Valuation nuances in today’s changing marketplace

Maria G. Melone, CPA, CVA
Brian D. Tortolano, CPA

Valuation nomenclature has changed over the years. Historically, practice values were referred to as a percentage of collections, but today’s most common reference point is a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). What is behind this shift? Group practice, meaning multiple doctors in multiple locations practicing together, has always been present in the industry, but in the mid- to late ’90s, we began to see entrepreneurial dentists and businesspeople shift to an investor perspective of owning and running a dental practice. Purchasing or managing a practice was becoming more challenging for young doctors, with their ever-increasing debt loads and the increased complexity of running a dental practice. Sophisticated investors entered the dental space because of its recession-resistant nature and the huge opportunity for consolidation.

Traditionally, a solo practitioner thought of earnings as the total earnings from the business in a given year. The reality, however, was that a portion of those earnings was compensation for the doctor providing clinical care, and a portion represented profit generated from the business. Historically, valuations largely considered the total earnings of the owner, whereas investors focus on the profits of the business as a basis for valuation. Further, investors consider the actual cash flow of the practice on a debt-free basis as the best predictor of their return on investment. This has led to the focus on EBITDA as a measure of a dental practice’s performance, and this is how most other businesses are valued.

What is the right multiple? There is no easy answer to that question because the multiple is meant to assess the opportunity of the investment and its relative riskiness, as well as provide a reasonable rate of return for the investor. Multiples in the industry range from two to 18 times—quite a range! There are many factors that influence multiples, including the following (in no particular order): location, trained staff, stable or growing revenue stream, type of revenue (e.g., fee-for-service, PPO, DHMO), Medicaid, condition of the facility, mix of services, patient demographics, and profitability. Here are some general rules of thumb for thinking about your practice value in terms of a multiple:

• Solo practitioner: 3–4 times


• Multidoctor practice: 4–5 times


• Multilocation, multidoctor practice: 5–6 times


• Group practice with management infrastructure and scalability: 6-plus times

For group practices, the most significant influence on the multiple is historical growth, in addition to having a pipeline of future growth. The largest reported multiple to date was for a company that had a developed management team with a defined model for delivering financial results, a history of growth, and a developed pipeline for continued growth. It is also important to recognize that the higher multiples are applied to those businesses that have a qualified management team in place to support continued growth and ensure replicable earnings, as well as documented policies and procedures to scale the business.

Business owners often focus exclusively on the multiple and don’t recognize that equally as important as the multiple is the number the multiple is being applied to—the EBITDA. The traditional valuation of a solo practitioner’s office is based on historical performance of the business as a predictor of future performance. The typical adjustments applied to the historical financials are to bring owner compensation to fair market value and for nonrecurring and discretionary expenses. In contrast, the valuation of a group practice is typically done on a prospective basis, which involves forecasting the performance of the business, in addition to making adjustments for owner compensation, nonrecurring expenses, and discretionary expenses. The purpose of forecasting for group practices is to help a prospective investor see the true investment opportunity, which may not be reflected in the historical financial performance. For example, if a group acquired a practice partway through a given year, the historical financials only reflect that partial additional impact on revenue and EBITDA. The EBITDA adjustment in this example is to show the prospective investor the impact of the acquisition for a full year.

The other nuance in today’s marketplace is the different perspective on earnings from different types of buyers. A private equity firm is generally looking to make an investment in a business or partner with the founder of the business and therefore will want to keep all members of the management team in place. Private equity firms don’t have management teams in place that they are able to deploy to operate the business and drive performance. However, they may make a downward EBITDA adjustment if they feel additional management team members are needed to continue to grow and support the business.

Conversely, strategic buyers—those who have existing group practices and experience in the industry—may make upward EBITDA adjustments for synergies, including duplicative management team members or third-party vendors, more favorable lab and supply contracts, and more favorable payer contracts. Generally speaking, a private equity firm will likely pay a higher multiple but on a lower EBITDA, whereas a strategic buyer will likely pay a lower multiple on a higher EBITDA.

If you are considering a transition, aside from the valuation of your business, it is critical to understand the other terms necessary to close a transaction. In many cases, there are legal provisions that can have significant economic consequences and therefore should be considered when looking at the “value” of the business. Using an advisor who specializes in the dental industry and transactions in particular will ensure that you negotiate the best price and transaction terms for your given situation.