Planning a Successful Dental Practice Transition
A dentist looking to transition in or out of any dental practice needs to formulate a plan with a team of experienced advisors and advocates.
by Gil Breiman and Benjamin Caldwell
If you are like many other dentists, you entered dentistry out of a desire to master clinical competence and enhance patient care while making a comfortable livelihood for you and your family along the way. What did not likely cross your mind when applying to dental school, however, was the prospect of owning a business, managing the day-to-day intricacies of running that business, and ensuring it stays in the black.
Many dentists, both young and old, treat the often unavoidable business component of their dental practice as a side nuisance and delegate most business responsibilities to an office manager or an accountant. While this may prove satisfactory during the time you own or co-own your practice, much more proactive planning is required during the crucial transition stage of entering or exiting a practice.
Transitioning into a dental practice as a young professional or transitioning out as a veteran practitioner both represent professional milestones that, unfortunately, are often extremely stressful given their inherent financial and professional importance. Fortunately, the anxiety that stems from a professional transition can be minimized by adequate planning, prioritizing your professional and economic goals, and educating yourself about what the process of transitioning entails, resulting in a successful and rewarding transition.
Demystifying the valuation process
The initial step in preparing an exit strategy is to divorce your emotional attachment to a practice and focus on the threshold objective of obtaining an accurate valuation of the practice. This is not unlike separating yourself from the emotional attachment you have to a home you are about to sell.
A proper valuation of a practice will include an appraisal which, in turn, will help determine what transition options are available to the exiting dentist. Of principal concern is whether an outright sale of the practice makes the most sense, or whether financial considerations and/or desirability to continue working encourage a leveraged recapitalization or a “earn out” offer, which includes a cash contingency. Obtaining an appraisal and having a financier with knowledge of financing dental practices engaged early on will allow a potential seller to compare his or her practice with other similar practices involved in transitions and provide suggestions on how to enhance the desirability of the practice and how best to structure the financing for such a proposed transition and ongoing operations.
What makes a practice valuable is often surprising to many dentists. While hard assets are easy to quantify, the majority of a practice’s value comes from its ability to generate a long-term income stream to a buyer. This ability is commonly coined as a practice’s “goodwill,” but what does that encompass? The current patients who have active appointments, referring dentists, or a combination of the two are often the single most significant asset a practice has from a prospective buyer's point of view and form the largest component of a practice’s goodwill. When this is coupled with the value of the staff members who would remain with the practice during and following the transition, the practice’s goodwill can normally be quantified. Knowing the goodwill of a practice, both as buyer and seller, is critical to assisting in the valuation process and in obtaining the appropriate financing for the transaction.
More than one way to structure a successful transition
There is more than one way to structure and effect a successful dental practice transition. Much of it depends on the special circumstances of each transition. An important threshold consideration for both buyer and seller is whether there is a preference to enter into an internal or external transition and whether the seller is planning to remain actively involved in the practice post transition. An “internal” transition, as the name implies, involves a transition to someone already working in the practice. Usually, this involves a younger associate, previously hired into the practice for a “trial” period, buying into a portion of the equity of the practice. At some point, the balance of the equity transitions to the younger dentist and the older dentist then retires or continues to work as a part-time or full-time employee of the practice.
The upside to this type of transition is that it is a gradual process that weeds out much of the uncertainty accompanied with other types of transitions. It also allows the outgoing dentist to better ensure that the practice is being transitioned to someone he or she is comfortable with and respects as a fellow practitioner. While the structure of internal transitions have many variations, negotiations and contractual arrangements for the first and final purchase of the practice often occur when the younger dentist first buys into the practice.
In situations where the seller and buyer intend to be partners for a period of time pending the final sale, important considerations arise in negotiating the final sale of the practice and the partnership arrangements between the parties while both dentists own a portion of the practice. Examples of items to address include:
- The formula used to calculate the subsequent purchase and its effect on the operations of the dental practice and the relationship of the dentists while they still work together.
- Important events and changes in circumstances, such as effects of disability, death, breach of partnership agreement, bankruptcy, and other financial distress as well as engaging an insurance broker /specialists to address some of these issues.
- Determining schedules and expectations of working time for each partner and whether work for other practices or other commitments such as teaching engagements are involved and allowed.
- Determining the budget for the practice.
- Allocating expenses for operations of the business among the partners and purchasing and replacing equipment.
- Allocating new patients.
- Hiring and firing of employees and other decisions related to staff.
- Restrictions related to further transfer of equity interest, noncompete, and nonsolicitation issues.
If an internal transition is either undesirable or not feasible, then a selling dentist can utilize an “external” transition to individuals and/or entities outside the practice. This typically involves a sale of the practice to another dentist, practice group, or consolidated health-care entity. Ideally, a detailed plan for an external transition should be planned in advance. This will, in turn, allow the selling dentist adequate time to create a practice profile (i.e., a packet containing financial and demographic information about the practice) for earnest buyers who have signed a confidentiality agreement, and to hold the practice out for sale. Unlike an internal transition, most of the contractual documents will be created and negotiated only after an earnest buyer concludes due diligence and makes an offer.
Don’t forget the tax man
While the tax rate is out of one’s control, the allocation of the purchase price is a decision that, if negotiated correctly, could save a buyer or a seller a significant amount of money in taxes during a transition. The parties need to analyze whether the appropriate sale should be an equity sale (purchase of the equity of the practice) or an asset sale (purchase of the assets of the practice). There are important legal considerations and implications between these two transactions which are outside the scope of this article.
In general, in an equity sale, the seller often realizes long-term capital gain on the shares he or she held in the practice for over a year, but the buyer does not get the benefits of depreciation of the assets or a step-up basis in them as a result of the sale of specific assets. If the parties utilize an asset sale, the parties allocate the purchase price to the various assets of the practice. One significant allocation is for the goodwill of the practice which is taxed for the seller at the long-term capital gains rate as opposed to ordinary income. A buyer can generally amortize this amount over 15 years. With regard to the personal assets of the practice (i.e., dental equipment, furnishings, computer equipment, etc.), the seller is subject to ordinary income taxes on the difference between the amount paid and the basis in those assets, and the buyer enjoys a faster depreciation schedule for equipment sold with a step-up basis in those assets.
Where to go from here
If there is one takeaway point to be had, it is that a dentist looking to transition in or out of any dental practice needs to formulate a plan with a team of experienced advisors and advocates who can help the dentist identify and understand the contractual matters and operational issues associated with a transition and to avoid potential operational, financial, legal, and tax pitfalls. This team of advisors would often include a financier, consultant, appraiser, attorney, and a CPA with experience handling dental practice transitions. Professional planning is critical to ensure that the buyer purchases a stable, long-term practice, and that the seller is provided with lifetime spending needs.
Gil Breiman is a partner in Burns & Levinson’s Corporate, International and Securities Law Groups. He can be reached at firstname.lastname@example.org. Coauthor Caldwell is an associate at Burns & Levinson.
Benjamin Caldwell is an associate in Burns & Levinson’s Business Litigation and Trusts & Estates Groups. He can be reached at email@example.com.