Let’s start at the beginning. Earned equity (a.k.a. sweat equity) is the assumption by an associate (who is now contemplating purchasing either a partial or total ownership position of a dental practice) that because of his or her tenure in the practice, they should be granted a discount of the fair market value of the practice. The thought is that because the practice was collecting say $1M when they joined it and now, 10 years later, it is collecting $2 million the associate was at least partially responsible for the $1 million in collection growth and should be credited accordingly. No one wants to pay for something that, on the surface, appears they have already earned.
Unfortunately, many associates, as well as sellers, wait until the time when a buy-in seems appropriate to begin the discussion of earned equity. That discussion should be initiated at the beginning of the relationship rather than at the end.
Don’t be fooled by an increase in collections.
While a discount may or may not be indicated, using collections as a sole measurement of growth and thereby practice value may be flawed logic. Collections are certainly an important component of market value, but they are not the only component. Let’s take a glance at some other factors that may negate an associate’s claim.
The value of anything is in no small degree dependent on the ancient economic principles of supply and demand. The value of a practice collecting $1 million in an area where there is a surplus of buyers may be more than a practice collecting $2 million in an area with no buyers–a clear function of supply and demand. It is possible that any growth in the value of a practice could simply be the result of external market growth and have nothing at all to do with the efforts of any individual provider in the practice, including the current owner.
The number of patients is another good indicator of growth. A practice that had 2,000 patients when an associate joined and still has 2,000 patients 10 years later hasn’t grown at all, even if collections have. It has recycled, but it hasn’t grown.
A practice that had 2,000 patients and now has 3,000 patients has clearly grown. However, the challenge is determining how many of those new patients can be directly linked to the efforts of the associate. Associates seldom bring patients with them, but instead are given patients by the seller. Just showing up doesn’t necessarily translate into an increase in new patients. Any increase could have been simply due to an increase in the population of the community, perhaps new factories or other job-producing ventures that tend to draw people from other areas.
The loss of a competitor may have similar albeit passive effect by increasing the size of the available patient pool within the existing population. And it would certainly be unrealistic to assume that either of these events were the direct result of something attributable to the efforts of any individual within a practice.
Often the addition of another employee—a personable hygienist, for example—may lead to a significant increase in new patient numbers as well as an increase in recall visits from the existing patients of the practice. Not only then does the direct hygiene revenue increase, but the revenue of the practice as a whole increases because the doctors have more opportunities to diagnose and treat potential or existing dental maladies. It would be a mistake, however, to charge the increase to the associate claiming a discount, when in fact it was due to the efforts of someone else.
Fee increases can also significantly affect collections. Anyone practicing in today’s world knows that third-party payers play a noteworthy role in how much of an effect a fee increase may have on the collections of a dental practice. However, it is certainly safe to assume that over time, some effect would accrue to the overall collections of a practice by fee increases. The cumulative percentage of any increases over the length of time an associate has spent in the practice must be accounted for in any calculation made to help determine a discount in value.
And finally, an argument can be made that if an associate has earned equity in a practice, he or she also will have been paid for that equity. If an associate does a single crown, which the practice would not have done without the associate, he or she has certainly contributed to the growth of the practice. However, the associate most certainly will have been paid for it as well. When viewed in this light, being paid for earned equity by means of a discount is very much akin to being paid twice.
So, is an earned equity discount ever justified?
To be fair, we should focus on what may be some perfectly legitimate reasons why a discount in the buy-in amount for an associate should be considered.
If an associate provides a service not ordinarily provided by the current practice owner–endodontics, orthodontics, oral surgery – virtually all of the collections generated by those services should be weighed into the calculations made to establish the market value of the practice and subsequently considered when justifying a discount.
Also, while just showing up doesn’t necessarily warrant consideration for a discount, being available on additional days to treat new patients, emergency patients and possibly even regular patients does. If an associate makes additional treatment time available and the current owner is as busy as he or she always was, then clearly any collections generated during that time should be factored into the market value and considered associate generated growth, as well.
Obviously, the earned equity discount can be negotiated. However, the parameters by which the discount will be considered should not be made solely at the time of the sale, but rather at the time the associate hires in. Giving consideration to these variables at the beginning may soften the negotiation process at the end or better yet, eliminate it entirely.
If you are a practice owner who is taking on an associate with the thought of making that associate an owner in the future, or if you are an associate eying an eventual ownership position, take some steps before you begin your relationship to prepare for the inevitable earned equity negotiation later. Waiting to address these issues until the actual time of a potential equity purchase is usually a little too late.
Here are some samples of things that should be considered before the associate’s buy-in scenario ever begins:
- First, have the practice appraised by an experienced transition consultant who will look at all of the different components that contribute to practice value and establish a basis of value to use for comparison later.
- Establish a base rate of growth that the practice has demonstrated before hiring the associate. If the practice has been growing at say 5 percent per year and is still growing at 5 percent or perhaps less per year during the associate’s tenure, there may not be any growth attributable to the associate at all, if everything else has remained relatively equal.
- Devise a method of tracking patients. How many new patients specifically ask to be treated by the associate, either because others have referred them or because they don’t want to see the current owner? How many don’t care which doctor they see? How many regular patients does the new doctor see because they are unable to see the owner due to scheduling issues?
- If the associate is to work days that have traditionally not been worked in the practice, devise a method of recording the number of patients seen on those days, as well as the collections generated.
- Along the way, take note of changes in your particular community that may affect the number of patients your practice sees.
- Keep track of collections and new patient numbers that can be directly attributed to other providers who may join the practice after the associate does.
- Plan to discuss how earned equity will be handled at the time of an ownership acquisition.
Earned equity discounts may be fair and justified. They also may be unfair and unjustified. What they are not is simply a given.