How rent can affect your dental practice valuation

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Do you know how much your dental practice is worth? That's a more complicated question than the market price of your home. A dental practice's value is linked to how attractive it is as an investment for potential buyers. For example, an edited profit and loss statement provides some information with one-time expenses, tax treatment, and expenses unrelated to operations backed out to arrive at a profitability estimate.

This profitability estimate is what investors tend to focus on. The term they use -- earnings before interest, taxes, depreciation, and amortization, or EBITDA -- is a nonstatic evaluation that can be affected by multiple factors. Two of the largest expense line items are salary and rent, so they have a significant impact on the EBITDA calculation because dollars that are paid out in salary and rent are subtracted from profits.

Depending on your long- and short-term career or retirement planning objectives, you may need to adjust these line items because potential investors will pay close attention to the final EBITDA calculation. Every dentist has unique goals, so making the right move will depend on your understanding of how the game is played and what it means for your practice.

The 'circular reference' in EBITDA

Kyle Francis.Kyle Francis.

One item investors scrutinize is how much the practice owner takes out of the business as a salary or payment. Dental practice owners typically make decisions about how much to pay themselves for their work based on how taxes affect their take home pay. There's nothing wrong with raising or lowering the amount for that reason, but the choice can affect EBITDA calculations.

Say a dental practice generates $1 million in revenue, and the practice owner takes a salary of $100,000 as W2 income. In this scenario, the net income would be high and the EBITDA would also be high, but it would be artificial as the dentist would not stay on board and work as hard as he or she was beforehand for such a low salary. Similarly, if the dentist took a salary of $500,000 to run a negative net income, there would be very little EBITDA remaining in the practice, but, again, that number would be artificial. In this case, the salary would likely be adjusted down to make the practice an attractive investment.

That's what's called a circular reference -- a trade-off that raises or lowers EBITDA to fit the practice owner's goals. Most dentists who run a practice may have a hard time understanding how this trade-off works because, as solo business owners, their main goal is maximizing how much they take home and not maximizing the value of their practice. But rent can be a circular reference too, and that's where things can get more complicated.

How rent factors into practice value

One complicating factor for practice valuation happens when a dental practice owner also owns the real estate the practice occupies. In this scenario, it's not at all unusual for dentists to pay rent that doesn't reflect the market value of the rent in their area. Sometimes the rent is much lower than the prevailing market standard, and sometimes it's considerably higher.

Rent is another circular reference that significantly affects EBITDA when valuing a practice. Whether the practice is paying above or below the rent that is standard in that community, when the rent is adjusted to reflect the true market value, the amount is directly added to or subtracted from EBITDA, making the practice correspondingly more or less attractive to investors.

When practice owners also own the real estate and building, the key is to balance the value of the business with the value of the real estate from which it operates. Typically, the owner achieves that balance by paying a market rate rent. That stabilizes each value to reflect market conditions. But it's possible to adjust it in either direction to meet buyer and seller needs.

Playing the game to meet your goals as a seller

Because the practice selling price is linked to EBITDA, it's important to keep in mind how big-ticket items such as salary and rent affect value. To return to our $1 million practice example, say the owner is paid $300,000 per year and the rent is $100,000; the standard amount of EBITDA would be $200,000. For illustrative purposes, a fair practice value might be the EBITDA multiplied by five: $1 million.

But if the rent (or salary) is raised by $50,000 above the market rate, that lowers the price by $250,000 ($50,000 x 5). If you are looking for a strong return on the sale while staying on board under the new ownership at a higher salary level, this can work out well. But you should carefully consider those terms since it would take a full five years to make up the difference in price (even longer if the opportunity cost or the time value of money is factored in).

In addition to rent, salaries can also be adjusted up or down to create a favorable circular reference that meets seller and buyer goals, though that's less common in the dental industry due to production price stability. The bottom line is that you should understand the basics of practice valuation, including how rent affects the value of your practice. By understanding how the game is played, you can keep your options open and play to win when it's time to make your next move.

Kyle Francis has worked in the dental and medical field since 2005, consulting for practices, medical device companies, and groups of practitioners. He has used this knowledge to consult with more than 50 startup companies and dental practices, as well as to help build over 100 dental and medical practices across the U.S. He has owned all or part of more than 20 practices and has been an investor in multiple dental service organization (DSO) concepts. Learn more about his company, Professional Transition Strategies.

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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