Unpacking DSO Deal Structures

Evaluating the pros and cons of the deal structures available in today’s DSO marketplace

When considering a DSO sale or partnership, practice owners face the exciting but complex opportunity to maximize the culmination of their life’s work.  To achieve the best outcome, the doctor must identify the right partner for their practice, negotiate the highest price, and select the optimal deal structure, which is more impactful than the initial valuation when examining the global economic impact of the transaction.  These objectives require getting educated on the options available, which is best accomplished through working with a specialized sell-side advisor who can bring the right DSOs to the table and explain/negotiate the intricacies of each offer.  While each objective is critical, selecting the optimal deal structure is the most complicated and important consideration, despite often being the least emphasized or understood aspect of DSO transactions. In this article, we’ll unpack the most common DSO deal structures.  

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

• Valuation Metrics. Most modern DSOs value practices based upon 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 associate wage) as opposed to the traditional method of applying a percentage of annual collections or 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/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 (bonus payment above and beyond the base purchase price) is designed to reward the seller for growing revenue or EBITDA to a certain benchmark within a defined timeframe following closing.
• Recapitalization Event (Recap): A recap is 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 in size and value and then ultimately sell in a successful recap that results in attractive investment returns for the private equity firm, their investors, and the partner doctors.  At the point of sale, the financial sponsor of the DSO changes, but the name, brand, culture, infrastructure, management team, etc. of the DSO stays 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 who focus 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 
  • Maxime cash at close 
  • Maxime ability to de-risk
  • Seller not exposed to risk related to the performance/growth of the practice or DSO (beyond hitting post-closing benchmarks related 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/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 is an employee, not a partner

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

In this scenario, the practice owner and DSO enter a partnership transaction where the DSO purchases 51%-80% of the equity in the practice and the practice owner retains 20-49% (often ~40%) equity at the practice level (referred to as joint venture or JV equity). The newly created joint venture entity owns the practice and pays all expenses. Thus, as partners, the DSO and the partner dentist effectively share pro rata in all expenses and all profit, which is 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/vendors, HR, recruiting, etc.), 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.  However, 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 the partner doctor with a lot more autonomy in regard to managing their chairside schedule. 

When the DSO reaches a re-capitalization event, the partner dentist can liquidate some or all of their JV equity at a significantly higher valuation compared to the valuation of the practice 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, which is typically in the range of 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 7 X EBITDA valuation for their individual practice and a few years later the DSO recaps at a parent company multiple of 14 X EBITDA, the partner dentist doubles their money on the amount of JV Equity liquidated at the recap event.  Further, if the EBITDA of the practice has grown between closing and the recap event, the partner dentist will exponentially increase their return on the liquidated JV Equity 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 is truly a partner, not just an employee 

• Cons
  • Retained JV equity lowers cash at close 
  • Profit distributions are burdened by the management fee 
  • Given 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 a partnership transaction where the DSO buys 100% of the practice, which consists of 65-90% cash and 10-35% stock in the DSO’s holding company.  Unlike JV equity, holding company equity does not typically pay distributions or dividends, but typically has higher upside and less limitation on the amount of equity that can be liquated as 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, the price of your shares 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 5 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 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 DSOs 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 brings more risk and more upside than joining a larger, more established group. The timing of when you receive your stock is also key.  Receiving stock shortly before a recap will produce a faster payout and lower return, whereas receiving stock well in advance of a recap will produce a longer payout and higher return.  Given that you will typically liquidate your Hold Co stock over multiple recaps, you also can 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 6 times your initial investment. 

• Pros
  • Best suited for dentists committed to practice long-term and 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 profit, growth, and future value of the DSO
  • Feel like a partner, not an employee
    
• Cons
  • Holding Company equity investment equity lowers cash at close 
  • Given your equity lies at the DSO level (as opposed to the practice level), you do not share as directly in the growth of your 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 & parent company equity)

Under the hybrid deal structure, you typically receive 60-70% cash at closing, with the equity component being bifurcated into a combination of 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 above Pros and Cons apply.  

Rollups

This concept attempts to bundle many individual practices into a “group” and market the collective to financial (PE firms) and strategic (existing DSOs) buyers.  The organizer charges substantial upfront and/or ongoing fees (unlike traditional sell-side advisors who only charge a commission at closing) and also charges an above-market transaction fee if a sale ultimately comes to fruition. 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 many 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 which will cause significant EBITDA erosion.  The integration risks are even worse if the collective is spread out over multiple geographic markets and/or includes multiple practice types/specialties. Further risk comes from the high difficulty of getting and keeping the numerous independent practice owners on the same page in selecting the a buyer, agreeing on price, and settling on a deal structure. Many of the individual owners often get tired of paying the fees as they wait for a unicorn deal to materialize and thus drop out over time, further reducing the appeal of the opportunity to potential buyers. DSOs typically avoid rollups/collectives all together 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 regarding 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.