Why and When You Should Consider an Earn Out with a Dental Practice Transition

OLEKSANDR / STOCK.ADOBE.COM

When it comes to dental practice transitions, there are times when the identified buyer wants to buy and the ready to go seller wants to sell his or her dental practice. These parties like each other’s attributes and think they are right for each other to consummate the sale.

Sometimes the sale price is not that far apart from achieving the goal but the stubbornness of either or both participants prevents them from the desired aim of having the transition being completed between each other. An idea to resolve the issue can allow the sale to take place and the participants to feel as if they did not really give in, but that each got what they wanted from the standpoint of the financial side of the transition. This is 1 way that an earn out is the answer for 2 parties who are not too far apart from the sale price but neither side will give.

An explanation and examples of an earn out will appear in the following paragraphs so that you can fully understand why this method of transitioning a dental practice may appeal to the buyer and seller when each side feels that the financial step is the last hurdle to clear for the transition to occur.

How is an earn out defined and what is an example?

An earn out refers to pricing an acquisition where the sellers achieve part of the sale price based on the performance of the enterprise after the purchase takes place. The seller is relying on the buyer to achieve the goal set by the seller. Buyers and sellers many times differ on the growth of the company where the buyer wants to pay an amount based on the historical earnings and the seller wants to receive a sale price based on the potential of the future profits. When this occurs, the buyers and sellers may compromise on a lower initial price with a provision that if the company does grow based on an agreed amount over a few years, the seller will receive additional funds from the buyer.

There is a small risk to the buyer and seller if each or one is not telling the truth to the other about the practice, its assets and potential for the future. If one or both buyer and seller are not being forth coming, this type of transition approach may still work in spite of that. So, there is a risk to the extent of both buyer and seller being totally truthful to each other and to their accountants and attorneys. The following paragraph gives a specific example of how an earn out works for the parties involved with the transaction.

An example of an earn out:

Let’s say that there is a successful beginning to a negotiation for the beginning of the sale of the dental practice where the potential buyer and seller both agree that the clinical skills, personality and administrative adeptness f each party fit each other and the practice. The seller knows that the patients will like the potential buyer so the piece of the puzzle remaining is the financial side of the transaction. In this hypothetical situation, the seller wants $1,000,000 and the buyer is stuck on $950,000. There is a $50,000 difference or just 5% between them.

The accountants and lawyers have each done what they can with tax benefit allocations of the purchase price, but the economics of the sale price still leaves a $50,000 difference. If the buyer and seller agree to $950,000, but the gross revenue of the practice is $1,100,000 in the year of the sale, instead of getting the extra $50,000, the seller gets the $50,000 plus 20% of the additional $100,000 above the $1,000,000 for agreeing to the terms. The buyer gets the $950,000 price that he or she wanted but the seller has an opportunity to earn the $1,000,000 that the practice was originally put on the market as the listing price. Each party has something to gain or lose so the risk is limited to the $50,000 or 5% of the total.

As in this example, there is also an upside so the seller has something to gain as well. This certainly is not much of a risk at all. The transition occurs which is what each party to the sale wants. The seller may say that he or she should have held out for the $1,000,000 but in this scenario, the seller gains more with the earn out if the practice grosses $1,100,000. If the practice’s revenue is $950,000 or less, the seller still gets the $950,000 which is better than nothing based on the final disposition where the buyer and seller could not agree on a sale price amount.

Other examples and risk versus rewards:

There are many other examples of earn outs where the years involved and percentages may vary but the basic concept is that there should be a small risk to the buyer and seller and the transition occurs immediately rather than in some future time or at a lower price or at all. The earn out may take more than 1 year and the amount of upside to the seller may be greater or lower. The buyer really can’t lose because if the gross revenue of the practice is smaller than he or she anticipated, the sale price paid will have been lower up front. If the gross revenue is better than expected, theseller pays the differential out of a higher amount than he or she would have had based on there being no transition.

The main question is how badly do the buyer and seller want the transition to take place? Also, how long will it take to find another buyer who qualifies for the transition while the seller is still waiting to see any money at all? Each party may have their own pacefor completing a transition but timing dictates everything and with an earn out.