There’s a great thread on dentaltown.com about why buyers should NOT pay for potential and projections. Part of the discussion revolves around normalizing cash flow, particularly the overhead of the practice. This prompted me to write a blog post to help potential buyers evaluate a seller’s cash flow specifically with overhead.
Over the past 25 years or so, as I’ve assisted buyers with managing their due diligence, assessing the asking price, and improving the performance of the practice, I’ve witnessed how the overhead assumptions used to normalize cash flow can drive the price that sellers ask for their practices.
I’ve compiled a list of common overhead expenses categories and some of the issues we’ve uncovered over the years. Buyers need to consider how various expenses might be impacted when they take over and how these expenses may have been adjusted for cash flow purposes. Keep in mind that many professionals (broker, CPA, seller rep, sometimes the seller themselves, or anyone charged with the task of determining a practice's asking price) who are trying to normalize cash flow, may not have known about these issues with the expenses they adjusted or simply didn’t take the time to understand how their adjustments might impact other expenses. After all, their primary responsibility is determining an asking price, NOT performing due diligence. That said, we know there are some professionals who will use overhead as a way to increase cash flow and therefore price. One way to accomplish this is by reducing overhead by adjusting (reducing) certain expense categories to “industry norms”. While the reduction in certain expenses may be valid and logical, unfortunately, we rarely see expenses adjusted by increasing them to “industry norms” which should follow the same logic.
The items below should assist a buyer when evaluating a practice’s overhead and how that overhead might change under their control and how “industry norm” adjustments might impact price. At the very least this will help them to know the appropriate questions to ask.
- Accounting/Professional Fees:
Reducing this to “industry norms” may not take into account a CPA firm which also does payroll, maybe full-service bookkeeping, etc., a buyer may have to pay for the payroll processing and bookkeeping, therefore, automatically reducing this may be an oversight.
If a seller’s cash flow has little to no advertising, a buyer has to ascertain whether or not they will need to add this expense in order to properly maintain the seller’s existing patient base with an increased flow of new patients. Many professionals overlook this as a necessary expense and will sometimes reduce it to “industry norms” for a FFS practice when that’s how the FFS gets its patients. So make sure you understand the appropriate level of this expense.
- Computer Maintenance & Expenses:
Many times we see old practices that haven’t been computerized and this expense is missing completely from their cash flow. With today's technology, it makes absolutely NO sense to operate any business, including a dental practice without computers, software, and other technology. Buyers must determine how much they need to budget for this expense as part of their overhead.
- Contract Labor/Temp Help:
Many times when a practice pays an associate as an IC, the seller will categorize their compensation to this category. However, they may also use this category for temp assistants, temp hygiene, and maybe other necessary vendors. Sometimes, a professional will eliminate the entire expense assuming it is all associate related. A buyer needs to ask for details, maybe general ledger details, and/or associate 1099s.
Many times, professionals fail to adjust (increase) insurance expense for some of the additional insurances that lenders may require to provide a loan to buyers.
- Office Expense and Supplies:
The industry norm is around 1%-1.5%, many times if its more than that, the professional will reduce this expense to industry norms without any consideration for what the seller may be including in this category. We’ve seen the following expenses coded as office expense and supplies: payroll processing, merchant services, software maintenance and monthly PM software fees, employee expenses like bottled water, telephone expenses, cable/internet, janitorial, dental supplies, repairs & maintenance, etc. Buyers need to see the details and determine if the adjustments the professional made are valid.
- Office Rent:
This is primarily an issue when the practice owner also owns the space. We see some professionals completely overlook this missing expense or choose a very low rent assuming the buyer will buy the space or include the mortgage payment as the “normal” expense. We believe to maintain separation of the practice value and the value of the real estate, the normalized cash flow MUST include a fair market rent and related expenses that an arms-length tenant would pay. Buyers need to know what the fair market rental rate is, even if they’re buying the space.
- Repairs and Maintenance:
We’ve seen situations where the seller is very handy and will do their own repairs to equipment and the space or, repairs and maintenance was included in dental supplies of office expenses that have been reduced to industry norms. Unfortunately, everyone can’t be a handyman & therefore, if a seller’s cash flow has very little repairs and maintenance, the buyer needs to understand why and include an amount for this, especially if it’s been eliminated from other categories.
If your locality assesses personal property taxes on the value or cost of equipment, many times the assessed value of a seller is very low or nothing. A buyer needs to understand this and determine how much they’ll have to spend due to state or locality regulations.
- Dental Supplies:
Here’s another category where professionals like to reduce it to “industry norms” without looking at the details to see if they should be doing this. We have seen practices combine their lab expense, office supplies, repairs and maintenance, etc. in dental supplies. For example, many supply vendors will issue their monthly invoices that include dental supplies, repair services and\or contracts, computer services and software and even equipment. Unless sellers are careful to allocate these invoices to the various categories, it winds up in dental supplies. The professionals simply miss this fact and reduce dental supplies to industry norms blindly. Also, if the practice uses a CADCAM/milling machine this will also explain “higher than normal” dental supplies, so you have to look at this area closely.
- Lab Expense:
As noted above, we see situations where the professional has lowered dental supplies that include lab to “industry norms” and fail to INCREASE lab expense to an appropriate level. We’ve also seen situations where practices may use an in-house lab or employee, or maybe the doc creates some of their own “stuff” which makes this expense low for them, however, the buyer may not be making their own cases or choose to use an outside lab they’ve been using.
Here’s another area where many professionals fail to look behind the total wages to learn more about who’s getting paid & why. This is why we want to see the W-2s, to see how much is being paid for assistants, hygiene, front desk, and admin. We’ve seen situations where professionals will lower the wages to “industry norms,” then, when we get the W-2s we see they have the cleaning person and/or bookkeeper on payroll. These are expenses the buyer will likely need yet the professional has eliminated them to industry norms.
- Capital Replacement (replacing old f&e):
Here’s an area where we rarely see professionals ADD expenses to accommodate the need of a buyer to replace old equipment that’s either on its last leg OR is simply too old to even be used in dentistry.
While we don’t see many issues with these categories, they should still be looked at for reasonableness…we’ve seen reductions for “estimated” personal cell phone usage that’s too high or reductions for “assumed” home phone or internet connections and we find out they are legit office expenses. We’ve also seen sellers use utilities for all three of these expenses, and the professional will reduce utilities to “industry” norms without looking at the details and asking the seller about them.
As a buyer, you’re getting ready to go on the hook for hundreds of thousands of dollars of debt for a business. Don’t hesitate to ask for details of certain expense categories to see what the seller has been paying or to understand why a professional adjusted them.
You, the buyer, are responsible for doing your due diligence on the business you’re buying, you better know exactly what it is you’re buying. That doesn’t mean you have to go into overkill and stuck in paralysis by analysis, however, unless you do this sort of work every day, you won’t know what to focus on or what to move beyond.
Hopefully, this serves as a guide to those looking to buy a practice on how to evaluate the overhead of a practice and understand why normalization adjustments were made, if they should have been made and should different adjustments should still be made.
About Tim Lott
Tim Lott, CPA, CVA has decades of experience working with dentists at all stages of their careers. He is a regular speaker at study clubs, societies, and dental schools. Tim is a frequent participant and a moderator on Dentaltown.com. You can reach Tim at email@example.com or any of the other dental partners/principals at (800) 772-1065 or firstname.lastname@example.org. For more blogs, visit our Dental CPAS blog page.