Beware of New Listing Fairy Tales

Dentists are consistently being provided with “new listing” emails and messages from the various dental brokerages.  In today’s highly competitive sellers’ market, it conjures up visions of shark hunters chumming the waters to create a feeding frenzy.  For the most part it works, creating a practice feeding frenzy and leading to multiple bidders.  Unfortunately, this frenzy may not be doing either the seller or the buyer any favours; consider the listing information, as shown below, that was recently received by thousands of dentists from one of the brokers.

GROSS REVENUE:          $ 1,800,000
APPRAISED VALUE:        $ 3,200,000
ASKING PRICE:           $ 3,200,000
CASH FLOW:              $ 1,066,000
ACTIVE PATIENTS:              1,700
NEW PATIENTS PER MONTH           50

On the surface, it looks pretty good.  As the seller, you would be selling for 178% of gross which is very good!  As the buyer, based on a purchase price of $3.2M and with a cash flow of slightly over $1M, this would be an exceptional buy!  However, the scenario starts to fall apart when you look at all of the information together, and take the time to understand what it means as a whole.  Let’s take a look at some red flags found in this particular scenario which will be helpful to you in any future sale or purchase you may make.

Red Flag #1:  At present, dental practice values fall somewhere between 5 and 6 times Net Profit.  If this practice really has cash flow of $1,066,000 then it should be valued somewhere between $5.3M and $6.4M.   At $3.2M this practice is sitting way below current marketplace standards.

Red Flag #2:  Most practices in Ontario are running with operational overheads in the 45% to 55% range, and that is before paying any dentists/associates.  After imputing the dentist/associate cost (usually 40% of gross dental production less lab) the total overhead can jump another 20% to 30%, resulting in a total overhead of 65% to 75%, and sometimes even higher.  With respect to the listing at hand, if we make a couple of industry assumptions, and given that we have been told what the Gross and the Cash Flow is, we should be able to estimate the operational overhead (overhead before any dentist/associate costs) as well as the total overhead.  If you look at the schedule below you can see that the operational overhead is likely to be in the range of 15% which is just not reasonable, or even maintainable.

DENTAL FEES AS A % OF TOTAL FEES (NET OF LAB)*          65%
NET DENTAL GROSS REVENUE                        $ 1,170,000
IMPUTED ASSOCIATE COMPENSATION @ 40%            $   468,000 

GROSS REVENUE                                   $ 1,800,000    100%
    LESS: CASH FLOW                             $ 1,066,000     59% 
    TOTAL OVERHEAD                              $   734,000     41%
    LESS: ASSOCIATE COMPENSATION                $   468,000     26%
    OPERATIONAL OVERHEAD                        $   266,000     15%

OPERATION OVERHEAD PERCENTAGE                        14.78%        

*Based on industry assumptions

Red Flag #3:  This practice is reported to be getting 48 new patients per month, which is 576 new patients per year.  This sounds great however, the practice only has 1,700 patients in total.  The new patient inflow could make sense if the practice was less than 3 years old, which it could be as we don’t know that from the information given – however it is more reasonable to assume otherwise; I don’t know of many 3-year-old practices generating 1.8M and being sold off.  If it is older than three years, as we suspect, then it has a very large attrition problem.  It would only have about 3 years of new patients in its entire patient base which means that lots of patients must be leaving the practice.  Strong growth is a very valuable condition, however, if it is coupled with very strong patient attrition it is no longer a valuable condition, it is a necessary condition.  According to the information provided, the patient base is turning over every three years, meaning that if the new patient flow fell by a factor of 50% the total patient base would fall to 850 in three years – not good.

Red Flag #4:  With 1,700 active patients and a gross of $1,800,000, the practice is generating an annual average of about $1,059 per patient.  The provincial average for practices outside the GTA ranges from $400 to $600 and within the GTA from $700 to $900.  What this means is that there is not a lot of upside potential in this practice.  This is potentially a very high-risk situation.  Nothing is static, everything is in a constant state of change.  If you start with average annual revenue per patient that is much higher than normal, it is not likely that they will increase, it is more likely that they will decrease, leaving you with less than you expected.

So overall, what we actually have here is an opportunity that, on the surface looks to be an “amazing” opportunity.  However, when you put all of the information together, and take the time to understand what it actually means, then the situation looks a little grim to say the very least.  The misleading information can create problems for both buyers and sellers as illustrated below.

Buyers:  The problem for potential buyers is that they will likely perceive they are getting one thing, when in reality they are getting something much different.  Regardless of what any salesperson says, both the cash flow number and the gross revenue numbers cannot be correct as stated.  Furthermore, if someone purchases the practice counting on the cash flow as presented, they will likely be extensively cash-short at the end of the day.  If the buyer has a good dental accountant, they will probably be rescued but if they don’t, they’re likely going to find themselves in a financial bind in fairly short order.  This is only one example of the problems which could arise from the misleading information of this listing.  There is also a problem with patient flow, patient stability, and the amount which is being billed per patient.  Any or all of these inconsistencies could cause serious financial problems for any buyer.

Sellers:  These listing notifications literally go out to thousands of dentists. Some of these dentists will be buyers, but many will be sellers or soon to be sellers.  When sellers see listings where practices are being appraised for unrealistically inflated values, they begin to believe that their practices are worth much more than actuality.  This creates unrealistic expectations and in many cases, will lead to a seller rejecting reasonable offers while in search of the impossible deal.

The next time you see an appraisal that looks too good to be true, be careful – you may find that it is too good to be true.