dental practice valuations in 2016 a · when determining the fair market value of the shares or...

Dental Practice Valuations in 2016 – a glimpse into an industryJared M. Behr, CPA, CA, CBV

1 hour webinar presentation to members of the CICBV – May 18, 2016

Overview

Dental practice valuations require expertise as uniqueas the industry itself.

This one hour presentation aims to look at key trends in2016 and specific factors that are taken into accountwhen determining the fair market value of the sharesor assets of a privately held interest in a dentalpractice.

Dental practice purchases are, generally, a highlyleveraged transaction and the valuations arecommonly used by the “big banks” when assessing thedebt capacity and reasonability of the purchase price.

Prepared by Jared M. Behr, CPA CA, CBV - Lighthouse Valuations Inc.

Agenda

1) Understanding the dental industry

2) Personal (non-transferable) vs. Commercial goodwill

3) Owners versus associates

4) Tangible Asset Backing (TAB)

5) Normalization of financial results

6) Capitalization rates – common multiples

7) Minority discounts

8) Who is buying and who is selling

9) Leveraged buy-outs and access to capital

10) Key Performance Indicators

11) Financial and non-financial value drivers

12) Common valuation pit-falls

13) The impact of regulation and tax legislation


1) Understanding the Dental industry

Across Canada there are different rules and regulations governingdental practices in each province.

This presentation will not attempt to discuss, in great depth,provincially specific rules and regulations. However, I doencourage you to consider province specific rules and regulationscarefully when performing a valuation of a dental practice inCanada.

In particular, tax rules in the province of Quebec are unique anddental college/licensing rules can be quite different from oneprovince to the next. All of which may have an impact on value.


1)Understanding the Dental industry (Cont.)

Some different types of dental practices include:

General care or Dental Public Health

Orthodontics and Dentofacial Orthopedics

Periodontics

Endodontics

Pediatric Dentistry

Prosthodontics

Oral and Maxillofacial Pathology, Surgery and/or Radiology

As an example, there is a big difference between determining thevalue of a dental practice that engages primarily in facial surgery and apractice that engages in general check-ups, cavities and generic toothcare.


1)Understanding the Dental industry (Cont.)

A general dental practice will:

Have a customer list (chart) for regular check up patients (i.e. annuity revenue);

Employ hygienists who perform most of the check up and regular dental cleaning work for patients;

Employ associate dentists who earn a set percentage of their production (usually 40%);

Derive goodwill from its reputation, location, customer list (chart) and skill of the dental practitioners on staff.

A dental practice that specializes in surgery will:

Usually get referrals from general dentist practitioners and other medical professionals;

Employ an anesthesiologist;

Earn income from high margin one time events;

Much of the goodwill will be attributable to the specific skills of the dental surgeon;

Goodwill can also be created by way of reputation, location and other factors outside of personal goodwill.


2) Personal (non-transferable) vs. Commercial goodwill

For a general practice where associates and hygienists are utilizing aset of policies, procedures and office space already set up much of thegoodwill associated with the practice is commercially transferable tothe purchaser;

There is professional goodwill (derived from services performed by adentist) and technical goodwill (derived from non-dental staff – like x-rays and hygiene).

Commonly, the vendor (dentist) will remain on staff for six months totwo years after the sale as an associate of the practice to ensure asmooth transition of patients and staff;

Patients tend not to change dental offices and respond well to calls toattend their next scheduled check-up appointment;

Geographic location, density of the population and competition playimportant roles in a dental practice’s ability to retain its goodwill;


3) Owners vs. associates

As with any private company, a dentist who is an owner/manager of a dentalpractice may elect to take salary or dividends as compensation to optimizetheir personal and/or corporate income tax position;

The salary paid to a dentist who is an owner of the practice may not approachmarket rates;

Not all dentists want to be private business owners;

Associates are dentists who enter into an independent contractor agreementor employment agreement with a dental practice;

Commonly, an associate earns 40% of their “production” as an independentcontractor;

Dentists may also be “locums” who temporarily come into an office to work –these individuals charge between 30-40% of their production as fees.


3) Owners vs. associates (cont.)

If more than one dentist is a shareholder of a practice, a cost-shareagreement is often used to coordinate the sharing of expenses;

A common structure for multiple dentists would be:

Dental practice incorporated (cost share)

Dr. A. Dental Corp Dr. B. Dental Corp

Dr. AA

Family Trust

Dr. BB

Family Trust


4) Tangible Asset Backing (TAB)

For a dental practice to operate, it generally needs to havethe following hard assets on hand:

Equipment (5-15% of total value) Small tools (1-5% of total value) Leasehold improvements (10-20% of total value)

We, as business valuators, will likely need to rely on anindependent third party’s assessment of the Fair MarketValue of the capital assets owned by the dentalcorporation.

Goodwill is usually between 2 and 4 times the fair marketvalue of the tangible assets on hand (i.e. $500,000 intangible assets will usually result in practice valuebetween $1 to $2 million)


4) Tangible Asset Backing (TAB) (Cont.)

As a hypothetical example, a conclusion to the value ofthe shares or assets of a dental practice will usually bepresented as follows:

Equipment - $180,000

Small tools - 70,000

Leasehold improvements - 250,000

Goodwill - 1,300,000

-------------

Total en bloc FMV $1,800,000

=========

Ideally, a range of values will be presented in theanalysis.


4) Tangible Asset Backing (TAB) (Cont.)

Advancements in technology of dental equipment havean impact on valuation;

Setting up a practice can be a relatively large fixed cost,particularly for the leasehold improvements;

A long term lease agreement for the premises willallow a dental practice to obtain the full benefit fromthe leasehold improvements in existence at thevaluation date.


5) Valuation Approach and normalization of financial results

A going concern capitalization of cash flows approach is generally the best valuationmethod for a dentistry practice;

When reviewing historical operating results it will be useful to normalize any one-time non-recurring transactions;

Assuming the shareholder(s) is a dentist working at the practice it will be importantto add back his salary reported in the financial results and deduct a market rate ofsalary he would have earned as an associate;

Other common normalization adjustments might include: Non-practice expenses Non-arms-length rent Interest on long-term debt Unusually high professional fees, bad debts and/or travel Charitable donations and other discretionary items

Operating expenses, as a percentage of annual revenue, are summarized each yearby the College of Dentists;


5) Valuation Approach and normalization of financial results (cont.)

The availability of the college dental averages allows us to perform areasonability assessment on the past and future (projected) incomestatements.

Quality of the practice’s production (revenue) can be assessed by separating itout into the following categories:

Cleaning; Hygiene; Restorative; Lab & other; Endodontics Prosthetics (fixed or removable) Surgery; and Orthodontics.

Production can also be broken out by dentist or by type of staff: Dentists; Hygienists; and Associates.

Discounting “lab fees” from income – lab fee income and expense net to zero.


6) Capitalization rates –common multiples

Build up method:

- Risk free rate – 2%

- Public equity risk premium – 5.5%

- Size (small company) risk – 10%

- Industry specific risk – (1)% - negative one percent

- Business specific risk - varied

Commonly 3 to 6 times discretionary after-tax cash flow(approximately 33% to 18% in risk premiums);

Multiple of adjusted gross revenue 0.5 to 1.5 ;

Usually a considerable tax shield to consider as there is significantcapital investment in a dental practice;


6) Capitalization rates –common multiples (Cont.)


Low High

Estimated Maintainable EBITDA 275,000 375,000

Less: Income taxes (37,125) (50,625)

Maintainable after-tax cash flow 237,875 324,375

Less: Sustaining capital expenditures (7,500) (7,500)

Add: Tax shield on sustaining capital expenditures 800 800

Discretionary after-tax cash flow 231,175 317,675

Capitalized at multiples of 4.75x 4.25x

1,098,081 1,350,119

Add: Benefit of tax shield available from existing UCC 37,800 37,800

Capitalized value of the operations 1,135,881 1,387,919

Add: Redundant assets 457,000 457,000

Less: Debt (344,000) (344,000)

Estimated fair market value of the Shares $ 1,248,881 to 1,500,919

Rounded $ 1,250,000 to 1,500,000

Mid-Point 1,380,000

7) Minority discounts

Similar to other business interests, a percentage of ownership thatrepresents a minority interest in the shares or assets of a Companymay be subject to a minority discount;

Traditionally between 10% and 30% discount of pro-rata value ofen bloc fair market value;

A discount exists as a result of a minority shareholder not beingable to exercise control over operational decisions of theCompany, not being able to control compensation structure andamount, and not being able to liquidate the Company;

Will often see right of first refusal on sale of shares of majorityshareholder(s) (tag along and/or drag along clauses);


8) Who is buying and who is selling

Sellers are often dentists who are: moving to a new location, retiring, required to sell forfinancial liquidity and/or the Executor of an estate of a dentist who has passed away.

Buyers are generally special interest purchasers: Dentists who want to own their own practice; Financial purchasers who want to employ dentists;

Buyers are often new licensed/accredited dental practitioners out of University orhaving recently moved to the country;

Buyers are commonly an associate currently working at the practice they wish to buyinto.

Buyers may be large investment corporations in Canada (this is more unique and arelatively recent phenomenon)

It is currently a sellers market: available inventory is low and there are more interestedpurchasers than ever before.


8) Who is buying and who is selling (cont.)

As previously mentioned, some purchasers of dental practices are notaccredited dentists themselves, but rather financial investors who hiredentists to run their business;

Dental Corporation of Canada (DCC) is one such investor achievinggrowth through acquisition of orthodontic practices across Canada;

Cost of capital to a large investor may be lower than a dentist whoneeds to borrow against future profitability of the business from thebank;

As cost of capital is lower, financial investors are willing to pay highermultiples of EBITDA and discretionary cash flow.

Dental practitioners must be employed in a services agreement (andnon-compete) by the Dental Services Organization as alicensed/accredited practitioner must be operating the practice.


9) Leveraged buy-outs and access to capital

Commonly, much of the purchase price will be funded by bankdebt;

Practice purchase debt often funds close to 100% of the purchaseprice;

Effective interest rates in recent years are between prime andprime plus 2% (3 to 5%) over a 5 to 10 year term;

The “big banks” – RBC, TD, CIBC, BMO etc. are amenable tomaking these loans (dentists are generally a good bet);

The bank will review an evaluation (marketing) report and/or aValuation Report to assess their willingness to lend and at whatrates.


10) Key Performance Indicators

Some key performance indicators include:

% of patients with private insurance plans

# of active patients (those who received treatment in past 2 years)

Geographic location of the practice

Age of the local population

Population growth

# of operatory rooms at the practice (capacity)

Past valuations of the practice to review


11) Financial and non-financial value drivers

Normalized Earnings Before Interest, Depreciation and Amortization (EBITDA)

Normalized Gross Revenue or Production

Goodwill vs. Fair Market Value (“FMV”) of hard assets

Sustaining capital expenditures (annual)

Financial projections outlining the viability of the practice and its ability to repay practice purchase debt can be a useful tool and exercise


11) Financial and non-financial value drivers (cont.)

The quality of the customer list – performance of a chart audit is key to ensure thatthe customers listed are active (i.e. still coming into the practice regularly);

Revenue per chart may provide insight into how well serviced and how accepting oftreatment recommendations patients have been;

Chart audits may also be indicative if the patient base has saturated with respect tohigher level, one-off procedures (i.e. crowns) – usually rising revenues will havepeaked and started to decline with a similar base throughout;

A practice with an uninsured customer base will have different revenue potentialthan a practice in a developed area where professionals have insurance to coverdental costs;

The geographic region and trends in its population (both size and age);

The lease terms of the premises – large fixed costs must be put into a practicewhich is why you will often find a long time practice owns the property out ofwhich they operate. The remaining lease term may have a significant impact onvalue.


12) Common valuation pit-falls

Reliance on “practice evaluators” who have provided an opinion ofthe FMV of the hard assets and leaseholds of the practice;

Not recognizing that increasing revenues over the same customerbase is not sustainable as customers will be “crowned out”eventually;

Ignoring changes in technology and obsolescence of dentalequipment on hand;

Recognizing too much commercially transferable goodwill whenthe particular skills of the vendor dentist contribute materially tothe success of the practice;


13) The impact of regulation and tax legislation

Dentistry, as a medical practice field, is highly regulated in Canada

There is limited availability for “financial buyers” of a practice asthere needs to be enough accredited licensed dentists to supportthese investors;

If all licensed dentists choose to leave a practice owned by afinancial investor, there only remains liquidation value of hardassets;

Generally, a licensed dentist will be the owner of a dental practice;


13) The impact of regulation and tax legislation (cont.)

The sale of shares of a dental practice will usually qualify for theLifetime Capital Gains Exemption as a Qualified Small BusinessCorporation (“QSBC”) is sold.

The ability of a dentist to incorporate as a professional and claimthe Small Business Deduction (“SBD”) limit on their income is anitem currently under review by the liberal government.

GST issues at hand – exempt taxable supplies versus zero ratestaxable supplies


Professional qualifications of the author:

Jared M. Behr, CPA, CA, CBV

[email protected]

604-697-7777

Since 2007, Mr. Behr has worked exclusively with privately owned companiesand entrepreneurs providing a diverse set of accounting and financial serviceswith a primary focus on business advisory and tax. Mr. Behr has prepared andprovided support services on valuation reports prepared in accordance with theCanadian Institute of Chartered Business Valuators in a variety of contexts,including but not limited to: family law, shareholder disputes, corporatereorganizations, Employee Stock Ownership Plans (ESOP), acquisition anddivestiture, and estate planning.

Over the past three years Mr. Behr has provided valuation and advisory servicesfor a variety of different professional dental practice purchases and/or salesincluding a reasonability assessment of the purchase price, preparing goodwillcalculations, advising on purchase and sale agreement terms and formalvaluation opinions.

Mr. Behr is presently the Director of Valuation Services at LighthouseValuations Inc. (an affiliate of Horizon Chartered Accountants) and provides awide variety of advisory services to private owner/manager enterprise clients,external legal counsel and other professionals.


mailto:[email protected]

dental practice valuations in 2016 a · when determining the fair market value of the shares or...

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