The dental industry, unlike other sectors, possesses a unique approach to determining the value of a practice. Instead of mostly relying on physical assets, the value is primarily linked to the profitability of the practice. The benefits of understanding this value extend far beyond merely estimating a sale price for a future transaction.
Before diving into the multiple advantages that a comprehensive practice valuation offers, let us first look at the main components of the valuation itself. Most valuation methods in the dental industry break down into two steps; assessing the actual profitability of the practice and then determining what multiplier or divisor will be used to arrive at the final value calculation.
Practice Profitability
You’ve likely heard EBITDA frequently used when referring to the profitability of a practice. EBITDA simply refers to Earnings Before Interest, Taxes, Depreciation and Amortization. This acronym simply lists the common expenses that are added back when identified in the financial statements to calculate profitability. Practically speaking what an evaluator is seeking to achieve is to calculate the true profitability of the practice after adjusting the net income to remove non-cash expenses (Depreciation), non-recurring expenses, or personal expenses of the current owner that are not necessary to produce revenue. In many cases, these adjustments can go well beyond just the simplified list spelled out in the acronym, EBITDA.
Itemize and Document: There’s a risk of going too far with adjustments to prop up the profitability of your practice that erodes the integrity of your valuation. A best practice is to clearly itemize each addback and document the reason for the adjustment. Where applicable, having backup documentation to support the adjustment should be included. For example, having W-2 statements for family members included in the staffing expense.
Multiplier or Divisor:
Now that you have the profitability of the practice dialed in, it’s time to calculate the estimated value. Terminology commonly used at this stage include familiar terms such as multiple of earnings or multiple of EBITDA as well as more complex sounding terms such as discount rate or capitalization rate. Regardless of the terminology or whether your profitability is multiplied or divided by that number, calculating this number involves an assessment of risk and ability to increase profitability of your practice. A good evaluator is going to look at your practice through the lens of a potential buyer. This approach provides for a realistic number that will be used to calculate your final estimated value.
- Location of practice: Are the demographics stable and sufficient to support revenue?
- Size of facility: Does the current space allow for future expansion of additional staff and increased patient flow or is the space maxed out and the full revenue potential is already realized?
- Financial stability: Is revenue trending down? Do we know why? When will it stop?
- Procedures: Does the practice revenue rely on highly specialized procedures that only a few qualified dentists can replicate or is it more conventional that many dentists can perform?
A thorough and honest look at the risks and opportunities within your practice will contribute to an accurate valuation that also sets the tone for a fair and objective negotiation when it comes time to sell. After all, the only true risk lies in the answer to a question that has not been asked yet.
Now that you have a better understanding of what goes into a valuation of your practice, let’s talk about some of the benefits of having a detailed assessment in advance of and not only during a transition event.
Identifying Areas of Improvement
Enhancing the profitability of your dental practice can remarkably impact its overall value. Consider this scenario: a practice yields a profit of $500,000, attracting a buyer willing to pay 4 times that amount, resulting in a $2,000,000 purchase price. Now, increasing the profit to $550,000 not only boosts the financial health but also elevates the purchase price to $2,200,000, an extra $200,000 at the time of sale.
Tips for Optimization: Changes impacting profitability may take a year or more to reflect in the financials. Document these changes to exhibit their sustainability, enhancing their consideration during evaluations by potential buyers or lenders.
Accurate Financials for Successful Negotiations
Transparent financial representation creates a solid foundation for negotiations. It builds trust and confidence, crucial in today’s meticulous buyer evaluations. Transparency eliminates gaps that could otherwise prompt a reduction in the purchase price.
Strategic Transparency: Think of it this way, if you were selling a used car that clearly needed new tires. Which approach would benefit you in negotiating the final price: Not mentioning it which increases the chance they notice it and ask for a reduction based on the value of new tires, or disclosing upfront that your car needs new tires and you set the asking price with the value of new tires in mind?
Financial Planning for Retirement
Understanding the potential sale value aids in retirement planning. While it should not be the sole contributor, proceeds from a practice sale can significantly impact retirement plans. An accurate valuation allows financial planners to calculate feasible monthly distributions and aids in strategic retirement decisions.
Rule of Thumb vs. Precision: ‘Rule of thumb’ valuations serve estimation purposes if a sale is distant. However, for a genuine assessment and identifying avenues for improvement, relying solely on such methods falls short.
Partnership buy-in and buy-out
According to a 2023 study by the ADA the number of dentists in solo practices is on the decline as more dentists practice in groups. This shift has led to an increase in the number of instances of buying and selling equity among partners. A common pitfall emerges when partners commit to buy-ins or buy-outs without initially determining the purchase price through an independent valuation. Imagine agreeing to purchase an item without knowing its upfront cost—it sets the stage for mismatched expectations and potentially awkward negotiations.
Early Valuation: Conduct a baseline evaluation before committing to exit or enter a partnership. This proactive approach establishes an objective understanding of the price, aligning expectations and minimizing potential conflicts during negotiations.
A comprehensive valuation empowers dental practitioners, not just in determining a sale price but in optimizing their practice for enhanced value. With insights into areas of growth, transparent financials, and strategic financial planning, practitioners gain a holistic perspective crucial for future transitions.
