Ask the Expert: How do I know if I'm overpaying for a practice or passing on a great one?

Dear Dr. Jerkins: I am starting to look at dental practices, and I'm not sure how to tell whether one is actually a good opportunity. How do I know if I'm overpaying for a practice or passing on a great one? 
— Looking

Dear Looking: It's a great question that gets to one of the most important, and often misunderstood, concepts in practice ownership: economic benefit.

There are several metrics you should look at when considering buying a practice: gross annual revenue, overhead and net income. They all tell an important story about the health of the business. But the metric that matters the most is economic benefit — the total financial value a practice creates for its owner — and it isn't a number that can be found on a tax return or income statement.

Why economic benefit is important

Imagine you're evaluating two practices. Both have established patient bases, experienced staff and strong online reviews. Practice A has a revenue of $1.2 million, overhead of 60% ($720,000) and a resulting net income of $480,000. Practice B also has a revenue of $1.2 million, a significantly higher overhead of 75% ($900,000) and a much lower net income of $300,000.

Which one should you buy? Common sense says Practice A. And that's where common sense is no match for deeper financial knowledge.

Looking under the hood

Start with Practice B's overhead. At 75%, it looks like a poorly run office, the kind of number that might make you walk away before asking another question. But a closer look at the books tells a different story. Roughly $250,000 of what's recorded as "overhead" isn't the cost of running the practice at all. Instead, it reflects discretionary financial decisions made by the current owner:

• Family on payroll: $80,000.
• Retirement and pension funding: $110,000.
• Vehicle, travel, continuing education: $60,000.
When we set these aside, Practice B's true overhead is no longer 75%, but 54% — lower than Practice A’s 60%.

Which means the practice isn't earning $300,000. It's generating $550,000 in real, recurring value for its owner. Practice B, the one that looked worse on paper, actually puts $70,000 more in its owner's pocket every year than Practice A.

Economic benefit as the foundation of practice valuation

That $550,000 is the practice's economic benefit: the real financial value it produces for its owner and the number you should be building a valuation on when buying a practice.

Unfortunately, it isn't always the number healthcare valuations are built on. Too often, brokers and generalist lenders rely on broad rules of thumb, such as multiples of gross revenue or reported net income taken directly from financial statements and tax returns. That approach prices a practice at face value and can miss its true financial picture.

This creates an arbitrage opportunity for informed buyers and their advisers. By understanding a practice's true economic benefit, you may recognize value that others overlook. That can help you confidently pursue an exceptional practice that might otherwise be mispriced, underfunded or even declined.

If you've followed the example above, you've already seen this process in action. At Panacea, for instance, we use seller's discretionary earnings in our underwriting. This is a financial analysis tool that starts with a practice's reported profit and adds back certain owner-specific discretionary expenses to estimate its true economic benefit.

Buying and running a successful practice is a team sport

That's why it's important to build a team of experienced advisers who understand the unique economics of dental practices. Your certified public accountant, attorney, practice consultant and lender each bring a different perspective, helping you evaluate opportunities from multiple angles.

You want a team that understands healthcare practices and knows how to look beyond the tax return, sort through the cash flow, and separate the true operating costs of the practice from the owner's personal financial choices. At Panacea, for example, we've built healthcare-focused underwriting models that help us identify a practice's true economic benefit more accurately than a generalist lender. That deeper understanding often allows us to approve larger loans, require lower down payments and move more quickly than traditional banks.

So the next time you're comparing two practices, don't ask which one has the higher revenue or lower overhead. Ask a deeper question: Which practice creates the greatest economic benefit? The answer may surprise you, and it could make all the difference in finding the right practice to own.

If you want to learn more, you can always reach out to our team at panaceafinancial.com/ada.

Dr. Jerkins is the president and co-founder of Panacea Financial and a practicing physician in Little Rock, Arkansas. Panacea Financial is endorsed by ADA Member Advantage as the exclusive provider of practice financing. It is a division of Primis Bank and insured by the Federal Deposit Insurance Corporation.