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Too Many People Are Naïve About Equity in DSOs. That Creates Risk.
April 11, 2024
By: Maria G. Melone
An Equity position can provide huge opportunities in dentistry.
To start, the growth rate of a dental group is almost always going to be greater than what a clinician can accomplish individually — mainly due to access to capital.
Additionally, the knowledge base within larger groups offers another growth advantage. Building a business individually means all responsibilities fall on you. Larger groups, however, have resource teams and specialists in various disciplines necessary for growth. One example: human resources for benefits administration, people management, and recruitment.
Larger groups also have sophisticated financial advisors, CFOs, and controllers. For growing groups, limited access to capital puts pressure on hiring skilled personnel. They often face a choice: run lean with more profit but fewer personnel resources, or invest in the right personnel resources to support future growth, which may temporarily reduce profitability.
However, most people don’t fully understand equity in the dental industry. This creates risk.
When DSOs first began forming, there was almost no equity opportunity for selling doctors. But a dramatic shift occurred, starting in the early 2010s, as private equity investors and larger companies realized that providing equity was one way to align with providers.
The shift has been significant, but generally, most sellers still don't spend much time understanding equity. Part of this is their naivete with the subject matter, but it's also due to advisors who lack experience with rolled equity provisions and can’t provide proper guidance.
To understand the basics, start with this guide by Pulse Equity.
Pulse is an equity management platform focused on dental and medical practices. People need to understand how their behaviors and influence impact their organization's value and how this translates to their individual equity positions. This connection is often not well articulated or understood. Tools like Pulse can help.
Additionally, tracking and understanding equity positions becomes critical as more DSOs shift towards equity roles or smaller groups seek rapid growth beyond what bank financing allows. Offering equity, instead of higher acquisition payments, is a strategy larger groups use that smaller ones might adopt. Tools that provide clarity and illuminate the impact of equity when offering positions to others are valuable in making informed decisions and fostering growth.
Most dental sellers focus on their transaction's multiple.
However, in today's transaction structures, the multiple is just one important element. Equally important is the EBITDA figure the multiple is applied to, and the other deal terms, many which have economic consequences.
Up until about the middle of 2023, many transactions were structured so that the seller received 80% cash and was required to roll 20% equity. Due to various macroeconomic factors, there's been a big shift. Sellers might only get 50 or 60% cash and have to roll a significantly larger portion of equity.
This changes the risk-reward structure of the deal. Consequently, the conditions and terms around the equity roll, as well as the historical performance of the operator, the DSO, and the backing private equity firm, become even more important.
Understanding where your equity is held is vital.
Buyers, dental groups, and private equity firms structure this differently, but the two basic options are holding equity at your individual office level or at the top Holdco level.
Holding equity at the individual office level means you benefit only from the performance of your individual office. Conversely, holding equity at the HoldCo level allows you to benefit from the performance of all offices under that umbrella, effectively diversifying and diluting your risk across more entities rather than placing all the pressure on your individual office's performance.
Moreover, if you hold equity at your office level, you are typically entitled to annual profit share distributions proportional to your ownership position. For example, if you have a 10% equity ownership in your office, you would receive 10% of the profit each year.
On the other hand, when your equity is at the HoldCo level, the strategy often involves reinvesting all profits back into the business to foster growth. Consequently, you might not receive annual distributions, but your equity value should increase as the business grows.
Equity in DSOs presents a powerful avenue for growth and expansion.
But its complexities require a thorough understanding and strategic approach.
Sellers and prospective owners must recognize not just the immediate benefits of expanded capital access and shared resources that larger groups offer, but also the longer-term risk and reward inherent in these transactions.
Navigating this landscape with the right tools and information can help people make decisions that better align with their long-term goals.
About the Author: Maria G. Melone is a recognized thought leader, published author, and speaker with a long history of mentoring, supervising, and developing teams. She has helped facilitate hundreds of transactions and has valued even more. She has extensive dental industry knowledge and a proven ability to analyze markets, operations, and growth opportunities. Currently serving as a managing director at Caber Hill Advisors, Maria represents clients in the dental industry who are transacting with institutional investors or strategic partners.
