By Thomas L. Snyder, DMD, MBA, Senior Director | Henry Schein Professional Practice Transitions
There is no doubt that the Pandemic has created delays in practice sales as some Buyers have changed their minds about a pending practice purchase. Numerous Sellers have also taken their practice off the market for concerns that they may not receive maximum value for their practice at this difficult time. Conversely, some Buyers have proceeded with their purchase plans but have done so by offering sale price reductions and/ or stipulations in their offers. For many Sellers, trying to get maximum value during this difficult time, it may prove to be quite challenging. There is an alternative strategy that may prove to be a win-win scenario for both Buyer and Seller It is called an Earn-Out. Future financial targets are established, and additional payments can be made to the Seller over an agreed-upon time frame. If the targets are not met over the earn-out period, no further payments are made to the Seller. Some Purchasers may initially reject this option unless they can see a financial benefit themselves as well, as they may feel that the only beneficiary in an earn-out is the Seller!
Here is a detailed plan which creates a pathway for the Purchaser and Seller to both benefit. To prepare this earn-out plan, the following steps need to be taken.
Step 1) Create a Gross Receipts Target
If a practice valuation was prepared to assist the Seller in establishing a sale-price, chances are it was based on results ending December 31, 2019. Most dental practices will suffer a reduction in their Gross Receipts in 2020 due to practice closures and in some instances a slower rebound to normal operations. Since the Seller’s sale price probably was based on 2019 data, the simplest approach is to set the Gross Receipts from 2019 as the financial target that must be met by the practice in 2021. Since many Purchasers may not offer a full price based on the 2019 valuation, the difference between the practice value and the offer price can be the amount of earn-out payments that can be made in the one to two-year period after the sale.
Step 2) Prepare a Practice Breakeven Point
An earn-out only makes sense if both Seller and Purchaser benefit with certain goals being met. The simplest way to measure the economic impact of an earn-out is to first determine the practice’s Breakeven Point. The Breakeven Point (BEP) is calculated by the following formula:
BEP = Fixed Expenses + Owner Compensation
1 – Variable Expense Factor
Fixed Operating Expenses are all practice related expenses such as Facility Expenses, Staff Expenses, General Expenses (i.e. bank charges, advertising, professional fees, computer expenses, licenses/permits, and practice acquisition loans). Variable Expenses are expressed as a ratio of revenue and are collectively termed the Variable Expense Factor. Common Variable Expenses are office expenses, dental and implant supplies, and lab expenses. Variable Expenses fluctuate directly with practice production. Once the Breakeven Point is calculated, you can then project the economic impact of an earnout by determining the additional profit the Purchaser buyer will realize after the earn-out payment is made. Normally this breakeven point is calculated using the prior calendar years’ financial performance. But due to the unique nature of 2020 with reduced Gross Receipts and PPP support you can get a more accurate picture in establishing your breakeven point. Here’s an example of calculating a Breakeven Point to serve as a baseline for an earn-out using the practice’s most recent year (2019), for revenue and expenses. The Purchaser’s desired compensation, however, is not just based on the prior owner’s historical income, but also what the Purchaser reasonably needs to pay his/her taxes as well as living expenses and dental education debt.
Practice Revenue: (2019) $1,000,000
Fixed Operating Expenses: (2019) $500,000
Variable Operating Expenses (18%): (2019) $180,000
Purchaser’s Desired Compensation: $300,000
BEP = $500,000 + $300,000 1 – .18. = $800,000 .82 BEP = $975,610
So, in this case, the Breakeven Point in this practice would be $975,610. Therefore, every dollar produced in excess of this amount will cost 18¢ in Variable Expenses. This gives the owner a net profit of 82¢ per every dollar produced in excess of the BEP.
To calculate the actual earn-out payment, take the difference between what the Seller wanted as a sale price verses what the Purchaser actually paid.
Step 3) Determine a Percentage of Dollars Earned in Excess of the Earn-out Amount to be paid to the Seller
Allocating 25% to 40% in excess of the earn-out Gross Receipts goal to be paid as the earn-out payment for a particular year. Again, this percentage is based on the results of the breakeven analysis, the amount of the sale price differential to the original asking price, as well as the earn-out payment period. Here is an example of how an earn-out payment works. We are assuming that the transaction closes in 2020 but this year’s numbers will not be used in the earn-out calculations.
|Practice Receipts in 2019||$1,000,000|
|Seller’s Asking Price||$700,000|
|Actual Sale Price||$620,000|
|Earn-out Payout (if revenue goals met)||$80,000|
|Annual Earn-out BEP||$975,610|
|Time Frame||2 Years|
|Earn-out % Payout||35%|
Actual Year 2021 Revenue $1,100,000
= $975,610 (earn-out BEP goal)
X 35% (earn-out %)
$43,536 Earn-out Payment Year 2021
In this example, the practice exceeded its BEP goal by $124,390. Assuming it cost 18% (Variable Expenses) to generate this excess, which translates into $22,390. Therefore, the Purchaser has a gross profit of $102,000 of which $43,536 will be paid to the Seller as the first year’s earn-out payment. So that means the Purchaser will have a net profit of $ 58,464 plus the $300,000 compensation already built into the BEP model. The total revenue earned for the Purchaser will be $358,464 in 2021. Remember when applying this calculation, the practice acquisition debt has already been included in the BEP. If the earn-out payment is made over one or two years, the balance will be paid in 2022 and will be based on a BEP calculation using 2021 financial data.
In summary, earn-outs can be a great solution when the sale price and practice potential come into play thus providing an economic win for both parties if the earn-out targets are realized. At times like this with so much uncertainty around us, this may be the best strategy to consider.