DSO M&A: Red flags for dental practice buyers and sellers

Editor's note: This is the third in a three-part series about the mergers and acquisitions (M&A) landscape in dentistry.

High interest rates combined with higher salaries, higher supply costs, and stagnant insurance reimbursement rates have many dental practices feeling squeezed. That convergence of factors has many dental practice owners looking to sell to a dental service organization (DSO) so they can consolidate costs around supplies, labs, marketing, technology, operations, and human resources.

In part one of this series, we answered frequently asked questions regarding mergers and acquisitions. In part two, we shared the timeline that dental practice sellers can expect. In part three, we dive into the red flags that can prevent a sale from occurring.

What DSOs/investors may consider a red flag in a dental acquisition

Rondi Michaux, the former director of corporate development for two large DSOs, shared the following list of potential red flags:

Rondi Michaux.

• Family relationships and salaries that may not be market value
• Extramarital relationships between team members
• A high-producing dentist wants to leave postsale
• High staff turnover
• Discrepancies between the profit and loss statement and tax returns
• Malpractice claims, active lawsuits, dental license issues, and background check concerns
• Equipment loans and liens
• Outstanding bills, invoices, and/or credit balances
• Personality conflicts
• Lack of empathy about what will happen with the team postsale
• Out-of-date technology
• Poor website functionality

Duff Bourassa is a managing director in the healthcare division of E78 Partners, an accounting advisory firm. He says his firm may also see the following as red flags:

• Lack of a developed hygiene program, with at least 30% of your revenue from hygiene
• Payer mix that doesn't match the buyer's preference, such as heavy Medicaid coverage
• Small practices with fewer than three operatories and no room to expand
• A location where it's difficult to hire staff
• A real estate lease that is coming up for renewal

Red flags regarding team culture

Samantha Strain.

"The analytical nature of most DSO M&A processes tends to focus on financial metrics and leave out some of those soft considerations that impact the transaction's success when it matters most: postclose," said Samantha Strain, a partner and chief development officer with Healthstream Ventures, a firm that offers buy-side transaction advisory services and capital and formation services for private equity companies in the healthcare sector.

"We highly recommend that the sellers truly vet the buyer/partner from a culture perspective. The seller should ensure that their clinical and operational values align with the buyer. Overlooking operational and business integration capabilities has had devastating consequences for both sellers and buyers over the past few years," Strain said.

Eye of the beholder: Red flags or positive indicators?

Some metrics can be viewed as a negative or as a positive.

Duff Bourassa.

"If a DSO sees that your labs and supplies are higher than average, they know they will be able to negotiate lower fees on your behalf, and that will save money," Bourassa said.

Another area to consider: specialty referrals.

"If you're referring out a lot of work to specialists, that can be a positive, because the DSO can bring specialists inside to grow that practice," Bourassa explained.

Red flags for the practice seller

There are red flags for the seller to consider, too. The dentist or dental entrepreneur should make sure the sale benefits the providers, the practice team, and the patients.

Workplace culture, employee benefits, training and staff development opportunities, and compensation are all important factors.

"Another important consideration that we believe sellers should know is related to transparency around any type of proposed equity value that could be conveyed to the seller as part of a transaction," Strain said.

"Equity rolls into the DSO's holding and has been a favorable part of many DSO offer structures over the past three to five years. This method of structure is meant to be mutually beneficial to both the DSO and the seller. It is meant to incentivize a dentist who is partnering with the DSO to have an ownership stake in the larger enterprise and to provide a payoff whenever the platform goes through a capital event in the future," she said.

"However, over the past 12 to 18 months, we have observed many DSO holding companies or equity shares diminish in value. The high interest rate debt environment, coupled with uncertainty in the financial markets haven't helped this situation. Another major contributor to this issue is internal to the DSOs in that many paid extraordinarily high multiples for practices that had operational inefficiencies surrounding same-store growth, resulting in significant issues, including tripping lending covenants with their debt providers," Stain remarked.

Dental M&A predictions

With high interest rates and compressed margins, many potential buyers are delaying M&As until the end of 2024. That gives sellers time to gather all the information they'll need to go to market. It also gives them time to implement technology and staffing solutions that can increase efficiency and revenue, which will increase their earnings before interest, taxes, depreciation, and amortization (EBITDA).

Chris McClure.

"Buyers are seeking to partner with practices that have greater than 20% EBITDA, are willing to roll equity, and where the owner dentist will stay on for five or more years," said Chris McClure, co-founder of Aligned Dental Partners, which provides M&A advisory and consulting services to group practices and DSOs.

"The main red flag that strategics look for is a seller's intention post-transaction. The industry has shifted from a traditional corporate model, where the DSO owns 100% of the practice to a DPO model (dental partnership organization), where the split may be 60/40. Buyers want to know that the seller will stay with the business long into the future and will operate as a partner to the business to ensure alignment."

Despite the recent slowdown in M&A activity, Brian Colao, director of the Dykema DSO Industry Group, predicts that industry consolidation is still on track to increase from about 30% right now to 75% to 80% in the next 10 years.

"It's going to happen," Colao said. "So whether you're thinking about partnering with a group this year, next year, or a decade from now, you can put yourself in the best possible position by preparing now."

Beth Gaddis is the editor in chief at Planet DDS, a dental technology company specializing in cloud-based practice management systems, digital imaging, and dental marketing services. Previously, Gaddis was the marketing director for two large dental service organizations. Prior to entering the dental industry, Gaddis was a journalist for 16 years in a variety of roles, including as a TV news producer at the CBS affiliate in Boston. You can connect with Gaddis on LinkedIn.

The comments and observations expressed herein do not necessarily reflect the opinions of DrBicuspid.com, nor should they be construed as an endorsement or admonishment of any particular idea, vendor, or organization.