It's a common conversation we have when approaching prospective sellers, "How much more can you really improve my offer? Why would I pay someone to negotiate on my behalf if I already have a deal in front of me that I'm happy with?"
In truth, most of our job isn't to ensure you get a valuation that you're happy with. It's to ensure the valuation you receive holds up and that you're protected from the other trapdoors built into a letter of intent (LOI) that impacts your value down the road. Unfortunately, you don't fully understand what your offer entails until it's too late.
Here's a pretty standard offer you might look at from a dental service organization (DSO):
- DSO-determined EBITDA (earnings before interests, taxes, depreciation, and amortization) = $850,000 on $3.5 million in revenue
- Valuation is an eight times = $6.8 million enterprise value, or 194% of collections
- Allocation = 65% cash ($4.42 million // 25% joint venture equity ($1.7 million) // 10% holding company equity ($680,000)
In the above example, the doctor/seller was thrilled with the valuation and ecstatic to sign the LOI. A few months after signing, the doctor came to us because the deal had blown up in due diligence and they were confused, tired, and upset about the entire process. So where did they go wrong? Why does this happen?
At face value, an outlined deal can look great. But buried deep into every LOI are deal terms, background information, and legal language that need to be reviewed and negotiated for the deal to move forward. Deals often change dramatically from LOI to final documentation, and doctors are left with the unenviable decision between agreeing to the changes or walking away from a process they've invested six or more months into.
Below are a few areas that are overlooked when perusing an LOI:
Problem No. 1: EBITDA
This baseline valuation metric is at the core of all private equity/DSO/venture capital offers. As a measure of profitability, it informs the buyer how long it will take to receive a return on their investment.
During the closing process, you'll go through a "quality of earnings" process, which is a third-party analysis of your EBITDA. If it comes up negative, the value of the deal will generally be reduced. If it comes up positive, in a DIY deal, you'll rarely receive feedback that it did.
In a represented sale, we'll help determine your EBITDA based on the same accounting mechanisms that a quality of earnings firm would and then defend that number. We see numerous offers sent to sellers that have heavily inflated EBITDA projections from the buyers, dramatically inflating the offer, just to keep the seller engaged in the deal.
Problem No. 2: Rollover equity
It is highly likely that between 30% to 45% of your transaction will come in the form of rollover equity. In dental transactions, there are two specific types of rollover equity: joint venture equity (localized to the practice you're selling) or holding company (holdco) equity (specific to the parent entity as a whole).
Both buckets can have all kinds of parameters that need to be sorted out for you to have a full picture of the offer you're receiving. Questions that many sellers are likely to have include the following:
- What is the exit valuation?
- What is the exit timeline?
- Whom can you sell to and at what price point?
- What is the historical track record of the equity?
- How realistic are the projections the buyer is putting forward?
- Can you sell it all at once or in chunks?
Problem No. 3: Management fees and distributions
Fees and distributions will impact the profitability of the practice and distributions allocated to your joint venture equity percentage. However, there are various clawbacks that are often a part of the final asset purchase agreement related directly to the maintenance of EBITDA, growth clauses in earnout computations, and the value of the joint venture equity. If you're selling to a management entity, you should understand how management fees will impact the numbers from which you're paid.
Problem Number 4: Private equity
This point is simple: It is critical that you understand both the purchasing entity and the organization writing checks to that entity. Where the funds come from matter, and ensuring that you're partnering with a group that has a track record of successful exits from their healthcare investments is critical for the future value of your investment in the organization.
These are a few of the overlooked areas that make or break deals after signing an LOI. We often also see obstacles with legal language, buyer risk mitigation, and myriad other topics. Suffice it to say, there are successful and disciplined buyers out there who understand exactly what they need out of a transaction to turn a hefty profit. They have a full team behind them helping them to bring on deals that check those boxes. You are at a disadvantage if you don't have the same working behind you!
Kevin Cumbus is the founder and president of Tusk Partners, an M&A advisory firm focused exclusively on large and group practices that want to partner with a DSO or private equity group.
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.
