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Gearing Up for a Successful Practice Transition by David Marks

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We all work with the hope that one day the fruits of our labor will allow us to retire happy and financially capable of living the lifestyle we desire.

When I entered the industry five years ago, I thought a large number of currently practicing orthodontists were approaching retirement age. My initial thoughts centered on how the industry would react to having to replace all the soon-to-be-retiring orthodontists to meet patient demand, and, more importantly, how quickly it could do so. After talking to a number of orthodontists, the AAO leadership, and after having reviewed the AAO’s list of practices for sale, you can appreciate my surprise when I realized that only a very small percentage of orthodontists were even considering transitioning their practice in the next five years. A deeper dive into exactly what was driving this desire or need to keep working at an advanced age (I can say that) was warranted.

As I asked more detailed questions of orthodontists I met along the way, I unearthed several reasons they continued to practice well past the typical retirement age of most medical professionals. Several answers seemed to be repeated:
  1. “I love what I’m doing.”
  2. “The nature of an orthodontic practice and its physical requirements allow me to continue to practice until my health stops me.”
  3. “My wife/husband/significant other won’t allow me to quit.”

But the one consistent theme that came up in every conversation was simply this: “Financially, it doesn’t make sense to sell. The economics just don’t work. If I work two more years, I will make as much money as I am being offered today and still own the practice. I can’t retire on the money I’ll make from selling, so I need to keep working.”

Wow! The American Dream of starting your own company (practice in this case), working hard through all the years, getting to a point in time where you could sell it and make lots of money, retire to the beach or golf course, all shot down in flames!

Many doctors have asked me what they could do about this perceived or real injustice. My answer is to grow your practice quickly and through whatever means necessary, but first you need to understand the underlying economics upon which the value of your practice is based. Secondly, understand what its fair market value is today, and there is no better definition of the fair market value of your practice than this—your practice is worth what a buyer is willing to pay for it.

For purposes of this article, let’s keep a somewhat difficult subject simple. Valuation of a practice is complicated and completed using several different comparative analyses. OrthoSynetics’ internal valuation expert utilizes a comparison of capitalized earning method versus a comparable transaction analysis. Multiple methods always lead to a range of values. It is not important to understand these valuation methods in detail today, only to know these valuations should be completed by certified business valuation specialists.

After the amount of pre-pays are determined, growth versus decline of the practice is identified, competition plotted, collection percentage and baddebt ratios reviewed, age and functionality of major equipment listed, and the probability of a comet hitting the earth in the next 60 days is agreed to (yes, I am being a little facetious here, you get my point), a value is established which on average is (+/-) 76 percent of trailing twelve month revenue (TTM). The final value is based on good or bad findings in the above listed due diligence items, as well as many underlying factors not listed.

This statement is not intended to 1) limit the need for a practice valuation when you choose to transition your practice or 2) suggest that someone other than those highly professional and competent companies or individuals that conduct them. It’s just that there’s not enough room in this article to write about all the items these experts review to assess value. They are, and will always be, a key part of the transition process.

Before we put this all to a test, let’s provide some definition to financial terms I discuss below:
  • Annual Gross Revenue: All receipts collected into a practice for services rendered over a 12- month period. Often referred to as trailing twelve month revenue (TTM) when looking at the most recent 12-month period.
  • Annual Net Income: Annual Gross Revenue minus all operating costs of a practice (staff, rent, insurance) and prior to paying taxes.
  • Profit: The money you take home, the bottom line, net profit, or net earnings after taxes.

Utilizing the 2013 Journal of Clinical Orthodontics Orthodontic Practice Study results for the average practice’s Annual Gross Revenue ($1,160,000) and applying the industry’s average 76 percent selling price, a sale would provide the seller $881,600 from the transaction. After tax (let’s just use a 20.6 percent blended tax bracket, derived from 75 percent of sale price taxed at capital gains rate of 15 percent and 25 percent at an ordinary income bracket of 37 percent), the average orthodontist would receive $699,900 profit from the sale.

Now refer back to one of the recurring statements I heard of why orthodontists are not selling: “If I work two more years I will make as much money as I am being offered today and still own the practice.” Let’s look if that statement is indeed true. The average annual net income for an orthodontic practice was reported at 41 percent of annual gross income, or $475,600 ($1,160,000 x 41 percent). Apply an ordinary income tax rate of 37 percent and what is left is profit of $299,628. Multiply times two years and you get $599,256 – not too far off from the $699,900 you would have made via a sale. So it appears correct at first blush that the assumption of working two years, or maybe two-and-a-half, yields the same return as you would receive in a sale. These calculations all assume practice revenue remains flat and that you are not holding a note, in full or in part, which would further negatively impact or delay your sale revenue.

So, should a choice be made to sell, the average orthodontist would receive a check at the sale closing in the amount of $699,900. And I’m just going to make a general statement here, but most of us can’t retire on $699,900 in the bank and expect to live a similar lifestyle to that we have been accustomed to. Hopefully, we have all saved and invested throughout our career and have enough money to continue to live in the manner we enjoyed preretirement; the practice sale proceeds would just be adding a little extra for some extravagancies along the way. But this doesn’t seem to be the case, at least with a number of the orthodontists I have spoken to who should now be considering a transition.

So, not unexpectedly, I often get the question, “What do I do to get a higher price for my practice when I’m ready to sell?” This one is pretty easy in today’s environment. I would bet you have already figured out the answer based on the examples above. Simply drive Annual Gross Revenue as high as you possibly can before considering a sale. And while the answer is simple, the ability to do so is not always easy to accomplish.

Many orthodontists getting to the end of their careers begin to slow down. Again, according to the 2013 Journal of Clinical Orthodontics Orthodontic Practice Study, those orthodontists practicing 26 years or more have shown a decline in Annual Gross Revenue of 18 percent versus gross income generated in their most productive practice years of 11- 15. The reasons might be health issues, fatigue or a general sense of complacency, a feeling that you have already reached the pinnacle of your career and just don’t need or want to “gear up.” Nevertheless, this decline is the exact opposite of what needs to happen. Certainly, there are good reasons to slow down, but absent those, the last five years of your career should be focused on growth and lots of it. Why?

Assuming the 76 percent of TTM sales price, every $100,000 of increased Annual Gross Revenue provides you an additional $76,000 in sale price. Every $500,000 adds an additional $380,000. Every $1,000,000 adds $760,000. So how do you get there?

First, set a goal to grow your practice by 50 percent over the last five years. That’s approximately 8 percent compounded growth per year. The Journal of Clinical Orthodontics study indicates the “average” practice median Annual Gross Income grew at a rate of 22 percent over the last two years (11 percent per year average, so it is not out of the question). Let’s take a look at what this growth in annual gross income would generate for the practice.

Base Year: $1,160,000
Year 1: $1,252,800
Year 2: $1,353,024
Year 3: $1,461,265
Year 4: $1,578,167
Year 5: $1,704,420

Effectively, we have raised our Annual Gross Revenue in year five by $544,420 versus the base year, leading to a $413,759 increase in sale price (76 percent of $544,420).

Now, let’s refer to Figure 1 to look at the impact in each of these last five years and the additional Net Income and profit generated to the practice by this growth. Because much of the overhead and cost is covered in the gross income of $1,160,000, we will utilize a 40 percent versus a 59 percent expense/overhead factor on all additional gross revenue (very conservative as any additional practice costs are based mostly on significant marketing initiatives to drive volume, supplies, small additions to staff and increases in staff compensation).

The top section of the chart marked “Stagnant” assumes no growth over a practice’s last five years. Your profit (take home after taxes) over those five years is $1,498,140. Your profit on the sale in year five is $699,900. Total take-home income in the last five years of practice is $2,198,130.

Fig. 1 Year 1 Year 2 Year 3 Year 4 Year 5 TOTALS
Stagnant            
Annual Gross Revenue 1,160,000 1,160,000 1,160,000 1,160,000 1,160,000 5,800,000
Net Income-41% 475,600 475,600 475,600 475,600 475,600 2,378,000
(37% Tax Basis) (175,972) (175,972) (175,972) (175,972) (175,972) (879,860)
Take Home after Tax 299,628 299,628 299,628 299,628 299,628 1,498,140

Sale Price-76% of TTM 		          881,600
(20.6% Tax Basis @ 75% CG)           (181,610)
Sale Price Take Home after Tax           699,990

8% Annual Gross		            
Revenue 1,252,800 1,353,024 1,461,265 1,578,166 1,704,420 7,349,675
Net Income On Original            
Base Revenue-41% 475,600 475,600 475,600 475,600 475,600 2,378,000
Net Income On Increased            
Revenue-60% 55,680 115,814 180,759 250,899 326,652 929,804
Total Net Income 531,280 591,414 656,359 726,499 802,252 3,307,804
(37% Tax Basis) (196,574) (218,823) (242,853) (268,805) (296,833) (1,223,888)
Take Home after Tax 334,706 372,591 413,506 457,694 505,418 2,083,915
Sale Price- 76% of TTM           1,295,359
(20.6% Tax Basis @ 75% CG)           (266,844)
Sale Price Take Home after Tax           1,028,515
Summary Stagnant Growth for 5 Years 8% Annual Growth for 5 Years Gains  
Take Home Over 5 Years 1,498,140 2,083,915 585,575  
Net Sale Receipts 699,990 1,028,515 328,525  
Income Over 5 Years Inc.
 2,198,130
 3,112,430
 914,100
  


The middle section of the chart marked “8 percent Annual Growth” assumes an 8 percent growth rate in each of the practice’s last five years. Your profit (take home after taxes) over those five years is $2,083,915. Your profit on the sale in year five is $1,028,515. Total take home income the last five years of practice is $3,112,430.

The bottom section of the chart marked “Summary” shows the difference in take-home income over five years ($914,000) assuming an 8 percent year-over-year growth.

So, by planning appropriately when you know you are five years from transition and spending some of the additional profits generated by the new growth to promote more growth, I have shown the average orthodontist how to add over $900,000 more take-home income in the last five years of practice. Maybe some of the money could be used for those little extra extravagancies along the way.

  Author's Bio
David Marks is the president and CEO for OrthoSynetics, Inc. (OSI), a business service company that assists orthodontic and pediatric dental practices utilizing a full-service, turnkey approach to address all non-clinical practice functions to gain better efficiencies and profitability. He has more than 30 years of experience in the health-care industry. For more information, visit www.orthosynetics.com.
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