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TRANSCRIPT
Senior or Younger Doctor:
What You Need to Know
About Transition Activities
Roger K. Hill, M.S.A., A.S.A.
Transition Alternatives:
Prototypical Sale
▪ Full Sale
▪ Control
▪ Least Secure
▪ Cash / Note Ratio
▪ Practice Size Limitation
▪ Time Frame 0-2 Years
▪ Asset Sale
Transition Alternatives:
Delayed Sale
▪ Variation on a Theme
▪ Full Sale
▪ Control and Compromise for Security
▪ Cash / Note Ratio
▪ Time Frame 1-3 Years
▪ Asset Sale
Transition Alternatives:
Fractional Sale
▪ Portion of Practice
▪ More Complex
▪ Emotional Aspects
▪ Larger Practices or Time Frame
of More than 5 Years
Transition Alternatives:
Hybrid (Fractional to Full Sale)
▪ Begins as Fractional Sale
▪ Predetermined Buy-Out Date
▪ Purchaser Owns 100.0% At End
▪ “Golden Handcuffs” (Security)
▪ Can Progress to New Fractional Sale
Transition Alternatives:
Mergers
▪ Most Complex
▪ Single Survivor Entity
▪ Longest Time Frame
(Generally 8-10 Years)
▪ Slow Down Merger
The 10,000-Foot View
(Or, What Do I Need to Know?)
1. Practice Valuation
2. Cash Flow Projections (Proforma)
3. Financing Considerations
4. Legal Documents
5. Managing Your New Practice
Appropriate Valuation Methodology
1. Fair Market Value (FMV) Is the Sum of:
A. Tangible Assets
• Equipment
• Furnishings
• Leasehold Improvements
• Office Equipment
• Supplies
B. Intangible Assets
• Goodwill
• Covenant Not to Compete
• Patient Records
• Telephone Number(s)
Appropriate Valuation Methodology
• Intangible Value Indices
• Practice Growth Rate
• Profitability
• Location
• Procedure Mix
• New Patient Flow
• Related Factors (10-12)
1. Establish Intangibles Value
2. Add Tangible Value
3. Could Be More or Less Than Static Percentage
4. Key is Value of the Intangibles
5. Database on Intangible Value
1. Mean
2. First Standard Deviation
Appropriate Valuation Methodology
Limitations of Fair Market Value
• Fair Market Value (FMV) Does Not Define
Financial Benefit
• FMV Defines:
• Value of Tangibles
• Value of Intangibles
• Normalized Overhead Rate
“Beans and Weenies”
• You Need to Know:
• Pre-Tax Income
• Estimated Income Taxes
• After-Tax Cash Flow, or
Will I Have Enough for
Beans and Weenies?
Cash Flow Projections (Full Sale)
• Illustrate All of the Above
• Test Value
• Increase Confidence
• Enhances Financing Request
Proforma: Previewing Financial Outcome
3rd Year 4th Year 5th Year
Proj. Prof. Income $1,111,980 $1,134,220 $1,156,904
Practice Overhead (764,929) (779,708) (794,782)
Distributable Profit $347,051 $354,512 $362,122
Dr. New's Coll. Alloc. $0 $741,104 $954,823
Associate Collections 0 194,997 0
Hygiene Allocation 0 198,119 202,082
Total Allocation $0 $1,134,220 $1,156,904
Overhead Allocation $0 ($779,708) ($794,782)
Pre-Tax Profit $0 $354,512 $362,122
Compensation as Associate $160,620
Practice Purchase Interest (43,209) (39,985)
Depreciation & Amortization (60,921) (56,874)
Equipment Purchase Interest (2,874) (2,520)
Depreciation on Equip. Purch. (5,769) (5,769)
Working Capital Interest (5,189) (4,192)
Payable to Dr. Seller (58,499) 0
Personal Deductions (22,700) (22,700) (22,700)
Pre-Tax Income $137,920 $155,350 $230,081
Estimated Taxes (41,837) (47,180) (71,161)
After Tax Income $96,083 $108,170 $158,920
Practice Purchase Principal (41,530) (44,754)
Depreciation & Amortization 60,921 56,874
Equipment Purchase Principal (4,559) (4,913)
Depreciation on Equip. Purch. 5,769 5,769
Working Capital Principal (12,845) (13,842)
Non-Financed Capital Exp. (10,000) (10,000)
Personal Deductions 22,700 22,700 22,700
After Tax Cash Flow $118,783 $128,627 $170,755
Cash Flow Projections (Partnership)
A. Trigger Point
B. Financial Structure
C. Income Distribution Formula
1st Year 2nd Year
Proj. Prof. Income $1,311,251 $1,507,123
Practice Overhead (607,311) (742,631)
Distributable Profit $703,940 $764,493
Dr. New's Alloc. Coll. $433,559 $524,833
Hygiene Allocation 0 228,729
Total Allocation $433,559 $753,562
Overhead Allocation (200,805) (371,315)
Pre-Tax Profit $232,754 $382,246
Assoc. Compensation 150,000
Management Fee Paid (19,240)
Existing Debt Interest (1,605)
Line of Credit Interest (2,391)
New CapEx Interest (21,695)
Personal Items (6,028)
Personal Deductions (20,200) (11,841)
Pre-Tax Income $129,800 $319,447
Estimated Taxes (41,000) (106,433)
After Tax Income $88,800 $213,014
Stock Pmts.Buyin (5,219)
Existing Debt Principal (16,083)
Line of Credit Principal (6,842)
New CapEx Principal (25,594)
Non-Financed Capital Exp. 0
Personal Deductions 20,200 11,841
After Tax Cash Flow $109,000 $171,117
Proforma: Previewing Financial Outcome
Lender Information Items
• Practice Information
• Valuation Study
• Cash Flow Projections
• Operational Information
• Tax Returns
• Interim Financials
Lender Information Items
• Purchaser Information
• Curriculum Vitae (Resume)
• Production History
• Brief Business Plan
• Telephone Interview
Minimum Lender Requirements
• Credit Score ≥ 680
• Production History
• Zero Years Experience (Orthodontic only)
• Practice Size / Years of Experience /
Seller’s Post-Sale Tenure
• Relaxed Standards
• “What if My Net Worth Is Negative?”
Not All Lenders Created Equally
• Asset-Based Lenders
• “Bricks and Sticks”
• Cash Flow Lenders
• Specialized Group
• National and Local
• Bank and Non-Bank Lenders
Fundamental Documents
for the Purchase
• Letter of Intent (LOI)
• Asset Purchase Agreement
• Lease Agreement for Office
• Employment Agreement for Seller
Letter of Intent (LOI)
• Defines the Agreement in Principle
• May Be Binding or Non-Binding
• Summary of Deal Points
• Superseded at Closing
Asset Purchase Agreement
• Conveys Ownership
• Typical Sections:
• Closing Date
• Purchase Price / Manner of Payment
• Allocation of Purchase Price
• Indemnification
• Covenant Not to Compete (Seller)
Asset Purchase Agreement (cont’)
• Representations / Warranties
• Rework / Work in Progress
• Covenant Not to Compete
• Seller’s Post-Sale Transition
• General Provisions
Lease Agreement
• New Lease Most Common
• Lender Requirements
• Length of Loan
• Base and Extensions
• Landlord Waiver
Seller Post-Sale Employment Agreement
• Typically Paid a Per Diem
• Usually No Benefits
• Can Be Independent Contractor
• Flexible Schedule / Front-End Loaded
Legal Documents for Partnerships
• Initial Documents – Associateship
• Employment Agreement
• Non-Transactional
• Compensation, Benefits, Covenant, etc.
• Letter of Intent
• Sets Out Transactional Details of Buy-In
• Daily Partnership Operations
• Income Division, Death, Disability, Retirement, etc.
Legal Documents for Partnerships
• Partnership Documents – Initiate Buy-In
• Doctors Jointly Owning Corporation
(Cardboard Box)
• Stock Sale Agreement
• Shareholder Agreement
• Employment Agreement
Legal Documents for Partnerships
• Partnership Documents – Initiate Buy-In
• Doctors Own Separate Corporation
(Triangle)
• Asset Sale Agreement
• Partnership Agreement
• Employment Agreement
Financing Options
• You Are Wealthy…Not Really
• Outside Lenders (Banks, etc.)
• Owner Financing (Seller Acts As Bank)
• Family Members – Really Complicated
• Robbing Convenience Stores –
Not Recommended
Financing Options
• Outside Financing
• Most Common
• Relaxed Borrowing Schedule
• Common Term Lengths
• 84 Months
• 120 Months
• Longer Term (120) and Paying Extra
Financing Options
• Seller Financing
• Seller Essentially Bank
• Usually Only Small Portion
• Same Rates / Terms as Primary Note
• Total of Payments Same as All Bank
Financing Options
• Seller Financing (con’t)
• For the Seller
• Risk Factor
• Need Insurance
• Second Lien Position
• No Tax Advantage
• Need For Continued Financial Oversight
Financing Options
• “Steppin’ Over Dollars to Pick Up Pennies”
• First Get Best Deal You Can, But…
• Sale Price $1.0 Million
• Payment On 10-Year Term
• 5.0% or 5.5%
• Different Over Term of Loan: $29,500
Financing Options
• “Steppin’ Over Dollars to Pick Up Pennies”
• Took a Month to Negotiate 5.0% Rate
• Practice Income = $100,000 per Month
• Overhead 55.0% = $55,000
• Pre-Tax Profit 45.0% = $45,000
• Net Result – Lost $15,500
The Purpose of a Valuation and Proforma
• In the Beginning…
• Establishes Value for Transaction
• Static Percentages (e.g., 80.0%) Inaccurate
/ Misleading
• First Standard Deviation 56.95% to 96.32%
• Range Is 39.37% - Not a Good Place to
Guess
The Purpose of a Valuation and Proforma
• Location in Range Established With:• Spreadsheet Analysis (Financial X-Ray)
• Due Diligence Visit
• Valuation Algorithms
• Typically Done by Valuation Professional
The Purpose of a Valuation and Proforma
• Valuation Is Only the Beginning
• Limitations of a Valuation Study
• Segue to Proforma (Cash Flow
Projections)
The Purpose of a Valuation and Proforma
• Proforma (PF) Establishes Financial
Outcome(s)
• (1) Full Sale
• (2) Fractional Sale
• Tests ABCs:
• A. Trigger Point
• B. Financial Structure
• C. Income Distribution Formula
The Purpose of a Valuation and Proforma
• Timing For Valuation / Proforma
• Full Sale at Outset of Process
• Fractional Sale
• Before Associateship Begins
• Update at End of Associateship
• Update Is Tangible Net Worth Only
The Purpose of a Valuation and Proforma
• The Update Protocol• Each Doctor’s Legitimate Agenda
• Baseline Fair Market Value Includes Senior’s Solo
Growth Rate
• Growth Beyond This Attributable to Associate
• Updated Fair Market Value =
$ Original Intangible Value
Then-Current Tangible Value
$ Updated Value for Buy-In
The Purpose of a Valuation and Proforma
• Proforma (PF) Establishes Financial
Outcome(s), con’t
• (3) Delayed Sale
• Baseline For Letter of Intent
• Triggering Events
• Reaching Agreed-Upon Date
• Seller’s Death – Immediate
• Seller’s Disability – Immediate
• Mutually Agreed Acceleration
The Purpose of a Valuation and Proforma
• Proforma (PF) Establishes Financial
Outcome(s), con’t
• (3) Delayed Sale
• Update at Triggering Event
• Update Protocol
• Intangible Value +/- 5.0% - No Change
• Intangible Value >5.0% - New Value
• Then-Current Tangible Value
The Purpose of a Valuation and Proforma
• Proforma (PF) Establishes Financial
Outcome(s), con’t
• (4) Letter of Intent for:
• Death
• Disability
• Retirement
• No Agreed-Upon Date – Contingency
Agreement
• Baseline Fair Market Value in LOI
• Update Protocol Same As Delayed Sale
Factors Affecting Value
• Fair Market Value (FMV), Sum of:
• Tangible Net Worth
• Intangible Value
• FMV = (Intangible + TNW)
• Intangible Value Larger / More Critical
Factors Affecting Value
• Factors Affecting Value of Intangibles
• Profitability
• The Big Four:
• Salaries / Wages (Staff) – 18.0% - 22.0%
• Rent / Occupancy Expenses – 5.0% - 7.0%
• Dental Supplies – 6.0% - 10.0%
• Laboratory Charges (Aligners, etc.) – 6.0% - 8.0%
Factors Affecting Value
• Factors Affecting Value of Intangibles
• Growth Rate
• Location
• Production / Collection Ratio
• Service Mix (Brackets vs. Aligners)
Factors Affecting Value
• Factors Affecting Value of Intangibles
• Effectiveness of Marketing Protocol
• Ratio of Doctor / Direct Referrals
• Range
• Depth
Factors Affecting Value
• Factors Affecting Value of Tangibles
• Age of Fixed Assets (F/As)
• Dental Equipment
• Office Equipment
• Furnishings
• Leasehold Improvements
• Current State of Technology
Factors Affecting Value
• Factors Affecting Value of Tangibles
• Orthodontic Receivables
• (+) Contracts Receivable (C/R)
• (+) Accounts Receivable (A/R)
• (-) Prepaid Treatment
• C/R Value Less Than Face Amount
• Science Says “Two Particles / Same
Space / Same Time”
• All the Same, It’s Happening with
Valuations
• Individual / Traditional Market
• Income Approaches
• $Financial Reward
%Risk = $FMV
• Comparable Sales (Market)
Typical Valuation Methodologies
Typical Valuation Methodologies
• Individual / Traditional Market (cont’d)
• Average (Currently) ~80.0% of Revenue
• BUT, It Varies Widely
• One Foot in Boiling Water; the Other in
Freezing Water
• First Standard Deviation Is
56.95% to 96.82%
Typical Valuation Methodologies
• Corporate Valuation Metric
• Typical Value Range: 4.0 to 7.0 x EBITDA
• Translated: 100.0% to 150.0% of Revenue
• Corporate Buyers Focused on Numbers
• An Income Stream Is an Income Stream
Typical Valuation Methodologies
• Corporate Valuation Metric
• EBITDA – What Is This?
• $ Practice Revenue
(Normalized Overhead)
(Reasonable Doctor Compensation)
$ EBITDA
Allocation of the Purchase Price
• Assigns Portion of Price to Each Asset Class
• Seller and Buyer Must Use Same Allocation
• Push / Pull in Tax Code
• Not As Difficult As It Sounds
• Tax-Driven Process
Allocation of the Purchase Price
• Order of Allocation• Receivables
• Consumable Supplies
• Fixed Assets
• Patient Records
• Covenant Not to Compete
• Personal Goodwill
Corporation Sells
Doctor Sells
Allocation of Purchase Price
Asset Seller Purchaser
Supplies* Ordinary Income Expensed in First Year
Fixed Assets* Generally Ordinary Depreciable Over 5-7 Years
Patient
Records*
Capital Gain Depreciable Over 15 Years
Contracts
Receivable
Included in Goodwill Depreciable Over 15 Years
Covenant Ordinary if Isolated;
Capital if Combined
with Goodwill
Depreciable Over 15 Years
Personal
Goodwill
Capital Gain Depreciable Over 15 Years
* If the practice is incorporated these items must be sold by the corporation. Gain from these may be subject to both corporate and personal taxation.
Allocation of the Purchase Price
• What Is Goodwill?
• Goodwill Is Only an Expectation
• Expectation Financial Benefit
Continues After Change of Owners
• That Is, the Patients / Referrers Will Stay
Legal Entities and Tax Implications
• Sole Proprietorship (Not Incorporated)
• No Separation Between You and the Practice
• No Protection from General Liability
• Limited Tax Reduction Flexibility
Legal Entities and Tax Implications
• Incorporating Your Practice
• Corporation Distinct From Individual (You)
• Limits Exposure to General Liability
• Increased Tax Reduction Strategy
• Tax Planning
• Discretionary Expenses
Legal Entities and Tax Implications
• Two Types of Corporations
• (1) C (or Closed) Corporation
• Original Type
• Less Tax Flexibility Than S Corporation
• Can Be Tax-Paying Entity
Legal Entities and Tax Implications
• Two Types of Corporations
• (2) Subchapter S Corporation
• Sub S
• More Recent Development
• Greater Tax Planning Flexibility
• A “Flow Through” Entity
• Not a Tax-Paying Entity
Legal Entities and Tax Implications
• What Is the Difference?
• C Corp – Money in Checking Account at
Year’s End Subject to Corporate Tax
• S Corp – Money in Checking Account Not
Subject to Corporate Tax
• Money “Flows Through” to Personal Return
• Not Tax-Paying Entity
Legal Entities and Tax Implications
• $100.0m in Bank Account Year End
• (21.0m) Corporate Income Tax
• (19.0m) Individual Income Tax
• $60.0m After-Tax Income
• C (Closed) Corporation
Legal Entities and Tax Implications
• C Corporations
• Can Be Tax-Paying Entity
• Inattention = Corporate Income Tax
• Doctor Incurred 40.0% Total Tax
Legal Entities and Tax Implications
• Subchapter S Corporation (Sub-S)
• $100.0m Still in Bank Account
• Called a “Flow-Through” Entity
• Flows Through to Doctor’s 1040
Legal Entities and Tax Implications
• Subchapter S Corporation (Sub-S)
• Taxed Only at Personal Level
• $100.0m in Bank Account Year End
• (24.0m) Personal Income Tax
• $76.0m After-Tax Income
Legal Entities and Tax Implications
• Limited Liability Company (LLC)
• Professional Limited Liability Company (PLLC)
• Blend of Subchapter S and Sole Proprietorship
• Can Be Advantageous in States That Tax Sub S
• PLLC in a Few States, Same as LLC
Legal Entities and Tax Implications
• General Partnership
• Requires Multiple Owners, Corporations Do Not
• Older Type Entity, Rarely Used
• Distinct From Individual (You)
• Joint and Several Liability
Advisors for Transitions – and Beyond
• CPAs
• Attorneys• Dental / Orthodontic Experience
• Tax Attorneys
• Consultants
• Wide-Spectrum Financial / Legal Groups
• Specific to Dentistry and Orthodontics
Senior or Younger Doctor: What You Need to Know About Transition Activities
Roger K. Hill, MSA, ASA
• Transition Alternatives: The Five Fundamentals
• What About the Transition Process?
• Practice Valuation: Fair Market Value
• Cash Flow Projections
• Financing: How Do I Get the Money?
• Legal Documents for Closing
• Financing Options
• The Purpose of a Valuation and Proforma
• Factors Affecting Value
• Typical Valuation Methodologies
• Allocation of the Purchase Price
• Legal Entities and Tax Implications
Terms & Definitions
Tangible Assets - A tangible asset is an asset that has a physical form. Tangible assets include
both fixed assets, such as machinery, buildings and land, and current assets, such as inventory.
Intangible Assets - Nonphysical assets, including, but not limited to: known location, trained
staff, assigned telephone numbers, patient records, web site(s), and personal goodwill.
EBITDA - Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure
of a company's operating performance. Essentially, it's a way to evaluate a company's
performance without having to factor in financing decisions, accounting decisions or tax
environments.