Should you form a dental services organization, or DSO? The answer is frequently no.
Dentists, investors, executives, and managers often assume they want to form a DSO without fully exploring the reasons to do so. Interest in DSOs and the dental sector generally has reached a fever pitch. This has resulted in a lot of newer market entrants (and veteran solo or independent dental clinic operators) rushing headlong into organizing themselves into a DSO without first fully considering either the problems a DSO structure is intended to solve or the consequences of that decision (in terms of cost to establish and maintain and the implications on the going-forward operations of the business).
We would encourage anyone considering this approach to carefully evaluate all of the factors and then decide after consulting with their advisors whether a DSO structure would achieve their goals despite the additional friction required to implement it.
What Is a DSO?
At its most basic level, a DSO is a legal entity separate and distinct from a dental practice that provides certain administrative or management services to the dental practice. In most states, due to the corporate practice of dentistry doctrine, a dental practice must be owned and controlled by one or more licensed dentists.
Some states require those dentist owners to be licensed in that particular state, while others will accept equivalent licensure from another state. Some states do allow non-dentists to own the practice directly, so long as patient care decisions are ultimately made by licensed individuals. In those states where practice ownership is restricted, non-dentists may own the DSO instead. These non-dentists may be investors, lenders, members of management, trusts, or friends and family investors. These individuals may own the DSO alongside one or more of the licensed dentists.
A DSO will typically enter into a long-term management services agreement (MSA) with the dental practice pursuant to which the DSO performs certain non-clinical administrative management services for the practice in exchange for a management fee.
The involvement of the DSO in the dental practice and the services provided by the DSO will vary based on the goals of the parties, as well as the applicable state regulations governing these types of arrangements and the corporate practice of dentistry. A DSO may be involved in almost every non-clinical aspect of the business of the dental practice and offer a full suite of administrative and management services, including billing and collections, IT support, human resources, professional management, payor contracting services, financial accounting, and benchmarking. On the other hand, a DSO may contract to provide a smaller subset of services in a fee for service model.
Establishing a DSO goes beyond having two distinct legal entities. A true DSO typically has significant infrastructure beyond what would be found in a standalone practice environment. These so-called “platforms,” usually including a number of dental practices or locations, has value if it is able to deliver efficient processes, standardization, and professional business management in a way that is scalable across multiple locations.
Advantages of Forming a DSO
Whether or not it makes sense to expend time and resources to form a DSO depends on the goals of the dental practice. It may be beneficial to form a DSO if the dental practice is contemplating or intends to pursue non-dentist ownership in the DSO.
First, many multi-site dental practices would like to provide management executives with equity or equity-like economics, which can be difficult (or impossible) to do in a tax-efficient and legally compliant way in a single dental professional entity. A DSO may help provide greater flexibility in this regard.
Second, a practice may wish to have separate legal entities to practice in different states. It can be cumbersome (or impermissible) to practice across state lines. Different states may have very different laws on employment of employees, clinical practice decisions, insurance requirements, payor environments, and a whole host of other issues. In this situation, it could make sense to have separate legal entities for the practices. This can be accomplished and scaled more easily across multiple states with a DSO model.
Third, DSOs can be used to unite different practices under a single umbrella and achieve standardized processes across multiple locations. This can include standard operating procedures, compliance efforts, and sharing of best practices. Moreover, similar to practice consolidation or mergers, DSOs can help achieve certain efficiencies of scale by aggregating higher volume purchasing power.
Many smaller or independent dental practices struggle to attract and retain a professional business management team. This becomes critically important to compete at higher levels. DSOs can help leverage a professional business team to support a larger network of practices.
Finally, by establishing different business responsibilities, such as clinical versus business management, parties may be able to achieve some level of segregation of liabilities, both historical and ongoing. In addition to the protection the corporate form would offer with different legal entities, it can help keep business decision making (and accountability) separate from the clinical decision making at the practice level.
Drawbacks of Forming a DSO
However, on balance, it is not always beneficial or the right time to form a DSO. Some dental practices are led to believe that just creating a DSO will somehow make them automatically more attractive to investors. While non-dentist investors will typically employ the DSO model, it is not always necessary or beneficial to form a DSO prior to taking the dental practice to market.
Creating a DSO does not in and of itself create any real value that is attractive to investors. The value is in being able to deliver efficient processes, standardization, and professional business management in a way that is scalable across multiple locations. Additionally, creating a DSO comes with some cost, such as legal and accounting, and adds a layer of structural complexity. Most importantly, the DSO and its arrangement with the dental practice will need to be structured in such a way to comply with the applicable state’s corporate practice of dentistry restrictions and federal and state fraud and abuse laws.
Additional structural complexity comes at a cost. Whereas operating out of a single professional entity as a dental practice is relatively straightforward, operating a DSO with one level (or even multiple levels) of management and sub-management can create headaches. Investors, management, and clinicians alike will need to be educated on the vagaries of a somewhat esoteric legal structure.
Creating a DSO can also create additional complexity in employee benefits. By definition, you will have more than one legal entity (and likely more than one employer). As a result, it will be important to think through issues like providing health and welfare benefits, retirement benefit plans and non-discrimination/ERISA testing, and affiliated service groups and controlled group analyses.
Finally, moving from a single-practice structure to a DSO structure can limit flexibility in structuring a sale or acquisition. Specifically in creating a DSO, parties may inadvertently create tax or healthcare issues, particularly around concepts like subchapter s-elections, depreciation recapture, triggering tax on built-in gain, anti-kickback statute concerns, and myriad other issues.
Regulatory Compliance
As mentioned above, the DSO and the MSA will need to be structured in such a way to comply with the applicable state’s corporate practice of dentistry regime. Typically, a dental practice can only be owned by a licensed dentist. Therefore, non-dentist investors can only own the DSO, and their primary tie to the dental practice business is through the MSA.
The arrangement must be structured in such a way to avoid the conclusion by a regulator, dental board, competitor, disgruntled seller, or patient that the DSO is really the owner of the dental practice or is controlling decisions that only a licensed dentist should make. This will require a close analysis of the elements of control that the DSO has over the dental practice, and the requirements and restrictions will vary widely by state. This is a very fact-specific analysis and should be undertaken with a high degree of caution with the assistance of knowledgeable professionals.
The Transaction Process
If a dental practice or DSO is financially attractive enough to become the basis for a “platform” or be grafted onto an existing platform, then the entity may go to market and attempt to enter into a sale or affiliation transaction. A transaction can take many different forms due to state corporate practice of dentistry laws, tax considerations, and payor contracting issues, among others. A typical transaction timeline is three to six months, and the sale transaction involves a number of key steps typically guided by attorneys, tax advisors, and bankers in consultation with their respective clients.
The first step is beginning to perform any self-diligence necessary to get the company ready for sale. This will involve gathering any relevant organizational documents, licenses, permits, financial information, and contracts so that when a buyer submits a letter of intent (LOI), the company is ready to pursue a transaction. A company may also go through corporate restructuring to make itself more attractive to potential buyers or to achieve certain tax goals.
The next step is going to market, usually with the help of an investment bank and/or a broker. The investment bankers and/or broker will help the company find a suitable buyer, typically private equity funds or other types of equity investment sponsors.
A company up for sale will then enter into a LOI with the buyer and the transaction will begin, with the signing and closing of a deal typically occurring a few months later. Between execution of the LOI and the closing of the transaction, a number of processes will occur including:
- Due diligence where the seller provides the buyer requested legal and financial information
- The drafting of key legal documents such as a purchase agreement, potentially new employment agreements, and rollover equity guidance documents
- The gathering of any necessary third-party consents to the transaction.
The final piece is the signing of the various legal documents and the closing of the transaction—finally transferring the company to the buyer.
Typical Acquisition Structures
A DSO or dental practice sale will usually be in the form of an asset purchase or a stock purchase. The agreed upon structure will primarily be driven by corporate practice of dentistry considerations and the parties’ economic and tax goals.
In a stock purchase, the buyer purchases a certain amount of equity directly in the company. In an asset purchase, typically the buyer purchases all of the non-clinical assets of a dental practice and enters into an MSA to contractually affiliate with the practice, which in many states must be wholly owned by a licensed dentist.
Other considerations that will likely drive the transaction structure include tax liabilities, the assignability of contracts, malpractice or regulatory liabilities, and retention of licenses and provider numbers, among others.
For example, some key contracts may have anti-assignment provisions. To avoid the termination of those contracts, the parties may choose to structure the transaction as a stock purchase so that the anti-assignment provisions are not triggered.
The authors are McGuireWoods lawyers based in the firm’s office in Charlotte, North Carolina, and members of its nationally recognized healthcare practice. Ms. Lawley focuses her practice on the healthcare industry, representing healthcare providers in mergers, acquisitions, divestitures, joint ventures, corportate governance, and regulatory matters. She can be reached at llawley@mcguirewoods.com. Mr. Walker concentrates on mergers, acquisitons, and healthcare regulatory compliance. His practice includes advising healthcare providers as well as equity sponsors and lenders to the healthcare industry. He can be reached at bwalker@mcguirewoods.com. Mr. Petitto focuses his practice on the healthcare industry, advising clients on transactional matters, mergers, acquisitions, and regulator compliance. He can be reached at bpetitto@mcguirewoods.com.
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