Valuation
We live in a time of great change with respect to valuations of healthcare provider transactions. There is a growing gulf between buyer and seller expectations of overall valuation and purchase price. Capital has gotten more and more expensive very quickly over the last year. This has pinched margins and returns for the usual consolidators and builders of these platforms. The traditional private equity model relies on a buy-and-build model predicated upon dollar cost averaging of acquisitions. The original platform typically receives the highest evaluation. You will see valuations typically expressed as a multiple of “EBITDA.” This stands for “earnings before interest, taxes, depreciation, and amortization.” In a typical dental practice, the free cash flow or net income at the end of the year is typically distributed to the practice owners. In order to measure or create the actual EBITDA generated by a practice, one needs to “normalize” provider compensation. This means determining a market compensation level for all providers, applying that to the current financial model of the practice, and then backing into the residual EBITDA that is being purchased in the transaction. The EBITDA used for purposes of valuing the transaction is usually some formulation of “pro forma adjusted EBITDA.” Here, the buyer/market may or may not give credit on EBITDA for new business expansions or offices that are still ramping up, extraordinary one-time costs, higher rates that were recently negotiated, or other prospects for new revenue that have not been fully realized. Ultimately, this will be a point of negotiation, and if you are approaching a broad segment of the market, you will receive varying levels of credit for these items.
Unsurprisingly, a number of factors affect valuation—financial performance, competition, age/anticipated retirement or departure of key dentists or executives, prospects for expansion (either through de novo or acquisition strategy, ideally with a list of targets already under discussion), ability to add ancillary service lines, payor mix/relative market strength with payor rates, succession planning, infrastructure (such as IT, quality, and performance tracking), compliance, and strength of the executive leadership team. Every practice has each of these elements to some degree. Generally, the stronger each of these factors is, the higher the valuation will be.
Structure
There are a few financial components in the overall transaction to consider:
- Cash at closing.
- Rollover equity. This is the amount of equity you retain or receive in the go-forward company.
- Earnouts/seller notes/deferred payments. These can be exceptionally tricky (or even impermissible) depending on how they are crafted. Approach with care.
- Going forward compensation. Do not lose sight of the provider compensation going forward. This is usually materially changed from the historical practice. It is critically important to understand whether the buyer intends to use a productivity-based model or a compensation pool methodology. Compensation models can vary widely from very simple to extremely complicated. Always ask for a sample calculation and a pro forma projection of provider compensation based on your historical performance to avoid surprises.
Hiring a Banker/Broker
Depending on the size and complexity of the transaction, sellers should consider whether it is advantageous to engage an investment banker or a broker to help “shop” the practice to multiple buyers. An investment banker or a broker experienced with dental and medical practices may be able to negotiate a higher purchase price or at least be able to assist with explaining anomalies in the practice’s earnings in an attempt to support multiple bids or ahigher purchase price. In the event there are multiple bidders, an investment banker will work closely with the sellers and their legal counsel to negotiate nondisclosure agreements and letters of intent (LOI). The investment banker will also assist the sellers with understanding differences and nuances in the LOI compared to one another and guide the sellers in selecting the best deal for them and their goals—which may not necessarily be the highest purchase price offer.
Purchase Agreement
Corporate practice of medicine and corporate practice of dentistry restrictions will limit the types of structures in a purchase agreement available to buyers and sellers and will vary state by state. In states like California, Texas, Ohio, Iowa, Illinois, New York, and New Jersey, a financial sponsor cannot own a medical or dental practice directly, so a structure must be created in order to comply with these state law prohibitions. Typically, this includes creating a management services organization (MSO) or dental service organization (DSO), which are responsible for the non-clinical operations of the business. An MSO/DSO transaction can be in the form of an asset purchase or a stock purchase. The agreed-upon structure will primarily be driven by taxes, corporate practice of medicine and dentistry considerations, and the parties’ economic goals. Simplistically, in a stock purchase, the buyer purchases a certain amount of equity in the already-created MSO/DSO. In an asset purchase, the buyer forms an MSO/DSO to purchase certain non-clinical assets of the practice and enters into a management services agreement to contractually affiliate with the practice. Other considerations that will likely drive the transaction structure include tax liabilities, malpractice or regulatory liabilities, and retention of licenses and provider numbers, among others.
Fees
The MSO/DSO performs non-clinical administrative and management services for the medical or dental practices, allowing the physicians and dentists to focus on patient care. In return, the management company receives payment for its service. There are several ways to structure how the buyer will get paid in connection to the MSO/DSO. One option is a flat fee where the parties agree to a standard fee in advance for the services provided. It is especially important when there are government payors involved, such as Medicare or Tricare, that this fee is considered fair market value to prevent certain regulatory concerns.
Another type of fee structure is a percentage fee based on the income a practice receives. While a fee based on a percentage of revenues or profits may be the most desirable option for management and private equity firms, it may not be permissible in certain states. In many states, it is not as clear, and the parties and their advisers need to determine the amount of risk they are willing to take in connection with the fee structure adopted for management services.
Earnouts
Some MSO/DSO transactions are structured so that a portion of the purchase price is earned over a period of time post-closing based on the practice’s performance. These payments may be made over time after closing and are primarily a tool to help to resolve a disagreement in valuation between the buyer and seller. These types of deferred purchase price arrangements can be very complicated and have healthcare regulatory implications. Therefore, parties should approach this type of structure with caution.
Rollover Equity
The rollover equity structure allows a dentist to retain an ownership interest in his or her individual practice or “roll over” equity into the parent company. An equity retention/rollover structure is typically utilized in transactions involving large, multi-location practices or in a scenario in which the selling dentist is a major producer and/or plays a major leadership role in the practice. The dentist, therefore, has the potential to generate more money as part of a large MSO/DSO.
Risk Allocation
Although the purchase price you receive is important, the purchase price you keep is even more important. The purchase agreement in any transaction will likely include indemnification provisions whereby the sellers effectively insure the buyer against the risk that any of the representations and warranties in the purchase agreement are untrue or if any of the sellers breach their covenant obligations. More recently, rep and warranty insurance has evolved as a way to shift the risk of breaching the representations and warranties to a third-party insurer in exchange for payment of a premium up front. This market has evolved very rapidly and is a key feature of many transactions above a certain size. The benefit of this policy is that it reduces the potential post-closing adversity and contentious disputes between buyers and sellers. This is especially important where the post-closing relationship between buyers and sellers is a critical aspect of the business.
Employment Agreement
To ensure the success of a practice going forward, the selling dentist typically signs a new employment agreement to provide clinical services post-closing. The go-forward compensation structure may be the same or very different from the pre-closing arrangement. The selling dentist can also help the MSO/DSO work with the other staff members regarding the sale to efficiently transition the other members of the practice.
Compensation Models
A dentist’s total compensation package may consist of several different elements, each of which will impact how much the seller actually earns. The amount of compensation could first be a flat salary based on the fair market value of the services provided to the practice. However, a flat salary is not very common. A dentist could also be compensated based on productivity. For example, under a productivity model, he or she could be paid a flat percentage of the revenue generated or by the number of patients treated/procedures done. We increasingly see compensation models that involve profit pools that are divided at least, in part, among a group to create alignment with respect to production and expenses.
Malpractice Insurance
In an employment agreement, there is typically some requirement of professional liability insurance. Depending on negotiations, either party may be responsible for securing insurance coverage. If the employee is responsible, the employment agreement may indicate the type and amount of the policy. However, in some circumstances, the employer is typically responsible for all insurance coverage other than, potentially, tail coverage (also referred to as an extended claims reporting endorsement on claims-made policies).
Restrictive Covenants
Almost every purchase agreement will have a noncompete for the largest reasonable area that would be enforceable by law. The enforceability of restrictive covenants varies from state to state. Some states, like California, prevent physicians and dentists from entering into noncompetes with MSOs/DSOs, while certain “employer-friendly” states, like Michigan, allow noncompetes that considerably limit the actions of former physicians or dentists in the same area. A buyer needs to confirm that the restrictive covenants are permitted under applicable state law and, if not, consider whether the private equity firm is willing to risk that the key dentists would not have any restrictions on their way to practice in the future.
FTC Proposed Rule and Noncompete Agreements
On January 5, 2023, the Federal Trade Commission proposed a new rule that would ban noncompete agreements between employers and workers in many circumstances. In addition, the proposed rule would require employers to withdraw any existing noncompete agreements with current and former workers. Under the proposed rule, the FTC would deem noncompetes between employers and workers “an unfair method of competition” and, therefore, unlawful under Section 5 of the FTC Act.1 The proposed rule says that it is not intended to prohibit or regulate reasonably tailored customer non-solicitation or employee-raiding agreements.
The proposed rule would apply to independent contractors and anyone who works for an employer, whether paid or unpaid, across all businesses, including healthcare providers. Noncompete agreements are common in the healthcare industry to prevent physicians and dentists from leaving to start a new practice or work at another practice.2 The ban could increase wages by nearly $300 billion each year and expand career opportunities for about 30 million Americans, according to the FTC.3 Going forward, employers should evaluate their current and future noncompete agreements and consider how the implementation of the proposed rule would impact their businesses.
REFERENCES
- McGuireWoods. Federal Trade Commission proposes rule to bar almost all non-compete agreements in contracts with workers. Published January 5, 2023. https://www.mcguirewoods.com/client-resources/Alerts/2023/1/ftc-proposes-to-bar-almost-all-noncompete-agreements
- Wallace C. FTC moves to ban non-competes: What it could mean for physicians. Becker’s ASC Review. Published January 13, 2023. https://www.beckersasc.com/asc-news/ftc-moves-to-ban-non-competes-what-it-could-mean-for-physicians.html
- Federal Trade Commission. FTC proposed rule to ban noncompete clauses, which hurt workers and harm competition. Published January 5, 2023. https://www.ftc.gov/news-events/news/press-releases/2023/01/ftc-proposes-rule-ban-noncompete-clauses-which-hurt-workers-harm-competition
ABOUT THE AUTHORS
Bart Walker
Mr. Walker co-chairs McGuireWoods’ Healthcare & Life Sciences Industry Team. A leading lawyer in the dental and DSO space, he advises healthcare providers as well as equity sponsors and lenders to the healthcare industry. He also works with providers, including dental services organizations, on regulatory and transactional matters. He can be reached at bwalker@mcguirewoods.com.
LauraLee R. Lawley
Ms. Lawley is a partner at McGuireWoods. She represents healthcare providers in mergers, acquisitions, divestitures, joint ventures, corporate governance, and regulatory matters. She also represents lenders in transactions involving borrowers in the healthcare industry, as well as sponsors and private equity funds investing in the healthcare industry. She can be reached at llawley@mcguirewoods.com.
Natalie Galdos
Ms. Galdos is an associate at McGuireWoods. She advises healthcare providers, sponsors, and lenders to the healthcare industry on mergers, acquisitions, private equity transactions, and healthcare regulatory matters. She represents hospitals, ambulatory surgery centers, dental services organizations, and large physician group practices. She can be reached at ngaldos@mcguirewoods.com.
Disclosure: The authors report no disclosures.
