The letter of intent trap: Don't get hooked by multiples

Ryan Mingus.
Ryan Mingus.

Offers from dental service organizations (DSOs) contain an array of terms, variables, vocabulary, and numbers. Yes, there is a "headline number" or "enterprise value" near the top of your letter of intent (LOI), but the reality is that many practice owners will never realize that headline number due to the structure of the deal.

Structure drives the long-term value of a transaction and the likelihood that you will receive it. As we have said previously in past articles, "Tusk Partners will happily buy your business for 25 times, if you let us structure the deal."

If you took me up on this offer and owned a business with $1 million of earnings before interest, taxes, depreciation, and amortization, or EBITDA (EBITDA is a proxy for operating free cash flow in your business after normalized owner-doctor compensation), I would offer you $25 million (25 x $1 million = $25 million). As for the structure, I would wire you $1 million at closing then put the remaining $24 million in unattainable earnouts, but you could tell your friends that you got paid 25 times for your deal.

That is what makes our job at Tusk so interesting. When we take a client to market, we may receive offers from five or more DSOs, and they are all different: different enterprise values, different deal structures, different equity considerations, different post-sale employment compensation, all from different leadership teams with differing strategies.

The one thing that is always consistent is that there are some dollars that are at risk and others that are not. Below are a handful of deal terms that we have seen over the years along with issues that accompany them.

Cash at closing

This is the cash amount that is wired to you at closing. The issues include the following:

  • In some cases, DSOs will include clawbacks, where the DSO can come after these dollars if revenue or EBITDA targets are not maintained post-close.

Dollars at risk

1. Post-sale compensation: How will you be paid as a clinician or manager in the business post-close?

The associated issues include the following:

  • Clinical commissions on what? Collections, net collections, production, collections less a percentage of labs? It all mattes as it drives your EBITDA, which impacts the valuation. This is especially true with orthodontists.

2. Earnouts: These are dollars only realized when your business achieves certain revenue or EBITDA targets.

The associated issues include:

  • Earnouts have become more prevalent in the past 18 months.
  • Deals are sometimes structured to show huge earnouts that are practically unattainable (20% growth per year for three years) simply to boost the headline valuation in LOIs.
  • This is a key area of negotiation that has a great deal of wiggle room with an experienced adviser.

3. Equity retained in your business: Sometimes described as sub-DSO equity or joint venture equity, this is equity retained in your business post-close. Most times, this equity allows you to enjoy distributions based on your pro-rata share of the retained equity in your business.

The related issues include:

  • Management fees charged by the DSO, which can range from 0% to 20%. Some are capped at a certain dollar amount, while others are not. The one thing that they have in common is that they are paid before any distributions to equity holders.

4. Equity rolled into the DSO: Some DSOs offer you the opportunity to roll proceeds from the sale into equity in their DSO at the holdco level. Many will tell you that these shares are the same as or "pari passu" to the shares that the private equity guys and leadership in the DSO have; others will not be so fast to tell you where these shares live on their capitalization table. These shares don't typically come with distributions and can return one to five times cash on cash rolled. That is a huge difference.

The associated issues include:

  • Timing. When a private equity group invests in a DSO, they expect to grow the business and then exit within a 60-month period. If you roll equity into the DSO at month five, your returns will likely be much higher than if you are investing in month 55. Keep in mind that some DSOs are mismanaged and overlevered and don't make it to a recapitalization.

If after reading this, you are still good with me structuring your deal, I am happy to pay you 25 times your EBITDA today for your business. But my guess is that you are smarter than that.

Ryan Mingus is managing director of Tusk Partners and has more than 12 years of sales and leadership experience in the dental and healthcare industry, most recently as the business development director for strategy and optimization at Align Technology Inc. Mingus earned his bachelor's degree in economics and business from the Virginia Military Institute and his Master of Business Administration from the University of San Diego. He also held the rank of captain in the U.S. Army National Guard.

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

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