The Business Terms Every Dentist Should Know Before Buying a Practice

All humans are entrepreneurs not because they should start companies but because the will to create is encoded in human DNA. — Reid Hoffman, LinkedIn cofounder

Before you can talk to a broker, attorney, CPA, or lender on equal footing, you need to speak their language. Here are the terms that matter most when evaluating a dental practice purchase.

Overhead. Overhead is all of the costs associated with operating the dental office, not including debt service. This is the calculation that consultants use when they talk about overhead being around 60 percent. If you had no debt, you would be taking home 40 percent of the practice gross before taxes.

Fixed versus variable expenses. Fixed expenses do not vary with the volume of dentistry and are present even if no dentistry is produced. Examples include rent and most employee salaries. Variable expenses change with the volume of dentistry you are doing. Examples include supplies and lab expenses.

Opportunity cost. Opportunity costs are the benefits you could have received by taking an alternative course of action — the difference between the return from a chosen investment and one that is passed up.

Asset. Assets are future economic benefits to a business. An asset can be tangible or intangible and is a valuable resource to the company that controls it.

Liability. A liability is an obligation of a business. A company typically settles liabilities by transferring assets, usually using cash.

Owner’s equity. Owner’s equity is the owner’s claim on the assets of a business. The formula: owner’s equity = assets – liabilities.

Balance sheet. The balance sheet summarizes the assets, liabilities, and owner’s equity of a company.

Income statement. Income statements summarize the revenues and expenses of a company for a period of time.

Cash flow statement. The cash flow statement is a financial statement that shows how the income for a certain period, and changes in the balance sheet accounts, affect cash on hand. It is broken down into operating, investing, and financing activities.

Lease. A lease is a contractual arrangement between two parties that allows one party, the lessee, the right to use an asset in exchange for making payments to its owner, the lessor.

Fair market value. Fair market value is defined as the price, in cash or equivalent, that a buyer could reasonably expect to pay, and that a seller could reasonably expect to accept, for the assets of a practice placed for sale on the open market for a reasonable period of time, with the buyer and seller each being in possession of all the pertinent facts and neither being under compulsion to act.

EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA is the cash flow available for debt service — the cash flow that would be available if you were to make an all-cash purchase. For an investor, EBITDA would be the practice overhead plus the compensation of the dentists (including you at 30 percent of your personal production) subtracted from gross collections:

Gross collections – (practice overhead + 30 percent of the dentists’ collections) = EBITDA

Including the cost of dentists performing work at 30 percent of their personal production lowers EBITDA significantly. A relatively high EBITDA is what attracts so many private equity groups into the dental industry. It’s also worth remembering that depreciation is a real factor in dentistry — equipment wears out and has to be replaced. Over the long term, there is a close correlation between capital expenditures and depreciation of hard assets.

Return on investment (ROI). ROI is the benefit, or increase in value, of an investment divided by the cost of the investment.

Cost of capital. Cost of capital is the minimum return that you, as an investor, expect in return for providing the capital (money) to the practice. Your cost of capital is the cost of the debt (the interest rate of your debt) plus an additional return to pay you for the risk you take on by buying the practice. A risk-free investment would be a ten-year US government treasury bond. If your cost of debt is 7 percent, you will need an additional return to pay the principal on the debt and to cover your risk. You can use your determined cost of capital as a discount rate to calculate the value of the business today. If an investment’s return exceeds your cost of capital, it is a good investment and adds value to your practice.

Capitalization rate. The capitalization rate, or cap rate, is often used in commercial real estate. It is the ratio of net operating income (NOI) to the asset value. NOI tells you the annual income available to an investor after subtracting all expenses associated with the operation of the business — it does not take into account any finance costs, debt service, taxes, or depreciation. When valuing a dental practice, NOI – (your 30 percent of personal production) = EBITDA. The cap rate, then, is the ratio of calculated EBITDA to the purchase price — the rate of return you receive for an all-cash purchase, today, after compensating yourself for your work in the practice. Capitalization rates vary by industry; in dentistry the cap rate ranges from 18 to 35 percent.

Discounted cash flow rate of return. Used in a discounted cash-flow analysis to determine the present value of future cash flows.

Capitalization of earnings. A method of determining the value of a business by calculating the net present value of expected future cash flows. A detailed appraisal will take into account expected inflation and steady growth. The formula: value of the practice = future cash flows / (d – g), where d = discount rate and g = growth rate.

What, then, is the difference between a cap rate and a discount rate? A cap rate is usually for just one year, whereas a discount rate takes several years into consideration and includes expected inflation and growth.

The three valuation approaches. Dental practice appraisers use three approaches for valuing a dental business: the asset value approach, the market approach, and the income approach.

• The asset value approach is used when there is zero or insignificant cash flow associated with a practice. Under this approach, the value of the physical assets is what is taken into consideration.
• The market approach uses historical data of sales for similar practices at comparable locations — this is why you hear price-to-gross ratios thrown around a lot. The price-to-gross ratio usually ranges from 60 to 80 percent. There are limits to what a dentist can, or would, pay and what a lender will lend, but when the market approach is used, the price could be a little higher, or lower, than the income approach would justify.
• The income approach is based on cash flow and how much a buyer can afford to pay and still be compensated fairly (that is, 30 percent of his or her personal collections). This number is determined using discounted cash flows or capitalization of earnings — and this is where you want to place your focus. The cash flow is typically normalized by adding back things like the seller’s car payments, depreciation, and other expenses that a buyer will not have to pay.

There are practices for which the market approach drives the price lower than the income approach would suggest. The practice might be in a rural area that few dentists have heard of, or in which few would consider practicing. Or the gross revenues might have decreased over the last few years because the retiring dentist is slowing down. Downward-sloping numbers usually drive the price down even when there is a legitimate reason for it. Sometimes, when the market approach rules the evaluation, you might find you can make 50 or 60 percent of your personal production. Some owner dentists make over 100 percent of their personal production when there are associate dentists present — a very safe bet for you and the bank!

Next up: in Part 3, we benchmark what an “average” dental practice actually looks like, so you know what’s normal and what’s a red flag.  Part 1 is here.