risk reward that we talked about earlier, depending on the size of the dso. That's why that arbitrage is significantly higher. And that cost average game also works when we talk about why we're able to achieve premium valuations for our clients. DSOs are soliciting doctors directly. They're trying to get proprietary deals. The bottom line is they're going to go buy 10 practices. Okay? Eight of those practices they're going to buy directly from a doctor that doesn't have representation and they might pay 5x. Well, if they buy the other two from us, they can afford to overpay. They can pay 7x8x for our practices because they just cost average the 10 together. And because they bought 8 of them for only 5 times EBITDA. Buying 2 from us at 7x barely moves the needle. So that's how this game works. It's a big cost average game. When you talk about recaps, arbitrage and.

Return, do you ever foresee, as it moves up to bigger and bigger and bigger, a PE selling to a bigger pe, bigger fish buying smaller fish, then a bigger fish buying, eating up that fish. Do you ever see it going to the top floor and doing a public offering, going public?

Yeah, I mean There were multiple DSOs eyeing IPOs prior to this, you know, new economic environment that we're in. I mean MB2, Heartland, several others were actively involved in potentially IPOing. So we, we expect that to happen if and when the market kind of turns back around. There haven't been any IPOs in the stock market for the past year and we probably won't see any for maybe the next year. But I fully expect that there will be some IPOs of DSOs and you will probably see pre IPO, some consolidation of the consolidators. So you may see a couple of DSOs pre IPO, go and buy a couple of mid sized DSOs because they're going to have that immediate arbitrage when they go to the public markets. So that's where we're headed I think over time is that today there's 300 DSOs, in 10 years there might be 15.

Do you believe at all that we are in the middle of a, of a bubble around this? Do you believe that the momentum that we're carrying right now, which still is strong in spite of rising interest rates, is going to carry on for the foreseeable future and do you ever foresee that it could reverse?

There will come a day when the industry reaches significant consolidation that we'll see valuations come down. At the moment, valuations are currently at an all time high for practices with EBITDA of half a million to I'd say 3 million. We have seen it slow down a little bit in the upper end of the Marketplace. EBITDA of 5 million plus. There's not quite as much demand right now and that comes down to a lack of leverage. Banks are being more conservative and not lending, you know, private equity, massive amounts of money to go out and acquire and start a dso. We've seen a little bit less demand on the smaller practices recently because there's so much activity in the marketplace. It takes the same amount of energy for a DSO to buy a practice with 300,000 in EBITDA as it does a million in EBITDA. And they want to spend their time and money wisely. So I think you're going to continue to see massive consolidation in the industry the next five to seven years. Where it starts to cool off and how it ends is, is anybody's guess. There are other industries that are out in front of us, so we'll probably, you know, see how some of this plays out in some of the other health care verticals before it fully plays out in dental. Could it reverse? Sure. A lot of that's going to come down to how well run these DSOs are, how well capitalized they are, what the public markets say when the IPOs happen. And then look, the dentists play a role in this, the staff plays a role in it, and consumers play a role in it. So there's a lot of variables at play that it'll be very, very interesting to see what this environment looks like three to five years from now.

And I do think you use the term gunpowder earlier. There's a lot of PE money or gunpowder looking for a place to, to go. And even if that did dry up and this momentum with PE money sort of dried up, there's still the other two reasons you said that people join DSOs is autonomy is. Is number one and support. If I recall, we had work life or. Yeah, autonomy was one, and those, those two seem independent of whatever that sort of market trend is and interest rates and PE money. Even, even without that, it seems like there's still benefits of getting support. A lot of doctors, I think a lot of the younger generation, doctors sometimes don't want to kind of go through that absolute headache of running a business. Maybe many do. I think many don't. And so that support unit is. Or element is still there. And also just I think a lot of the younger generation wants to have that balance in their life and some autonomy, maybe they're willing to give up some autonomy in the business. Ownership is probably the better way to say that in order to have the career experience they want. So, Brandon, this has all been so substantive. Thank you. This is clearly your space. You know what's going on here. So I would just say to any, anybody who's selling their practice, and especially your larger practices, where you think a DSO might be a better, if not your only option, depending on how large you are and you want to find just the best scenario, Brandon and McLaren are going to be a great option for you. Thanks for joining the show, Brandon. We'll have you back again another time.

Thanks, Wes. Thanks for having me.