Key Takeaways
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DSO buyers run detailed quality-of-earnings reviews that can reduce purchase price when financials are weak or poorly documented.
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Preparing a diligence-ready adjusted-EBITDA package before the LOI can protect valuation and lower the risk of renegotiation.
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Key steps include compiling 36 months of monthly P&Ls, normalizing owner compensation, documenting add-backs, reconciling AR, and building a footnoted EBITDA bridge.
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Well-prepared financials can support transaction success rates in the 85–90% range and help maintain agreed valuation multiples through due diligence.
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McLerran & Associates provides CPA-led financial preparation to help sellers build packages that withstand buyer scrutiny, so you can schedule a free, confidential discovery call to get started.
Why Owners Lose Ground Before the Letter of Intent
The letter of intent (LOI), which states the proposed purchase price and deal structure, marks the starting point for due diligence, not the finish line. Healthcare practice acquisitions can fail at a rate of 30 to 40 percent during due diligence, often because financial records do not hold up under buyer review rather than because the practice itself is weak.
Institutional buyers can reduce purchase prices during post-LOI quality-of-earnings audits when practices have not pre-normalized EBITDA, even if they previously agreed to strong multiples at the LOI stage. A practice owner who enters diligence with undocumented add-backs, unreconciled AR, or an unsupported owner-compensation adjustment effectively hands the buyer a lever to renegotiate.
This risk is largely preventable. The practical solution is to complete the financial work before the deal goes to market, not after the LOI arrives.
Essential Financial Terms for Dental Sellers
Several core definitions can help clarify how buyers evaluate your practice.
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EBITDA refers to Earnings Before Interest, Taxes, Depreciation, and Amortization. It serves as the starting measure of a practice’s operating profit, calculated by taking net income and adding back those four non-operating or non-cash items.
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Adjusted EBITDA means EBITDA that has been further normalized to remove owner-specific, non-recurring, or personal expenses, so the figure reflects what the practice might earn under new ownership. DSO buyers typically multiply this number to set a purchase price.
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Quality of Earnings (QoE) describes an independent financial review, usually commissioned by the buyer, that tests whether the seller’s adjusted EBITDA is accurate, sustainable, and defensible. A QoE report differs from a financial audit because it evaluates whether underlying earnings are sustainable after a transaction closes, not just whether statements follow accounting rules.
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Add-back means a specific expense or income item removed from, or added to, the P&L to normalize earnings. Each add-back must be clearly documented and defensible.
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Letter of Intent (LOI) refers to a non-binding document that outlines the proposed purchase price, deal structure, and key terms before formal due diligence begins.
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Earnout is a portion of the purchase price paid after closing, based on the practice meeting agreed performance targets.
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Equity rollover describes the portion of deal proceeds paid in DSO equity (stock) rather than cash at close. Up to 40% of a DSO deal can be structured this way.
For solo practices, the adjusted-EBITDA calculation usually centers on a single owner’s compensation and personal expenses. Multi-location or multi-doctor practices need separate normalization analysis for each clinician, and specialist practices such as oral surgery, orthodontics, or pediatric dentistry can face different compensation benchmarks and buyer expectations than general dentistry practices.
The 8-Step Checklist for a Diligence-Ready Adjusted-EBITDA Package
Step 1: Compile 36 Months of Monthly P&L Statements
Three years of financial statements give buyers a clearer view of growth, stability, or decline than a single year. Monthly detail, not just annual summaries, helps identify seasonality, unusual spikes, and one-time events that require explanation or add-back treatment.
Tax returns should match the practice’s internal financial statements during DSO buyer diligence, because buyers routinely compare filed returns with provided statements. Unexplained gaps between the two can create skepticism and slow the process.
DSO vs. private-buyer note: DSO buyers typically require accrual-basis monthly P&Ls. Cash-basis accounting can distort period comparisons, and unreconciled AR balances are one of the most common deal-killers in dental practice due diligence. Private buyers and their SBA lenders also request 3 years of signed tax returns before underwriting.
Step 2: Normalize Owner Compensation
Owner compensation often becomes the single largest EBITDA add-back in a dental practice sale. Normalizing owner compensation usually follows two steps. First, add back the full owner compensation, including W-2 salary, benefits, and payroll taxes. Second, subtract the market-rate cost to replace the owner’s clinical production.
Consider a dentist who paid themselves $700,000 annually while the market rate for the clinical role is $350,000. The $350,000 excess becomes an add-back because it reflects an owner-specific decision that likely will not continue under new ownership. The adjustment can also move in the opposite direction. If an owner takes modest compensation but works 4 clinical days per week and a market-rate associate would cost more, the shortfall becomes a negative EBITDA adjustment during normalization.
Supporting documentation can include W-2s, K-1s, owner distributions, payroll records, and compensation survey references for the relevant clinical role and geography.
Step 3: Document Every Add-Back with Clear Evidence
Hard add-backs, which buyers rarely challenge during QoE, often include depreciation and amortization, one-time expenses such as litigation costs or buildout expenses with proof that they will not recur, and debt service on loans that will be retired at closing.
Common discretionary and personal add-backs that usually require stronger documentation include:
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Personal vehicles expensed through the practice
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Owner-specific continuing education and seminar costs
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Meals, entertainment, and non-essential travel
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Owner life insurance premiums
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Excess retirement contributions above staff-plan match
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Charitable contributions
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Family member payroll above market rate for actual work performed
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One-time consulting or legal fees with documentation of non-recurrence
Well-documented add-backs with clear supporting evidence are more likely to be accepted by a buyer’s quality-of-earnings team. Poorly documented add-backs may be accepted at only 30% to 50% of their value or rejected entirely.
Step 4: Reconcile Production and Collections by Provider
Production and collections data work best when organized by provider and service line. An anonymized provider roster can list role, hire date, compensation structure, and provider-by-provider production, with any provider responsible for 35% or more of collections clearly flagged.
Practices where the founding dentist generates more than 90% of total production can face owner-dependence discounts in dental-practice valuations. Separately documenting associate and hygiene production helps show that the practice’s revenue does not rely entirely on the selling owner.
DSO vs. private-buyer note: DSO buyers often apply algorithmic scrutiny to CDT code patterns and use auditing software to flag coding anomalies before signing the LOI. Private buyers tend to focus more on total production trends and collection efficiency.
Step 5: Clean AR Aging and Review Payer Mix
Accounts receivable (AR) aging, which shows how long outstanding patient and insurance balances have been unpaid, is usually one of the first documents a buyer requests. DSO underwriting teams often expect AR aging reports showing at least 90% of balances under 60 days, monthly credit balance reconciliation, and current unclaimed property filings to avoid purchase price reductions or escrow holdbacks.
Payer-mix analysis, which breaks down revenue by insurance type, fee-for-service, and government programs, can be equally influential. High government payer concentration can suppress valuation multiples and narrow the buyer pool. Phantom PPO write-offs, where production is recorded but structurally written off due to uncapped fee schedules, also need clear explanation and reconciliation.
Step 6: Prepare AP and Accrued-Expense Schedules
Accounts payable (AP) aging, which lists what the practice owes vendors and suppliers, and accrued-expense schedules, which list incurred but unpaid liabilities, form standard parts of a diligence package. A QoE review often examines working capital needs by analyzing receivables, payables, inventory, and accrued expenses to estimate the normal level required to operate without disruption, which can influence closing terms and working capital targets.
Deferred expenses, unusual vendor arrangements, and equipment lease obligations should be disclosed and documented at this stage. Any debt that will be retired at closing should appear in a separate debt schedule.
Step 7: Build Operational KPIs That Support the Numbers
Financial statements alone rarely tell the full story. DSO buyers often review operational metrics alongside the P&L to judge whether earnings appear durable. Key performance indicators (KPIs) to compile can include:
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Hygiene production as a percentage of total production, with a common benchmark of 28–35% of total production
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New-patient flow by month over the trailing 36 months
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Active patient count and recall reappointment rates
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Chair utilization and schedule capacity
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Case acceptance rates by treatment category
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Overhead ratios by category, such as staff compensation, supplies, lab, and occupancy
Beyond these core KPIs, DSO buyers often request supporting operational reports that provide context for the numbers. Active-patient definitions, hygiene recall reports, reappointment trends, payer mix, AR aging, and collections reports all help buyers distinguish between a practice with sustainable systems and a fragile income stream tied closely to the owner.
Step 8: Assemble the Final Adjusted-EBITDA Package
The final package pulls together all prior steps into a single, organized data room. A dedicated buy-side data room can accelerate due diligence and can create a positive impression that shapes how assertively the buyer negotiates on price.
The package typically includes a normalized EBITDA bridge, which is a line-by-line reconciliation from reported net income to adjusted EBITDA, with a footnote and supporting evidence tab for every add-back. Each adjustment should be applied consistently across all 3 years of financials. Every EBITDA add-back needs supporting evidence and a brief explanation to withstand quality-of-earnings scrutiny.
Partnering with McLerran on a Diligence-Ready Package
McLerran & Associates has guided owners through more than 2,000 successful practice sales and evaluated more than 10,000 practices. The firm’s CPA-led EBITDA analysis follows the same standard that a buyer’s QoE team is likely to apply, so the numbers are more likely to hold when it matters most.
Talk with McLerran & Associates about building a diligence-proof financial package, call (512) 900-7989, email info@dentaltransitions.com, or use the contact form on the firm’s website.
Common Financial Roadblocks and How to Address Them
Even well-run practices can encounter financial documentation issues during diligence. The following red flags appear frequently and can often be addressed in advance.
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Undocumented add-backs. An add-back without an invoice, ledger entry, or written rationale may be rejected or discounted by a buyer’s QoE team. Every adjustment benefits from a clear paper trail.
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AR spikes in the trailing 12 months. A sudden increase in outstanding receivables, especially in the 90-day-plus bucket, can raise questions about billing practices or collection discipline. Reconciling and writing off uncollectible balances before going to market can reduce this concern.
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Owner-compensation disputes. Buyers and sellers often disagree on the appropriate market-rate replacement cost for the owner’s clinical role. Using published compensation survey data and applying the adjustment consistently across all 3 years can reduce the risk of a contested QoE finding.
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Gaps between tax returns and internal P&Ls. Unexplained differences between filed returns and management financials can force buyers to rebuild records from source data, which adds weeks to diligence and can erode confidence.
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Related-party rent not normalized. Above-market rent in a seller-owned building is a soft add-back that usually requires an independent lease comparable analysis to be defensible during buyer QoE review. Below-market rent creates a negative adjustment that buyers are likely to apply.
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Associate misclassification. Associates classified as 1099 independent contractors who function as employees can create misclassification risk that transfers to the buyer unless resolved before closing.
Measuring the Impact of Your Financial Preparation
A well-prepared financial package can produce visible results at each stage of the transaction. Several objective indicators can signal that the work is holding up.
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Valuation stability through diligence. The adjusted EBITDA figure agreed at LOI ideally remains within a narrow range through the buyer’s QoE review. Large post-LOI reductions can indicate that upfront normalization work was incomplete.
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Reduced supplemental information requests. A complete, organized data room can minimize back-and-forth with the buyer’s diligence team and help keep the transaction timeline on track.
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Offer-to-close conversion. McLerran & Associates reports a transaction rate of approximately 85–90% among its clients, significantly above the industry baseline discussed earlier. Thorough financial preparation can be one of the main factors behind that difference.
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Multiple defensibility. At 7x to 10x EBITDA multiples, a $500,000 overstatement in adjusted EBITDA can translate into $3.5 million to $5 million in purchase price exposure. A well-supported package can help protect the agreed multiple from compression.
Conclusion
A clean, defensible financial package can be one of the most effective tools for protecting valuation and deal certainty in a DSO sale. The 8 steps outlined above, from compiling 36 months of monthly P&Ls to assembling a footnoted EBITDA bridge, reflect the same CPA-grade process McLerran & Associates applies to its engagements. Practices that complete this work before going to market often enter diligence from a position of strength, with numbers that hold up under scrutiny and fewer disruptions from documentation gaps.
McLerran & Associates has closed approximately $2 billion in dental practice transactions over roughly 35 years, working exclusively on the sell side. The firm’s diligence-grade EBITDA analysis is built upfront so the agreed value is more likely to hold and the deal can move to closing.
Discuss your practice transition with McLerran & Associates to explore your goals and what a diligence-ready financial package might look like for your situation. Call (512) 900-7989, email info@dentaltransitions.com, or submit a contact request through the firm’s website.
Frequently Asked Questions
How do I calculate adjusted EBITDA for a dental practice?
Adjusted EBITDA for a dental practice starts with net income from the P&L statement. From that figure, four standard items are added back: interest expense, income taxes, depreciation, and amortization, which produces base EBITDA. The next layer, the adjusted portion, removes owner-specific, non-recurring, and personal expenses that are unlikely to continue under new ownership. The largest adjustment often involves owner compensation, which is normalized to a market-rate replacement cost for the owner’s clinical role rather than the amount actually paid.
Additional adjustments can include personal expenses run through the practice, one-time equipment purchases, above-market or below-market rent on a related-party lease, family member payroll above market rate, and non-recurring legal or consulting fees. Every adjustment benefits from supporting evidence and consistent application across all 3 years of financials. The result is a single, defensible number that DSO buyers can use as the basis for their purchase price calculation.
What are the most common EBITDA add-backs in dental DSO sales?
The most common add-backs usually fall into three categories. First, owner compensation normalization replaces the owner’s actual pay with the market-rate cost to replace their clinical production. This adjustment is often the largest and can be frequently discussed during quality-of-earnings review. Second, personal and discretionary expenses run through the practice can include personal vehicles, owner-specific continuing education, meals and entertainment, non-essential travel, life insurance premiums, and excess retirement contributions.
Third, non-recurring items such as one-time legal costs, buildout expenses, or consulting fees that will not repeat after closing can be added back. Negative adjustments, which reduce EBITDA, also matter. These can include below-market associate compensation that a buyer will likely correct post-close, deferred maintenance or equipment catch-up costs, and below-market rent that a buyer will need to reset to an arm’s-length rate after the transaction.
What does a DSO quality-of-earnings review examine in a dental practice?
A DSO quality-of-earnings review typically examines four broad areas. Revenue quality covers clinical procedure coding patterns benchmarked against insurance databases, collection rates by payer, and whether reported production converts into collectible revenue. Expense verification tests each proposed EBITDA add-back line by line, often requiring invoices, payroll records, tax returns, and practice management system reports to support each adjustment.
Operational risk assessment evaluates owner dependency, including what percentage of revenue is tied to the selling dentist, along with associate classification, staff compensation relative to market rates, and whether the practice has documented procedures that allow it to function without the owner’s daily involvement. Growth defensibility reviews patient retention trends, new-patient flow, hygiene recall rates, and case acceptance data to gauge whether earnings are likely to continue after the transition. Findings in any of these areas can reduce the EBITDA figure used for pricing or compress the valuation multiple applied to it.
How should owner compensation be normalized for a DSO sale?
Owner compensation normalization replaces the owner’s total compensation, including W-2 salary, distributions, benefits, payroll taxes, and personal expenses run through the practice, with the market-rate cost to hire a replacement clinician for the same clinical hours and production volume. The adjustment can move in either direction. If the owner paid themselves significantly above market, the excess is added back to EBITDA. If the owner paid themselves below market, which can be a common tax strategy, the shortfall is subtracted from EBITDA because a buyer will need to pay a market wage to replace that production.
In multi-doctor practices, each clinician usually requires a separate normalization analysis. W-2 associates already paid at market rates generally need no adjustment. Supporting documentation for this adjustment can include the owner’s W-2s, K-1s, distributions, payroll records, and references to published compensation surveys for the relevant clinical role and geographic market. Because buyers often focus on this adjustment during quality-of-earnings review, a high documentation standard can be helpful.
How far in advance should a dental practice owner start preparing financials for a DSO sale?
Many advisors suggest beginning financial preparation at least 12 to 24 months before a planned transaction. This timeframe can allow the practice to clean up its chart of accounts, reconcile AR, address any associate classification issues, and establish a track record of clean monthly financials that can hold up under a 36-month review. Practices that invest in preparation before going to market often move through diligence more smoothly, experience fewer post-LOI renegotiations, and can show consistent overhead ratios and growth trends that support stronger valuations.
Starting early also creates time to address operational issues, such as owner dependency or hygiene department underperformance, that can influence the valuation multiple a buyer is willing to apply. McLerran & Associates offers a complimentary valuation update for owners who are not yet ready to sell, which can make it practical to obtain a baseline assessment well before making a final decision.
