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Ken Alexander is a Key Presenter

2009 Practice Transitions Program

AAO, May 1st, 2009 in Boston

Ken Alexander has been in the business of orthodontics for more than 25 years and is an expert in orthodontic practice valuation, both from a financial perspective and a management perspective.

Ken often works with both parties in the transaction to develop a Letter of Intent that summaries all the key points of the deal that will then be taken to each doctor’s attorneys for review and approval prior to developing the legal documentation. This approach can save thousands of dollars and greatly accelerate the process while minimizing disagreements.

If you are looking for help from a consultant who has experience in putting together partnerships, transitions and practice sales and intimately knows the orthodontic profession, please call Ken, or email him, and he will enjoy speaking with you at no charge to see how he can help with your particular situation.

A Brief Look at the Major Issues Affecting Practice Valuation

Although there are many similarities in buy/sell and partnership transactions, each one has its share of negotiated terms and final sales prices as one size does not fit all. Each practice, and buying and selling doctor are very different, with varying needs and desires. Each appraiser has their own method for establishing practice value. Ken Alexander valuation method differs slightly from other appraisers as I tend to weigh many more factors, especially management statistic factors of which many appraisers are not even aware. Ultimately the goal of the appraisal is to reach a fair sales price that unites a willing seller and a willing buyer.

The buyer’s greatest concerns. In most cases the two greatest concerns for any buyer should be answered by these two questions:

Can I purchase the practice and have enough left over cash flow and profit to both pay off the debt in 5-7 years and enough left over to allow for a reasonable living experience for my family?
Can I sustain or grow the practice after the purchase with a reasonable effort of my part?

Unique Issues that Affect Practice Valuation in Some Order of Priority

Terms of the agreement. The number one issue affecting any orthodontic practice sale are the terms. Too often the focus is on the sales price, not recognizing that the most important issue answering the question: “Can the buyer pay off the purchase in a reasonable number of years and survive or thrive on the remaining cash flow?” In this equation must be a consideration for tax implications of stock which are not deductible, or personal goodwill which is amortized by the buyer over 15 years and thus has a “time value of money” implication for the buyer. A major issue for terms is whether the buyer will be an associate, and if so, how long, and also the questions concerning any period of partnership: Full 50-50% partnership? Fractional Partnership? Disproportional Partnership? or Senior Doctor as Associate? The list of possible key terms is extensive and these terms can have a major impact on the overall deal and cash flow for the buyer and after tax net gain for the seller.

Profit margin. Although the profitability of a practice is the single most critical component of sales price, it is vital to understand how the profit is generated. Practices accepting capitation plans, those accepting poor credit risks and practices with low fees may generate a sizeable profit, yet the orthodontist and staff must work 20-30% harder or more days to do so. Practices that charge above average fees may have a larger profit that a new buyer cannot sustain without matching the senior doctor’s experience and reputation.

A profit margin of 43% is considered average, and those with profits above 50% should be investigated to see if this margin of profit can be maintained by the buyer within the approach that he/she is willing to operate the business. This consultant believes that very rarely should a valuation give credit for anything more than a 50% profit margin.

A profit margin under 40% can also be a red flag, but in some very healthy larger practices one will find that staff costs and investments in facility and equipment will push up overhead costs above 60%. Long term employees and extra costs for a strong management team can be a terrific asset to a practice, especially in a transition. A nicer, well equipped facility may cost the buyer a little more in the short run, but longer term it may be a big savings over having to construct and equip a new facility.

In the past, a practice could expect to sell between 1.5 to 2.0 times net income. The more recent past shows this important multiplier declining. The reasons for this include that:

The Contracts Balances are often smaller
It is difficult for some practices to attract buyers to their areas
Many orthodontist are retiring much later in life

The overall health of most “retirement” practices is not as good as those retiring more at the top of their game. Older orthodontic practices often command a lower sales price as they may have been hesitant to make any recent capital expenditures and their market share has been on a decline. Logic and fairness dictate that a practice that is on a decline should not be valued with the same multiplier as one that is growing.

Various “valuation gymnastics” exists to create a valuation based on the profit of a practice, and a wise and experienced evaluator will recognize the many nuances that will affect the continued stream of profitability after the practice is acquired by a buyer.

Gross income or total practice revenue. Often buyers and sellers will focus on the gross revenue of a practice and compare practice sales in an effort to create an average multiplier to determine the valuation of their particular practice. Most offices sell for a value set between .7 to .9 of averaged gross income for the past two years.

Let the Buyer and Seller Beware! Income numbers have a way of lying in orthodontics, and this can be especially true in the last few years. With the advent of new 3rd party payers who will for a fee finance orthodontic treatments and pay the entire fee up front to an orthodontist, minus a nice commission of course, the gross income multiplier is becoming less reliable. Care must be taken by the appraiser to be sure that the practice production, (new charges) matches or exceeds the gross income. Often production, minus adjustments, is a more reliable gauge of practice health than income numbers.

Contracts balance. Much emphasis is now placed on the contracts balance as a primary tool for determining practice value. Contract Balances in practices have been declining steadily with orthodontists collecting fees at a much faster pace than was seen 3-5 years ago. All things being equal, it should be obvious that the practice with a higher Contracts Balance is worth more to a buyer than one which has a lower balance. Exactly how much lower is open to debate, but it is an excellent advancement in the valuations of orthodontic practices that valuators are now taking a much closer look at how much money is remaining on the books.

The Contracts Balance is all monies owed to the practice, pas, present and future that can reasonably expect to be collected. Bud Schulman is credited with establishing a practice value at the Contracts Balance divided by .7. Yes, divided, not multiplied. This formula is said to establish what a practice should be worth if all patients paid a 25% down payment and their balance was distributed evenly over the length of their treatment time.

Certainly this becomes a very important formula for establishing practice value, but many other considerations must also factor into final valuation, not the least of which are practice location, facility and equipment, gross income and profitability. This consultant has seen other appraisers over emphasize this Contracts Balance formula and as a result undervalue a practice. When the seller’s representative undervalues a practice no buyer’s representative will correct the error.

Some evaluators believe it necessary to look at each patient in treatment and evaluate how many patients are paid in full, yet still in treatment, and exactly how many months each account is paid in advance of estimated treatment time. Although this may be important in some transactions, a simple calculation of Contracts Balance divided by average monthly income can easily reveal to the evaluator if a problem exists that should adversely impact the value of a practice, or increase the practice price. This consultant would argue that a practice with 5-6 months of averaged income is a good rule of thumb and anything above or below this amount in the Contracts Balance should impact the valuation.

Location of the practice. Location has always been a large part of practice success and practice size, but a new trend appears to have been established whereby many newer graduates only want to live in major metropolitan areas or in Southern California. A disproportionate number of orthodontists are looking for practice purchases in the sunny areas of the country, large cities and areas surrounding the immediate area in which they received training, while some parts of the country are lacking specialists, other areas are teaming with them.

If in real estate location is a cardinal advantage to valuation, so it should be true in any business where there are multiple buyers desiring to be purchasers of the same practice. Caution must be taken in elevating the sales price as any significant premium to valuation may create a problem to the purchaser in acquiring financing and insuring the cash flow necessary to repay the loans. On the flip side, some orthodontic practices in less undesired areas are being acquired by a neighboring orthodontist for as little as the cost of equipment alone. I believe that the trend to assigning a significantly higher practice value to more desired areas and a much lower valuation to less desired areas will accelerate throughout the next decade.

For valuation purposes the issue of location goes beyond even the city to the specific area and street within the town that the practice is located. Declining socioeconomic areas must have a lower valuation to areas where the economy and affluence are greater.

Facility and Equipment. It becomes a double blow to a unwary buyer if a valuation is done focusing almost strictly upon net profit and gross income, even Contracts Balance and other stats, without recognizing the practice pattern for regular capital improvements. Not only can the buyer get caught with a higher valuation based solely on numbers, he/she also saddled with make large expenditures in the first five years of practice when they can least afford it. Although a value may be established for equipment and facility improvements, a wise evaluator will make appropriate adjustments for practices which could benefit from immediate capital investments, and will also give extra credit to those who have recent investments in facility and equipment.

Staff and management team. The leaders or Coordinators who will remain behind in the practice after the senior doctor has retired should affect the amount that a buyer is willing to pay for a practice. It is next to impossible for an evaluator to access this area adequately, so it is incumbent upon the seller to disclose to the buyer if he anticipates certain key staff departing quickly after the sale, and important that the buyer do his/her own interview with staff to access this vital area. Although staff can be hired to do the work, there is great value in having a few pillars of the practice who will steady the ship while the patients and referral sources transition their loyalties to the new doctor.

The number of New Patients and Observations. Many practices brag about high New Patient to Start percentages and yet the higher the start ratio the more risk the buyer has of being able to sustain the stream of revenue. Take for example two $800,000 practices for sale. One claims a 92% NP to Start ratio and the other claims a 50% NP to Start ratio. This appraiser with his management background understands clearly that the practice with almost twice the number of NP exams is actually a better buy than one that has already reached its maximum % with a much fewer number of NP exams.

Likewise, a practice that is into early treatment may have actually eaten a large part of future profits, while the same size practice with 2-3 times the number of patients placed on observation recall may be the better deal. Beware if you work with an appraiser who has no experience or understanding of the management aspects of a healthy orthodontic practice. Some practices are being sold to young buyers where the seller has maximized profitability at the expense of the future leaving the buyer to pay a higher price and having to pick up the extra expenses of the future.

Treatment time and quality. This area falls mainly on the buyer to evaluate. It is important to understand the seller’s technique and to be able to reasonably finish up his/her cases in a timely manner with quality. I have witnessed doctors who have bought practices that they knew were “treatment challenged” assuming that all the patients would love them for rescuing their treatments and delivering quality, only to be run out of town by the patients and area dentists who did not appreciate the extra 6-18 months tacked onto every case.

In conclusion: It is vital that both buyer and seller hook up with a reputable, knowledgeable consultant who can help to create a win-win deal for both parties taking into consideration all of the major issues related to practice valuation.

Ken Alexander has been in the business of orthodontics for more than 25 years and has an excellent grasp on practice valuation both from a financial perspective and a management perspective. If you are looking for help in this important area, please call Ken, or email him, and he will enjoy speaking with you at no charge to see how he can help with your particular situation.

Just a few of our many happy transition clients you may wish to contact: clients

A Perspective on Large Orthodontic Practice Transactions

(For information purposes only and should not be relied upon as any specific advice on the purchase of any specific practice.)

Although there exists certain valuation methodologies which are used in determining a “fair” market value of an orthodontic practice, the end result of any sales and partnership transaction is a willing seller and buyer. If either party feels that the deal is not fair, or if the deal does not cash flow for the buyer, the deal will not go to completion. I have been involved in numerous orthodontic practice transitions and have evaluated the valuation methods and terms of buy/sell agreements put together by consultants and lawyers specializing in orthodontic practice transactions. Although there are some similarities in the transactions, each one has its share of negotiated terms and final sales prices as one size does not fit all. Each practice transition, and buying and selling doctor are different, with varying needs and desires.

In many large practice transitions I often recommend a profit split differential of 60% for the senior doctor and 40% for the junior doctor for the first five years of the partnership. The reason for this differential is the results of four factors:

First, the buyer, no matter how talented he or she may be is rarely a match for the senior doctor and significant training is necessary for the junior doctor to be able to produce the same results while seeing the same number of patients.

Secondly, it is rare that the junior doctor can match the marketing draw of the senior doctor at any time during the first five years.

The third reason why the differential split of profit is often necessary is that the senior doctor might not otherwise bring in a partner, but might choose instead to simply work with associates or on his own for a year or two longer. The potential loss of profit from a decline of the practice pales in comparison to what is allocated to the junior doctor in terms of profit.

Lastly, although it is understood that the buyer/junior partner has many school debts and is a trained orthodontic specialist, and must pay to buy into the practice, the amount of profit allocation at 50% is simply gigantic in comparison to what he/she can offer the practice in the first few years. A typical $2,000,000 practice might have a net income of $850,000. It seems unreasonable to this consultant that $425,000 be immediately allocated to a junior partner, UNLESS certain other differentials are applied to the terms.

What one finds for terms in large practice transitions is often a differential in days worked between the buyer and seller. In most cases, even with a 60% - 40% differential in profit, the junior doctor will be asked to allow the senior doctor four to six additional weeks of vacation time over and above the four weeks given to the junior doctor. This means that the junior doctor must work 12 - 24 days more than the senior doctor each year of the partnership.

If one asks why would a potential buyer accept such differentials in the purchase of a large orthodontic practice, the answer is that when all the terms are placed on the table side by side with smaller 50%-50% deals with no differentials, the larger deal pays much more per day worked, and the junior partner acquires significantly more equity each year.

By way of example, which one of these deals is more appealing? Perhaps the answer depends on the personality of the buyer and his/her long term goals.

Traditional #1

50% - 50% for a $950,000 practice with $415,000 profit
Junior doctor is allocated 50% at $207,500 and works 3 days per week
Loan payments on $375,000 are $92,324 per year for 5 years.
Perks expenses might be $5,000 per year

Total gain for Jr. Dr.: Pre-tax: $110,176 = $800 + $125 equity per day worked

Note #1: Many buyers are looking for just this size practice to purchase, but are unwilling then to work for five years making such a modest income, even after anticipated growth is factored into the equation.

Disproportional #2

60% - 40% for a $1,900,000 practice with $830,000 profit
Junior doctor is allocated 40% at $332,000 and works 3 ½ days per week
Loan payments on (40%) $680,000 are $167,415 per year for 5 years
Perks expenses might be $5,000 per year

Total gain for Jr. Dr.: Pre-tax: $159,585 = $1000 + $845 equity per day worked

Note #2: The buyer in example #2 is given $115,000 in greater allocation for working 24 more days per year, or $4,792 more per extra day worked. He also has to see a higher volume of patients each day than the buyer in Traditional #1.

Many variations of terms exist in both large and small practices to create an acceptable deal. One common form of practice purchase is to allocate 50% of the profit based on days worked and 50% based on ownership share. The buyer is sold 10% of the stock or equity each year for five years. Although this eliminates interest payments the actual allocations to the junior partner are very similar to the 40% allocation:

Fractional Sale #3: Half of profits based on days worked and half on ownership for a $1,900,000 practice with $830,000 profit

Year #1: Jr Dr 25% + 5% = $249,000, minus $170,000 = $ 79,000
Year #2: Jr Dr 25% + 10% = $290,500, minus $170,000 = $127,500
Year #3: Jr Dr 25% + 15% = $332,000, minus $170,000 = $162,000
Year #4: Jr Dr 25% + 20% = $373,500, minus $170,000 = $203,500
Year #5: Jr Dr 25% + 25% = $415,000, minus $170,000 = $245,000

Average gain Jr. Dr.: Pre-tax: $162,000 = $1,000 + $1,080 equity per day worked

Note #3: This plan is excellent in allocating profit based on the anticipated contribution of the junior doctor. This is not ideal for the junior doctor in two ways: First, the first couple of years are sparse in salary, and second, many buyers do not like the feel of only buying 10% per year. Compared to the Alexander #2 example, the numbers are almost identical, except for the fact that this buyer may be working 12-24 fewer days than in the Alexander approach.

Conclusion: Ultimately the final conclusion as to whether a disproportional or fractional approach to transitioning a large orthodontic practice is acceptable rests solely with the buyer. The buyer’s advisors can clearly explain the pros and cons of any practice purchase, but the buyer must decide if he/she finds the terms acceptable.

The buyer should be focused on the financial benefits he/she will obtain in the transaction and evaluate the extra days and work he/she may need to expend in comparison to other opportunities. There is also a risk factor associated with the purchase of any practice. Some might find that the smaller transaction with less debt less risky, when in reality, this may not be the case. A smaller office with less net profit often places the buyer at greater financial risk if the practice were to decline 15-20% verses the practice with significantly greater margin of profitability. The larger acquisition most often creates the greater benefit with the majority of the risk absorbed with the buyer simply having to work harder and more days.

Partnership & Transition Services

Ken Alexander is a Key Presenter

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