Buying a Dental Practice and Wondering if Overhead was Adjusted Properly?

There’s a great thread on dentaltown.com about why buyers should NOT pay for potential and projections. Part of the discussion revolves around normalizing cash flow, particularly the overhead of the practice. This prompted me to write a blog post to help potential buyers evaluate a seller’s cash flow specifically with overhead.

Over the past 25 years or so, as I’ve assisted buyers with managing their due diligence, assessing the asking price, and improving the performance of the practice, I’ve witnessed how the overhead assumptions used to normalize cash flow can drive the price that sellers ask for their practices.

 I’ve compiled a list of common overhead expenses categories and some of the issues we’ve uncovered over the years. Buyers need to consider how various expenses might be impacted when they take over and how these expenses may have been adjusted for cash flow purposes. Keep in mind that many professionals  (broker, CPA, seller rep, sometimes the seller themselves, or anyone charged with the task of determining a practice's asking price) who are trying to normalize cash flow, may not have known about these issues with the expenses they adjusted or simply didn’t take the time to understand how their adjustments might impact other expenses.  After all, their primary responsibility is determining an asking price, NOT performing due diligence. That said, we know there are some professionals who will use overhead as a way to increase cash flow and therefore price. One way to accomplish this is by reducing overhead by adjusting (reducing) certain expense categories to “industry norms”. While the reduction in certain expenses may be valid and logical, unfortunately, we rarely see expenses adjusted by increasing them to “industry norms” which should follow the same logic.

The items below should assist a buyer when evaluating a practice’s overhead and how that overhead might change under their control and how “industry norm” adjustments might impact price. At the very least this will help them to know the appropriate questions to ask.

-          Accounting/Professional Fees:
Reducing this to “industry norms” may not take into account a CPA firm which also does payroll, maybe full-service bookkeeping, etc., a buyer may have to pay for the payroll processing and bookkeeping, therefore,  automatically reducing this may be an oversight.

-          Advertising:

 If a seller’s cash flow has little to no advertising, a buyer has to ascertain whether or not they will need to add this expense in order to properly maintain the seller’s existing patient base with an increased flow of new patients. Many professionals overlook this as a necessary expense and will sometimes reduce it to “industry norms” for a FFS practice when that’s how the FFS gets its patients. So make sure you understand the appropriate level of this expense.

-          Computer Maintenance & Expenses:

Many times we see old practices that haven’t been computerized and this expense is missing completely from their cash flow. With today's technology, it makes absolutely NO sense to operate any business, including a dental practice without computers, software, and other technology. Buyers must determine how much they need to budget for this expense as part of their overhead.

-          Contract Labor/Temp Help:

Many times when a practice pays an associate as an IC, the seller will categorize their compensation to this category. However, they may also use this category for temp assistants, temp hygiene, and maybe other necessary vendors. Sometimes, a professional will eliminate the entire expense assuming it is all associate related. A buyer needs to ask for details, maybe general ledger details, and/or associate 1099s.

-          Insurance:
Many times, professionals fail to adjust (increase) insurance expense for some of the additional insurances that lenders may require to provide a loan to buyers.

-          Office Expense and Supplies:

The industry norm is around 1%-1.5%, many times if its more than that, the professional will reduce this expense to industry norms without any consideration for what the seller may be including in this category. We’ve seen the following expenses coded as office expense and supplies: payroll processing, merchant services, software maintenance and monthly PM software fees, employee expenses like bottled water, telephone expenses, cable/internet, janitorial, dental supplies, repairs & maintenance, etc. Buyers need to see the details and determine if the adjustments the professional made are valid.

-          Office Rent:
This is primarily an issue when the practice owner also owns the space. We see some professionals completely overlook this missing expense or choose a very low rent assuming the buyer will buy the space or include the mortgage payment as the “normal” expense. We believe to maintain separation of the practice value and the value of the real estate, the normalized cash flow MUST include a fair market rent and related expenses that an arms-length tenant would pay. Buyers need to know what the fair market rental rate is, even if they’re buying the space.

-          Repairs and Maintenance:
We’ve seen situations where the seller is very handy and will do their own repairs to equipment and the space or, repairs and maintenance was included in dental supplies of office expenses that have been reduced to industry norms. Unfortunately, everyone can’t be a handyman & therefore, if a seller’s cash flow has very little repairs and maintenance, the buyer needs to understand why and include an amount for this, especially if it’s been eliminated from other categories.

-          Taxes:
If your locality assesses personal property taxes on the value or cost of equipment, many times the assessed value of a seller is very low or nothing. A buyer needs to understand this and determine how much they’ll have to spend due to state or locality regulations.

-          Dental Supplies:
Here’s another category where professionals like to reduce it to “industry norms” without looking at the details to see if they should be doing this. We have seen practices combine their lab expense, office supplies, repairs and maintenance, etc. in dental supplies. For example, many supply vendors will issue their monthly invoices that include dental supplies, repair services and\or contracts, computer services and software and even equipment. Unless sellers are careful to allocate these invoices to the various categories, it winds up in dental supplies. The professionals simply miss this fact and reduce dental supplies to industry norms blindly. Also, if the practice uses a CADCAM/milling  machine this will also explain “higher than normal” dental supplies, so you have to look at this area closely.

-          Lab Expense:
As noted above, we see situations where the professional has lowered dental supplies that include lab to “industry norms” and fail to INCREASE lab expense to an appropriate level. We’ve also seen situations where practices may use an in-house lab or employee, or maybe the doc creates some of their own “stuff” which makes this expense  low for them, however, the buyer may not be making their own cases or choose to use an outside lab they’ve been using.

-          Wages:
 Here’s another area where many professionals fail to look behind the total wages to learn more about who’s getting paid & why. This is why we want to see the W-2s, to see how much is being paid for assistants, hygiene, front desk, and admin. We’ve seen situations where professionals will lower the wages to “industry norms,” then, when we get the W-2s we see they have the cleaning person and/or bookkeeper on payroll. These are expenses the buyer will likely need yet the professional has eliminated them to industry norms.

-          Capital Replacement (replacing old f&e):
Here’s an area where we rarely see professionals ADD expenses to accommodate the need of a buyer to replace old equipment that’s either on its last leg OR is simply too old to even be used in dentistry.

-          Telephone/Utilities/Internet:
While we don’t see many issues with these categories, they should still be looked at for reasonableness…we’ve seen reductions for “estimated” personal cell phone usage that’s too high or reductions for “assumed” home phone or internet connections and we find out they are legit office expenses. We’ve also seen sellers use utilities for all three of these expenses, and the professional will reduce utilities to “industry” norms without looking at the details and asking the seller about them.

As a buyer, you’re getting ready to go on the hook for hundreds of thousands of dollars of debt for a business. Don’t hesitate to ask for details of certain expense categories to see what the seller has been paying or to understand why a professional adjusted them.

You, the buyer, are responsible for doing your due diligence on the business you’re buying, you better know exactly what it is you’re buying. That doesn’t mean you have to go into overkill and stuck in  paralysis by analysis, however, unless you do this sort of work every day, you won’t know what to focus on or what to move beyond.

Hopefully, this serves as a guide to those looking to buy a practice on how to evaluate the overhead of a practice and understand why normalization adjustments were made, if they should have been made and should different adjustments should still be made.

About Tim Lott
Tim Lott, CPA, CVA has decades of experience working with dentists at all stages of their careers. He is a regular speaker at study clubs, societies, and dental schools. Tim is a frequent participant and a moderator on Dentaltown.com. You can reach Tim at tlott@dentalcpas.com or any of the other dental partners/principals at (800) 772-1065 or info@dentalcpas.com. For more blogs, visit our Dental CPAS blog page.  

Why You Need Certain Information for Your Due Diligence – Part II

I decided to write this blog series mainly because of the pushback we get from sellers’ advisors on some of the information we request when representing the buyer. The second items I’ll discuss are the practice management reports for production by provider by ADA code and production by payor.

What’s interesting about the pushback we get on these reports is that we want these reports when we’re representing the seller and assisting them in coming up with an asking price or a value for their practice. We believe we can do a more thorough job for the buyer if we have this information.

Of course, we’ll get the standard response of “it’s in the information we already sent to you. Unfortunately, that’s not correct. Many times what they’ve provided is a summary of the production by category like diagnostic, preventive, restorative, etc. and it’s usually for the entire practice, not by provider. While this might be good information for practice management consultants to get an overview of the practice for their consulting engagements, it’s never enough information for a buyer who needs to understand how the collections are being generated and who’s generating them. We may also get a fee schedule and/or a practice production by ADA code. Again, good information, we just need more.

You see, the buyer is in a different position than the seller. The seller knows what they do; they know what their hygienists do, but guess what, the buyer has no idea. The seller could be performing procedures that the buyer doesn’t perform which could mean the buyer can’t replicate the seller’s collections. Or, maybe the buyer does procedures that the seller doesn’t so there may be some upside potential for the buyer. You can’t determine that without seeing the procedures, ADA code no matter what the practice questionnaire might state.

The other problem we often see is that many practices put the doctors’ exams under hygiene production. So we’re told the hygiene production makes up 40% of the total revenue of the practice when it’s more like 25%, which is closer to normal. Without seeing the detail and taking the seller’s word, the buyer might draw an incorrect conclusion that there’s a lot more dentistry to be done.

The two other aspects of knowing the true production by provider is A) we can evaluate the hygiene production to their wages to see if it falls within industry norms and B) we can better assess “reasonable” compensation for a dentist when performing our price assessment. We see valuation reports that have used incorrect assumptions based on bad PM reporting where practice prices have been overstated because “reasonable” doctor’s compensation has been understated based on dentistry of only 60% of total practice revenue instead of 75%.

The other PM report we ask for, production by payor, shows the total number of PPOs in the patient base. This also becomes important when trying to assess the collections generated by PPOs in which the seller is IN network with and the percentage of patients in PPOs where the seller is OUT of network.

Many of you already know about the Delta Premier issue, where buyers may not be able to retain the Delta Premier fee schedule w/o also participating with the regular PPO and therefore, a buyer won’t be able to replicate the seller’s collections in many cases. However, what many buyers of FFS practices fail to understand is the percentage of patients in a FFS practice that belong to PPOs. The buyer runs the risk of having those patients leave the practice to look for an IN network provider when the seller leaves the practice. The attrition rate is generally known to be higher in a FFS practice for a buyer anyway; if the buyer also knows that 40% of the patients have a PPO, then they need to appreciate that the risk of attrition could be worse.

This report will also be helpful to a buyer who is buying a FFS practice with the intent of potentially joining PPOs in the future, or a buyer of a PPO/FFS mix practice who has the intent of potentially dropping out of some PPOs in the future. It’s very useful information for the buyer and, unfortunately, we get pushback from sellers and their advisors when asking for these reports.

So here are some real life examples of why these reports can be very enlightening for a buyer:

1. I’m in the middle of an assessment right now on an FFS practice where the top ten PPO payors represent about 35% of the practices total production. For the buyer, if they remain FFS, they run the risk of higher than normal attrition as patients may take the opportunity to go to an IN network provider. The buyer is also contemplating joining some PPOs as the practice revenue isn’t very high so they now know what the potential impact could be to the existing patient base and revenue by getting into certain PPOs.
2. As mentioned above, we’ve seen valuation reports calculating reasonable doctor’s compensation for dentistry using a lower doctor collection figure because the doctor’s exams were under the hygiene production column. This has the effect of creating a higher value than would otherwise have created with proper information.
3. We’ve seen other dentistry codes thrown under the hygiene column like crowns, extractions, etc., almost always by mistake. However, with production by provider by ADA code reports we can make the proper adjustments and provide a more accurate picture of practice price and performance for the buyer.
4. We’ve seen situations where practices were labeled FFS when in fact they were a mix FFS/PPO practice and the PPO portion was significant enough that the buyer chose to walk away. We determined this when comparing collections to gross productions were less than 85% of gross production. In FFS practices, collections are generally greater than 90% of gross production.
5. Lastly, we’ve seen production by provider reports that show other doctor providers in the past, like specialists where their revenue wasn’t removed from prior year collections even though their compensation was removed. Needless to say, prior year collections were overstated so that the asking price was way overstated. We would have NEVER known this if we only relied on a tax return and/or P&L collections.

The fact is most practices have the PM software that can generate these reports easily, even if the office has to contact the software company to find out how to generate these reports. There isn’t any reason why sellers and their advisors can’t provide these reports and in our opinion, there isn’t any reason every buyer shouldn’t be asking for these reports.

Written by Tim Lott, CPA, CVA. For more information on our services, please feel free to contact one of the members of the Dental CPA team by calling 844-DENT CPA or emailing info@dentalcpas.com.