Dentistry Today Management Buying a Practice: The Bottom Line Method of Practice Valuation
Management

Buying a Practice: The Bottom Line Method of Practice Valuation

  • February 1, 2002
  • 15 minutes read
  • 23 years ago

I have been in practice for 36 years, for 32 of those years as a private practitioner. I have purchased and sold three practices in the last 5 years, two of which were great financial successes, and one a financial bath. You live and learn. This article is aimed at potential buyers of dental practices and looks at price from the vantage of the bottom line. How much profit is there in the purchase? Does it make financial sense? I have attempted to make sure the models I use are real and the numbers accurate. However, I would encourage everyone to do their own math.

ASSIGNING A VALUE
Assigning a value to a dental practice is always difficult. No other business models really fit very well. This is true for several reasons. First and foremost, it is not unusual for a dental practitioner to take 40% to 50% of the yearly production of the office as profit. Some of this profit comes in the way of perks—advantages for the owner that are not taxed. These can include life insurance, health insurance, retirement funds, IRAs, 401Ks, pension and profit sharing plans, travel to exotic places for meetings, computers, automobiles…the list goes on depending on the ingenuity of the dentist’s accountant and the rules of the IRS. It is rare for another type of business to generate this percentage of income from a similar level of production or sales.

It is true that much of the profit is dependent on the owner-dentist. If that dentist leaves and is replaced, a certain number of patients will go somewhere else. This may not have anything to do with the new dentist. The patients may have been coming to the practice, even though it may have been inconvenient, because they had developed a professional relationship with that dentist. There are ways around this problem. If the practice is large enough to have one or more associates, all patients will be accustomed to seeing a variety of dentists if their usual dentist is not available. This also allows the group to develop techniques and procedures that are uniform, regardless of who may be seeing the patient. In these practices, the difference in dentists becomes less noticeable to the patients. In making a transition after a sale, much the same can occur if there is cooperation between the buyer and seller.

 

Table 1. Calculating Profitabity for a Medium-Size Practice

Numbers for This Medium-Size Practice:

•Production per month $45,000
•Collections per month $42,750
•Production per year $540,000
•Collections per year $513,000
•Bad debts $27,000
•Bad debts percentage 5% (this should be lower,
but often is not)
•Overhead 65%
•Profit $165,000

 

Table 2. Calculating Profitabity for a Large Practice

Numbers for This Large Practice:

•Production per month $83,333
•Collections per month $82,500
•Production per year $1,000,000
•Collections per year $990,000
•Bad debts $10,000
•Bad debts percentage 1 %
•Overhead 65%
•Profit $340,000

The bottom line, however, is whether the profitability of the practice is high enough to justify the price. You can use all the formulas that exist, but if the practice will not generate enough income to cover the cost of all overhead, minus the perks and the debt payment (or, if the buyer has enough cash to buy the practice outright, a reasonable return on that investment), and leave enough profit for the practitioner to live, the purchase does not make sense. How can this be determined? It is possible to devise a spreadsheet that will allow it to happen by just plugging the various amounts into the appropriate slots. However, it can be done with simple paper and pencil. Lets look at three examples: a small practice, a medium-size practice, and a large practice.

A $10,000 PER MONTH PRACTICE
This practice has a production of $10,000 per month and collections of $9,500 per month, or $120,000 per year production and $114,000 per year collections. Bad debts are $600 each month or 5% of production, a common percentage that with careful management could be reduced.

We will assume a
n overhead percentage of 55%. Because of the size of this practice, it would be very difficult to have an overhead below this level. Usually it will be a bit higher. Fixed expenses such as rent, phone, insurance, etc will tend to adversely affect a practice this small. The need for at least one full-time staff person would also tend to increase overhead. The profit for such a practice would be $48,000 a year.
Let’s next look at the cost of a loan. You should shop for your loan. In the greater Seattle area, at the time of this writing, loans from smaller community-based banks can be as low as 6%, or as high as 7.75% for the large national banks. The smaller community banks are looking for our business, while we are too small to excite the larger banks. We will assume the loan will be for 7 years (84 months), a common length of time.
The first assumption I will make is that you pay 100% of 1 year’s production for this practice. We will also look at the bottom line for a purchase price of 90% of production and 80% of production.
For a purchase price of 100% of annual production, at 6% the yearly loan payment will be $21,036. At 7.75% the yearly loan payment will be $22,265. The moral to this story is, shop for your loan. The profit (take-home prior taxes) is $26,964 for the 6% loan and $25,735 for the 7.75% loan. The profit would be a bit higher because interest is tax deductible, as is depreciation of the cost of goodwill. At this income level the tax rate is so low that these deductions are not of much value.
Is this practice worth 100% of a year’s production? This is an important question. Typically, a practice will sell for a certain percentage of production plus value of equipment and a certain percentage of accounts receivable (ARs), or that money owed to the practice. If the ARs are not purchased, then operating capital will need to be borrowed, so it comes out the same. This is assuming that the ARs are collectable. Typically, anything over 90 days is questionable. The bottom line could care less if you purchase ARs or borrow working capital.
Should the value of equipment influence the value of the practice? Used dental equipment is not worth much. The day it goes into an office, equipment is probably worth only half what you paid for it. If it is 5 years old it is probably down to 10% of cost. The value of equipment becomes an issue when it is so old it detracts from the practice. Do not think that all equipment needs to be new or color coordinated for a practice to be successful. This will bother the dentist far more than the patients. So long as equipment is in good repair, most patients will not notice. If it is ripped or dirty, they will notice. If a needed piece of equipment is nonfunctional, it will either need to be repaired or replaced. If you must replace it, you will need to consider this cost in the size of the loan you seek. You should consider used equipment—good used equipment is available at a fraction of the cost of new. Suppliers will tell you about how great their equipment is and how it will give you years of service. Used equipment will have slightly higher maintenance costs but, as a rule, used equipment that is functional is much kinder to the bottom line.
It is the total cost compared with overhead and loan costs that decides what is left over for the owner. For the purposes of our discussion, we will look at total cost. Let’s see how these figures change if you pay 90% and 80% of 1 year’s production for a practice. We will again look at loan rates of 6% and 7.75%, both extremes of what is available.
At 90% of a year’s production ($108,000), the profit with a 6% loan is $29,067 and for a 7.75% loan it is $27,961. If we consider paying 80% of a year’s production ($96,000), the bottom line for a 6% loan is $31,171, and $30,188 at 7.75%.
It should be clear to you by now that this is probably not a viable practice. The take-home income is too low to justify putting you that far in debt. If you are going to invest time and money in such a practice you must believe that it has phenomenal growth potential. You would need to triple the collections within the next 2 years to make this a viable practice. After all, as an associate in the greater Seattle area, it is often possible to take home three to five times what you would be taking from this practice, with no investment. 

A $45,000 PER MONTH PRACTICE

Let’s next look at a much larger practice. This practice is producing $45,000 per month (Table 1). It is a mature practice to have reached this level. It is possible to grow such a practice, but not much without a partner, associate, or hygiene services. This practice will have multiple assistants and receptionists, and probably a hygienist. It will have many systems: recall, collections, computer billing, insurance submissions, OSHA manuals, etc. In a practice of this size, it is very important to have the selling dentist help with the transition. It is important to keep as much of the staff and procedures in place so the transition goes smoothly for the new doctor and the patients.

You may want to keep the selling dentist on as an associate. However, if you do, you must make a profit on the procedures done by the previous owner and have control over which patients he sees and how much he works. It makes sense to have the previous owner there if you make 10% to 15% on his production. He should see no new patients unless the new patient insists on seeing him, and he should only see those existing patients who insist on seeing him. If this is not enforced, the transition to the new dentist will never happen. This is especially true in the large practice we will look at next.

 

Note that the overhead has climbed compared with the small practice, but the bottom line is much greater. In fact, every 3 years the doctor takes home the equivalent of 1 year’s production. The doctor will get paid 1 year’s production by just working for 3 years. Unless health or age is forcing a sale, there is little reason to sell. Work for 3 years and walk away, and he or she will have been paid 100% of a year’s production. Needless to say, at the 3-year point the practice will still be salable.
At a sales price of 100% of a year’s production, the loan figures are as follows: at 6% the yearly loan payment will be $94,663; at 7.75% the yearly loan payment will be $100,193.
At these levels, shopping for a loan is imperative. If you are going to borrow this much money, you must shop.

The profit, take-home prior taxes, is $70,336 for the 6% loan and $64,806 for the 7.75% loan. Remember, however, that interest on loans is tax-deductible, and between 0.33 and 0.4 of the loan payment is interest, which as a deductible expense will raise your effective take-home up to 40% of the interest payment because of those taxes you will not have to pay. The amount paid for goodwill is depreciable over a 15-year time span, giving you up to a $35,000 a year deduction to be used against your profits when paying income tax. This raises the bottom line to $92,224 for the 6% loan, and $89,798 for the 7.75% loan.
Let’s see how these figures change if you pay 90% and 80% of one year’s production for a practice. At 90% of a year’s production ($486,000) the profit with a 6% loan is $76,803 to $99,600 after adjusting for the interest costs and depreciation’s effect on taxes. For a 7.75% loan the profit is $74,825 to $97,318 after adjusting for the effect on taxes. If we consider paying 80% of a year’s production ($432,000), the bottom line for a 6% loan is $86,269 to $107,254, and $84,845 to $104,838 for a 7.75% loan. We are beginning to see a living wage, and when the lo
an is paid off in 7 years the income will jump dramatically to $162,000 even if there is no growth, without considering the depreciation tax benefit.
Realize that in the last example at a sale price of 80% of a year’s production, the seller will take home this same amount of profit in less than 2.7 years, probably 2.5 years if you consider perks. It is doubtful many would sell at this level of discount.

It should be clear by now, only a fool does not shop for the best price for a loan. A fool should not be able to get through dental school, although some do. However, it is very foolish to go after this size loan without working the numbers. We will only consider 6% loans for the next large practice because the buyer will need a large loan. 

A $1,000,000 PER YEAR PRACTICE
Now let’s look at a large mature practice. This practice has a productive senior dentist, several associate dentists, and a hygienist. There is a large staff and large facility. It probably has equipment of varying ages, from new to quite old. It probably also has many of the toys dentists seem to need: air abrasion, digital x-ray, apex finders, multiple x-rays, nitrous oxide, intraoral cameras, etc. All those things we can practice without, but really like to have. Its production is $1,000,000 a year—“the seven-digit practice.” It is truly a business, and its purchase must be treated as such (Table 2). 

There are some major financial advantages to purchasing such a practice. The transition can appear to patients as just the addition of a new associate and the phasing out of an older practitioner. The existing associates should be profitable for the owner. It is not impossible to make 15% on their production. As we get into the numbers, you can see that these practices can be very rewarding. However, you must really crunch the numbers to be sure you are getting into a wise business opportunity .
Note that the bad debt percentage has dropped compared with the small- and medium-size practices. With the larger staff, stricter financial control is possible. For a sale price of 100% of a year’s production, the yearly loan payment will be $175,302. At this level, shopping for a loan is imperative. If you are going to borrow this much money, you must shop. We will not consider the cost of a more expensive loan rate because this size loan should attract the best rates. The profit, take-home prior taxes, is $164,697 for the 6% loan. Factoring in tax deductions for interest and depreciation, which can raise effective take-home pay up to 40%, the bottom line rises to $205,433. 

Let’s see how these figures change if you pay 90% and 80% of 1 year’s production for a practice. At 90% of a year’s production ($900,000) the profit with a 6% loan is $182,227, or $218,890,953 after adjusting for interest and depreciation effect on taxes. If we consider paying 80% of a year’s production ($800,000) the bottom line for a 6% loan is $199,757, or $232,347 after adjusting for effect on taxes. Note: The effects on taxes are approximate depending on other deductions.
It is clear that even with these large loan payments, these practices can be very profitable. When the loan is paid off in 7 years, the income will jump dramatically to $340,000 even if there is no growth, without considering the effect of depreciation on taxes. These larger practices can be a lot of fun, but do require a considerable effort to manage. There will always be staff issues to contend with, and you will need contracts for associates, office manuals, etc. You may come under a different set of OSHA and other regulations because of your size. 

RISKS AND REWARDS
The numbers used in the above examples were taken from real practices. The small practice model would be typical of an older dentist who kept working while the practice declined, because he or she wanted to work less. In many cases it may be a way to get out of the house every day and see your old friends. They can be a bargain when you find one, but they must be made to grow, and grow rapidly, if they are to be viable. 

The middle-size practice is quite common. It comes close to the average take-home income we see published by the ADA. It is somewhat difficult to grow because this typically will depend on going to a much larger facility. 

The large practice example is by no means the largest practice you may find. When they come on the market, they are a jewel. It is possible for a dentist in his/her first few years of practice to take over such a practice, but it is probably wise for several dentists to become partners in such an endeavor.
While all these numbers are representative of real practices, the dentist considering purchase of a practice should sit down with an attorney and an accountant familiar with the purchase and sale of dental practices to determine just what the tax and legal ramifications are to the individual purchaser(s). Never, under any circumstances, take the word of the seller, the practice manager, or sales person as to profitability, overhead, tax implications, etc. They may not know or may be trying to make a sale. They may be a dentist just like you and may be guessing. Audit the books and demand IRS filings for not only the practice, but also the seller’s personal filings for the last 3 years. Look at financial statements for the last 3 years, and have the accountant and the attorney review these for accuracy.
Lastly, be honest with yourself. While these big salaries look good, they come at a price. You must be comfortable with debt. You must want to get involved with the management of the practice. A large practice can be a lot of fun and make for a good life, but it is a bit like riding a tiger. It is one heck of a ride, but if you do not pay attention the beast can eat you. Use consultants, attorneys, and accountants. Be sure you get good professional advice, and understand it. However, the bottom line is yours—if they make a mistake, you suffer. 
When buying a practice, do your homework. The risks as well as the rewards are yours. 

Dr. Quarnstrom has received fellowships in the Academy of General Dentistry, American Dental Society of Anesthesiology, and the International College of Dentistry, and is a diplomate of the American Board of Dental Anesthesiology. He is a clinical assistant professor in the Department of Dental Public Health Sciences at the University of Washington School of Dentistry and is on the faculty of Dentistry University of British Columbia. He has authored 30 papers and three manuals, and continues to conduct research in nitrous oxide sedation, electronic dental anesthesia, and Halcion oral sedation. He has been in private general practice in Seattle since 1967.