Here at Polaris, we want to create paths of clarity, confidence, and results for our clients in the group practice space, and part of that process is ironing out affiliation strategy details. We thought you might like to hear this side of the story from an expert, so we sat down with Ryan Metzler, partner, and chair of the Corporate Department at Stock Legal, out of St. Louis, Missouri.
We work with Ryan and his boutique transactional law firm a lot, especially when it comes to developing associate equity programs for our clients. Ryan focuses on small and medium-sized businesses, on matters involving their entire life cycle. That can include entity formation, corporate governance, contracts, capital infusion, exit strategies, sales and acquisitions, and other general business issues. Ryan also has a specific corporate and regulatory niche with respect to representing dental practices and dental service organizations, and as a result, Ryan is a reliable resource, bringing both perspectives on affiliations.
We’ll start the conversation with a bigger picture - what does the term affiliation mean, from a legal perspective?
“There are basically three paths to growth with group dental practices: de novo, vertical acquisition, and affiliation. Affiliation is a growth strategy that allows the original dentists to maintain ownership of what they have built to date but establish a formal relationship with a DSO, or larger management organization, whereby they pursue up-side growth together. The basis of the relationship is contractual - for the provision of third-party services and assistance with managing the respective practice.” Ryan states.
This strategy is all about working together with a bigger organization, especially when you’ve maximized your current earnings as a sole owner. For a solo practice owner, this might seem daunting. Ryan breaks it down for us:
“There must be natural synergies between practices and larger management organization, where there's mutual opportunity for growth. The practice will benefit from the DSO taking away some of the headaches of running a dental practice, whether that be HR, accounting, marketing, supply chain management or legal issues, and the DSO benefits from adding another great practice to its group, adding to its collective value,” says Ryan.
Affiliation is a great way for a practice that has maximized its opportunities in its current space to grow further – without diluting ownership. At its core, this method is more like a collaboration than it is an acquisition.
“The DSO isn’t coming in and taking over direct membership of the practice, rather, it’s a collaboration where they offer new perspectives and pathways to success.. It's an absolute two-way street, and there's got to be that appetite for creativity and growth on both sides,” Ryan says.
For example, DSOs have the ability to drive revenue through curtailing costs, recruiting, and increasing efficiencies; all are things that are immensely beneficial in a solo practice. However, keep in mind that nobody is going to affiliate with your group until you have proof of concept and proof of delivery - that’s on you as an owner.
Another one of the beauties of this concept is that there is no additional debt taken on by either party to achieve growth. Yet - if there is no debt, how is any value created? Well, through something called a “profits interest.”
“Profits interest are a form of equity, but only valued on growth. So the existing owners themselves retain 100% of the membership interest in the practice. But, upon entering into an affiliation with a DSO, the owner grants the DSO somewhere around a 50% profits interest,” states Ryan.
Thus, as an example, let’s say the solo practice is valued at One Million Dollars, and it has stagnated in growth. The DSO then offers the affiliation the opportunity to unlock greater value. The owner is entitled to that first million dollars they've created, but any additional valuation above a million dollars is split 50/50 between the practice and the DSO.
Ryan summarizes the valuation proposition, “So, not only does the solo practitioner get the increased value in their practice, they are also increasing the value of the DSO (as the more practices folded into a DSO’s structure, the higher EBITDA or exit multiple that can be achieved). The original owners thus can achieve 50% of the upside in the growth that they may not have had the ability to unlock alone, but then will also get access to the higher valuation, multiplied by a higher EBITDA upon the long-term exit. This is the ultimate payoff for a solo practice.”
The concept that our co-founder Diwakar loves to talk about is called arbitrage. This means that a solo practice is typically going to value between 3-5 times EBITDA on multiple. However, a group practice will value a lot higher than that, up to 8-12 times. For this reason, affiliation is the right strategy for a grow-and-exit intention, versus a grow-and-operate type of intention.
While the upside is great, it is important to understand the contractual arrangements that need to take place to make the affiliation work.
Ryan touches on this further: “When contemplating an affiliation, it needs to be understood as a long-term partnership, where we grow and practice for a while, build the organization out, and then exit. To get there, the DSO and owner need to prove that they are, in fact, one cohesive organization, rowing in the same direction,” states Ryan.
That means uniformly adopting a similar set of organizational documents, a similar accounting structure, and doctor employment agreements.
Change in management can be hard, and something that takes years to be successful - this is not a quick flip solution. There is no exit in six months with an affiliation strategy. Instead, this will be at least a two-to-five-year time investment with some level of change, all the while keeping the promises of equity and stability for those originally involved in the practice, pre-DSO.
So, what’s the main takeaway if you’re considering an affiliation journey?
“Affiliation definitely requires commitment from both sides to be successful. No one gets anywhere alone, and this is especially true with affiliation. However, with the right people, partners, consultants, DSO, and legal team, anything is possible!” adds Ryan.
Give us a call at Polaris, or send us an email if you’d like to discuss any of these points further - we would love to guide you in the right direction.