Transitions through earn out provisions

March 21, 2012

In many cases, the sale of a dental practice is similar to the sale of a personal residence. Sellers sometimes feel that their practice is worth more to them than the market will pay. This is a similar situation involving the emotions in the sale of a home which will cause the value to be more to the seller than to potential buyers. These same feelings can reflect a higher transition listing price than what the practice will bring.

In many cases, the sale of a dental practice is similar to the sale of a personal residence. Sellers sometimes feel that their practice is worth more to them than the market will pay. This is a similar situation involving the emotions in the sale of a home which will cause the value to be more to the seller than to potential buyers. These same feelings can reflect a higher transition listing price than what the practice will bring. Practice brokers and advisors may prepare analyses and do their best to assist in the sale of the practice at the highest price possible but there may be no buyers at that price. The practice may be listed for a long time, which also may scare buyers away, while the seller is attempting to obtain the price that he or she feels is appropriate for the time spent in building it.

Can the Seller’s Price Still be Obtained?

There are times when a fixed sales price presents the lowest amount available for a seller, especially when the practice has been on the market for a long time. As an example, if the selling dentist feels that he or she should receive $500,000 for the practice and the most a potential buyer will offer is $400,000, there would seem to be a stalemate where there is no transition at all at any price because neither the buyer nor the seller will budge. There is a way to continue the negotiations and to come to a satisfactory conclusion where a transition does take place and where the seller may be able to obtain the $500,000 thought to be the value to the seller, or possibly, more.

Consider an Earn Out

Maybe you have heard of the term “earn out” and did not know what it meant or how it would work. An earn out in brief, is a method for achieving a price that could be more than the fixed price that is offered by the buyer and  the same or even possibly more than the fixed price that is asked by the seller. This may seem contradictory but an understanding will be achieved after reading an example. If the seller is at a point where there is no turning back and the practice must be sold, the earn out may be the appropriate format for achieving the best results possible. There could be many reasons why the practice must be sold such as the age of the seller, health problems, a divorce or a relocation. To participate in a transition when there is no movement in the negotiations and to restart them, a guide line for the earn out to accommodate both the buyer and the seller is offered below:

Example of An Earn Out

Let’s use the $500,000 non budging asking price and the $400,000 non budging offer. If the seller is so sure the value of the practice is $500,000, and could prove it, the selling dentist could offer the following as a form of that proof:  Set the transition price at the $400,000 amount that the buyer is willing to pay. A formula can be created based on gross revenue, as an example, that if the practice produces a certain amount in the next year following the transition, the buyer will then agree to pay the additional $100,000 and possibly more, because proof was entered that the practice did produce the amount necessary to be valued at $500,000. Based on percentages of costs, the amortization of loan plus its interest charge, and the gross revenue needed to produce what would create the value of the $500,000 sale price, the buyer could pay the extra $100,000 from the production and earn even more, and the seller would get the $500,000 sale price that was thought to be its realistic value. Of course there are risks, but they are insignificant with proper guidance from advisors who have had experience with sales involving earn outs.

What Are the Risks?

Let’s think about the risks and what they may be. First of all, with one party to the transaction at $400,000 and the other at $500,000, there is no transition. The buyer has not purchased the practice and may go look elsewhere for another practice. Of course the selling dentist would have lost the sale at a point when there may be no other buyers, especially if the practice has been listed for some time. Can the buyer or the seller lose anything by using an earn out? If the transition price is $400,000 plus an earn out provision, and the earn out takes place only if certain agreed upon conditions are met, the buyer and the seller are each betting that the earn out does take place because each will be a winner. Think of a sales person who earns a commission. Every time there is a sale, the sales person earns more money. The business also earns money every time the sales person earns money. That is the way an earn out works. It is a winning situation for each party to the transition. If the conditions are not met for the earn out to take place, the selling dentist would have received $400,000 instead of not having a sale take place at all. The buying dentist would have paid $400,000 but would have lost because the value would really have been less than the selling dentist thought. This means that the buyer would have paid the correct price in his or her opinion, but would have lost on the value that would have been easily paid for if the earn out conditions had been met and the practice had produced enough to amortize a $500,000 acquisition price.

How Does Someone Learn More About Earn Outs?

For advice about whether an earn out is appropriate for you as either the buyer or the seller of a dental practice, contact a CPA with experience in working with the dental profession, especially someone involved extensively with transitions. Many practice brokers and CPAs do not know what an earn out is, so beware from whom you are asking advice.

Bruce Bryen is managing partner for Bryen & Bryen LLP, Certified Public Accountants. Based in New Jersey, Mr. Bryen specializes in deferred compensation such as retirement plans, income and estate tax planning, the determination of the proper organizational format, asset protection and structuring loan packages for presentation to financial institutions. Bruce is also experienced in providing litigation support services and has testified on numerous occasions as an expert witness. Contact him at 800-988-5674, ext. 112.