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Bruce Bryen is a certified public accountant with over 45 years of experience and is a part of Baratz & Associates CPAs. He specializes in deferred compensation, such as retirement planning design; income and estate tax planning; determination of the proper organizational business structure; asset protection and structuring loan packages for presentation to financial institutions. He is experienced in providing litigation support services to dentists with Valuation and Expert Witness testimony in matrimonial and partnership dispute cases. He is also a financial writer for several dental journals. You may contact him at 609-502-0691 or at Bryenb@baratzcpa.com.
How many times has a prospect attempting to buy a dental practice been stymied by the seller feeling that his or her office is superior to the amount being offered? Of course, it means that the buyer’s offer is going to be rejected. Sometimes this happens when the buyer and seller are not that far apart pricing the transition. This causes frustration to the buyer and seller, especially if the due diligence has taken place and the financing is close to being arranged for the transition’s closing date. If the parties to the transaction are at a fixed point and not budging on price, there is a realistic method where the seller can get his or her price and the buyer can pay that amount, based on proof that the value is there. This type of transaction is called an “earn out.” In a transition where an “earn out” occurs, both the buyer and seller of the dental practice feel they have negotiated its proper price and neither has left anything to be determined.
The following is a specific example of this. Suppose the buyer has offered $500,000 and the seller has stopped at $550,000 as the acquisition cost. There is a difference of $50,000 which the seller is sure the practice is worth and the buyer is not comfortable paying. To proceed, the sale price would be $500,000 plus an “earn out” of up to an additional $50,000. The next step would be for the advisors to prepare a formula for the buyer to pay the additional $50,000 based upon certain conditions occurring. The additional payment, or “earn out,” would provide the seller the extra $50,000 over up to three years. Here is how it works: If the agreed upon gross revenues upon the sale were $775,000 and the net profit plus owner’s actual compensation was equal to $310,000 (40% of gross revenues), those amounts would be used as the base. If the gross revenues of the practice exceeded $775,000 the following year, a formula would be included in the agreement where the seller would get one half of the net profit using the base year of 40%, which would be the same as 20% of the gross revenue in excess of $775,000 from the base year.
In the year after closing, if gross revenues were $825,000, the seller would receive an additional $10,000 (20% of the increase in the base year gross revenue of $50,000, which is the $825,000 minus the base year of $775,000, producing a 40% profit). In year two, let’s say that the gross revenue went up to $875,000. The additional $100,000 from the base year of $775,000 gross revenues at 20% would give the seller an additional $20,000 (20% of the increase in gross revenue base of $775,000 that produced a 40% net profit). Since the seller already got $10,000 from year one and $20,000 from year two, the “earn out” would have produced an additional $30,000. If in the third year, the gross revenue rose to $925,000, the seller would be looking at an additional 20% of the increase in gross revenue from the base year of $775,000, which would be 20% of $150,000 since the third year of $925,000 minus the base year of $775,000 equals $150,000. The $30,000 however, is capped at $20,000 since the “earn out” was $50,000. At closing, the seller got $500,000, then the seller received $10,000 from year one, $20,000 from year two, and $20,000 from year three. The interesting thing is that the buyer would have earned an additional amount of money as well since the buyer was paying half of the profit up to the capped amount of $50,000. In this case, the buyer and the seller both were happy with the results. The example reflects annual gross revenue increases of about 6.5%, certainly achievable.
In the example, the proof of value was the seller’s. That does not always happen. The point is that in an “earn out,” the transition occurs. To find someone with the expertise to assist in this type of transition, a dental CPA would be the choice since he or she would probably have experience with this method of transition. A practice broker may also have this type of expertise but it is important to interview the broker to be sure since this type of sale is not the norm