Evaluating DSO Deal Structures

When considering a DSO sale or partnership, practice owners face the exciting yet complex opportunity to maximize the culmination of their life’s work. Achieving the best outcome requires identifying the right partner for your practice, negotiating the highest price, and selecting the optimal deal structure. In fact, the deal structure carries more weight than the initial valuation when examining the transaction’s global economic impact. These objectives require education on the available options, which is best accomplished by working with a specialized sell-side advisor who can bring the right DSOs to the table and explain and negotiate the intricacies of each offer. While every objective is critical, selecting the optimal deal structure is the most complex and consequential, but is often the least emphasized and least understood aspect of a DSO affiliation. In this article, we unpack the most common DSO deal structures.

Before diving into specific structures, let’s cover several concepts that apply to any deal:

• Valuation Metrics. Most modern DSOs value practices based on a multiple of EBITDA (the net cash flow of the practice after all overhead is paid, including paying the owner and associate doctors a fair market wage) rather than the traditional method of applying a percentage of annual collections or a multiple of net cash flow before owner compensation. DSO valuations are often significantly higher than doctor-to-doctor valuations, sometimes by as much as 300%.
• Holdback/Earnout & Earn-up. A holdback/earnout is a percentage of the base purchase price that is withheld at close and paid over a multi-year timeframe, predicated on the owner doctor fulfilling his or her post-closing employment obligation (if any) and maintaining the annual revenue and/or EBITDA at the pre-close level during the holdback period. While an earnout does not require post-closing revenue or EBITDA growth, an earn-up (a bonus payment above and beyond the base purchase price) is designed to reward the seller for growing revenue or EBITDA to a defined benchmark within a set timeframe following closing.
• Recapitalization Event (Recap). A recap occurs when a controlling stake in a DSO is sold to a new owner, typically transitioning from one private equity firm to another. Generally, the goal of a DSO (or any private equity-backed company) is to grow and increase its value and ultimately sell in a successful recap that delivers attractive investment returns for the private equity firm, its investors, and the partner doctors. At the point of sale, the DSO’s financial sponsor changes, while the DSO’s name, brand, culture, infrastructure, and management team typically remains intact.

Conventional Deal Structure (full buyout with holdback and no equity)

Selling 100% of your practice with a holdback (but no equity in the practice or DSO) is a traditional deal structure that was conceptualized by a couple of legacy DSOs years ago and is sometimes used today by smaller regional DSOs focused on acquiring smaller practices where the selling doctor is not planning to stay on long-term. In this model, you sell your entire practice to the DSO for a combination of 70-90% cash at closing and a holdback/earnout for the remaining 10-30% of the practice value.

Pros

• Best suited as a succession planning tool when the selling dentist is not staying at the practice long-term
• Maximizes cash at close
• Maximizes the ability to de-risk
• Seller is not exposed to risk related to the performance or growth of the practice or DSO (beyond hitting post-closing benchmarks tied to any holdback/earnout)
• May involve lesser commitments for chairside production, management, and post-closing employment

Cons

• Lower valuation relative to more modern deal structures
• No retained equity in the practice results in no ongoing EBITDA distributions or upside associated with the post-closing performance or growth of the practice
• No equity in the DSO eliminates any arbitrage opportunity associated with the post-closing growth of the DSO
• The selling doctor participates as an employee rather than an equity partner

Joint Venture or JV Deal Structure (partnership with practice-level equity)

In this scenario, the practice owner and DSO enter a partnership transaction in which the DSO purchases 51-80% of the practice’s equity, and the practice owner retains 20-49% (often around 40%), referred to as joint venture (JV) equity. The newly created joint venture entity owns the practice and pays all expenses. Thus, as partners, the DSO and the partner dentist share pro rata in all expenses and profits, which are distributed to the partners each month or quarter after all expenses are paid.

In exchange for the support services provided by the DSO (accounting/bookkeeping, payroll, payables, negotiating with payors and vendors, HR, recruiting, and more), the DSO charges the joint venture entity a management fee (typically 5-9% of revenue, though some DSOs will cap the management fee for large practices). The management fee is a shared expense, as neither partner takes their distribution until all expenses have been paid. The partner doctor will also enter into a multi-year employment agreement (typically 5 years if maximizing valuation) at a fair-market compensation rate. That said, most DSOs do not require their partner doctors to work chairside, so long as they backfill their production responsibilities with competent associate doctors, thereby providing partner doctors with far more autonomy in managing their chairside schedules.

When the DSO reaches a recapitalization event, the partner dentist can liquidate some or all of their JV equity at a significantly higher valuation than the practice’s valuation at the initial sale. Often, you can sell up to half of your retained JV equity at the first recap event following closing, with the ability to sell additional JV equity at subsequent recap events (usually down to a floor amount of 10-20%, which will eventually be sold to another doctor when the owner is ready to divest themselves of all equity). Typically, you are selling the JV equity at the EBITDA multiple at which the DSO is trading, generally 12-15X EBITDA. The multiple is applied to the practice-level EBITDA, either before or after the management fee is deducted, which is an important detail to consider when comparing offers.

As a simple illustration, if a dentist sells a majority ownership interest in their practice to a DSO at a 7X EBITDA valuation for their individual practice, and a few years later the DSO recaps at a parent company multiple of 14X EBITDA, the partner dentist doubles their money on the amount of JV equity liquidated at the recap event. Further, if the practice’s EBITDA has grown between closing and the recap event, the partner dentist will see their return on the liquidated JV equity increase exponentially at recap.

Pros

• Best suited for dentists with a long runway to exit (many younger practice owners naturally gravitate to the JV model)
• Take meaningful chips off the table while retaining significant equity upside
• Ongoing EBITDA distributions allow you to maintain a higher level of annual personal income
• Ability to liquidate JV equity at attractive returns at recap events
• Share directly in the profit, growth, and future value of the practice
• The selling doctor becomes a true partner with retained ownership

Cons

• Retained JV equity lowers cash at close
• Profit distributions are burdened by the management fee
• Because the equity lies at the practice level, you do not benefit as directly from the growth of the DSO
• If problems arise elsewhere in the DSO’s portfolio, this will impact the parent company EBITDA multiple at which you can sell your JV equity

Holding Company or Hold Co Deal Structure (partnership with parent company equity)

In a holding company deal structure, the practice owner and DSO enter into a partnership transaction in which the DSO buys 100% of the practice, with 65-90% in cash and 10-35% in stock in the DSO’s holding company. Unlike JV equity, holding company equity typically does not pay distributions or dividends but offers greater upside and fewer limitations on how much equity can be liquidated at recap events. This scenario is similar to owning stock in Tesla or Amazon. The stock is issued to you at the current share price, and as the DSO’s parent company grows, your shares’ price increases. You share in the upside of all the current and future practices of the growing DSO. The partner doctor will also enter into a multi-year employment agreement (typically five years to maximize demand and valuation) at a fair market compensation rate (30% of collections for general dentists and 32-40% for specialists).

You can often liquidate up to half of your Hold Co equity at your initial recap following closing and divest your remaining equity at future recaps, with your return on invested capital being influenced by how much the DSO grows in size and value from the inception of your partnership to the DSO’s next recap event. For example, if your stock is issued at $1.00 a share and the DSO later recaps at $3.00 a share, you triple your money. As with any investment, there is a continuum of risk and reward. Joining a smaller, more rapidly growing DSO entails greater risk and greater upside than joining a larger, more established group.

The timing of your stock delivery is also key. Receiving stock shortly before a recap will produce a faster payout and a lower return, whereas receiving stock well in advance of a recap will produce a longer payout and a higher return. Because you will typically liquidate your Hold Co stock over multiple recaps, you can also benefit from the power of compounding. As a simple illustration, if your equity increases in value from $1 at close to $3 (3X) at the first recap, you re-roll all $3 into the next recap cycle, and the equity increases to $6 (2X) at the second recap, your compounded return is six times your initial investment.

Pros

• Best suited for dentists committed to practicing long-term who prefer the upside of the DSO over the upside of their individual practice
• Take meaningful chips off the table while retaining significant equity upside
• Ability to liquidate Hold Co equity at attractive returns at recap events
• Share directly in the profit, growth, and future value of the DSO
• You participate as a partner with a stake in the broader organization

Cons

• Holding company equity lowers cash at close
• Because your equity lies at the DSO level rather than the practice level, you do not share as directly in the growth of your own practice
• If problems arise elsewhere in the DSO’s portfolio, it will directly impact the investment returns on your Hold Co equity

Hybrid Model (partnership with practice level equity and parent company equity)

Under the hybrid deal structure, you typically receive 60-70% cash at closing, with the equity component split between JV equity (typically 15-20%) and holding company equity (typically 15-20%). For example, a 60%/40% JV hybrid deal structure would result in 60% cash at closing, 20% JV equity, and 20% holding company equity. In this model, you have the benefit of diversification by owning stock in two different companies (both your practice and the DSO’s parent company), and all of the pros and cons above apply.

Rollups

This concept attempts to bundle many individual practices into a “group” and market the collective to financial buyers (PE firms) and strategic buyers (existing DSOs). The organizer charges substantial upfront and/or ongoing fees (unlike traditional sell-side advisors, who charge only a commission at closing) and also charges an above-market transaction fee if a sale ultimately closes. The theory is that a group of practices is worth a higher EBITDA multiple to a potential buyer than the practices would trade for if sold individually. However, organizers who have attempted this concept have been largely, if not entirely, unsuccessful for several key reasons.

PE firms and DSOs view buying a bundle of unintegrated or “loosely affiliated” practices as an operational headache with major risks, including a messy integration that will cause significant EBITDA erosion. The integration risks are even greater if the collective spans multiple geographic markets and/or includes multiple practice types or specialties. Further risk comes from the difficulty of getting and keeping numerous independent practice owners on the same page in selecting a buyer, agreeing on price, and settling on a deal structure. Many individual owners grow tired of paying fees while they wait for a unicorn deal to materialize, and thus drop out over time, further reducing the appeal to potential buyers. DSOs typically avoid rollups and collectives altogether or offer to buy only a cherry-picked subset of the practices at a multiple that does not justify the extra fees.

In Closing

While understanding the intricacies of DSO deal structures is complex and critically important to maximizing your outcome in a sale, you also have to consider your WHY, focus on finding the right DSO partner for your practice, and create a competitive environment for your practice among multiple bidders to ensure you receive the highest valuation possible.

If you are planning to pursue a DSO affiliation at some point in the future, we encourage you to schedule a Discovery Call with our team at McLerran & Associates to get educated on the multitude of options available in today’s marketplace and chart a course to achieving your goals. You can reach our office at 512-900-7989 or info@dentaltransitions.com.