How to structure the buy-in and buy-out of dentists to a dental group practice
By Matt Dickstein
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Dentists come and go from dental groups. When a dentist enters a practice as a shareholder or partner, the practice should prepare for the dentist’s exit. The exit is inevitable. In this article, I give one simple rule for structuring the dentist’s buy-in to a practice and the later buy-out of the dentist’s shares from the practice.
Buy-in should mirror buy-out. If a dentist buys-in to a dental group at $X, the group should buy-out the dentist at the same $X. In other words, you should use the same formula to determine both a dentist’s purchase price for shares in a practice, and the dentist’s buy-out price when leaving the practice. The reason for the rule is fairness. Neither the practice nor the dentist should get a windfall from the buy-in and subsequent buy-out.
Founders are the primary exception to the rule. Founders usually get a special deal because they built the practice and made it valuable. In the start-up years, a founder’s compensation is low and he suffers higher risk, so it’s fair for the founder to receive the full buy-back price later on.
The Purchase Price for Buy-in and Buy-out
The buy-in & buy-out prices (when taken together) can be high (for example, $100,000-in and $100,000-out), or they can be low ($10-in and $10-out), depending on the practice. In most practices, the price is either a formula that approximates fair market value (FMV), or an arbitrary or nominal number.
I’ve seen many different buy-in and buy-out prices. I’ve seen a practice with a nominal price of $10 for both buy-in and buy-out, and what’s more, the structure worked! Most practices, however, base the price on FMV. An FMV buy-in / buy-out price will equal the percentage share of the practice to be bought or sold, multiplied times the value of the practice.
You determine the value of the practice based on 3 factors – tangible assets, accounts receivable, and goodwill. You can determine tangible assets and accounts receivable without much debate, because they represent hard assets that exist in the here and now. Goodwill is much harder to fix. Goodwill is the value of the practice’s expected future earning power, and the future is unknown. Goodwill varies from practice to practice. Although you can spend thousands of dollars on a fancy practice valuation and appraisal, ultimately you make a gut call on the value of goodwill.
The dentist can pay the buy-in price, and the practice can pay the buy-out price, in cash or in installments. If a dentist pays for shares in cash, the dentist should receive the buy-out in cash (to the extent that practice liquidity permits this). Likewise a dentist who buys-in to the group over time using installment payments (e.g. a promissory note or salary reduction) should receive a buy-out in installments (e.g. a note or deferred compensation).
Many groups pay the buy-out price as a combination of the buy-back of shares and deferred compensation. They do so for tax reasons because deferred compensation is deductible to the group and taxable to the dentist as ordinary income. Deferred compensation can be useful if a dentist paid the buy-in through reduced salary (which are pre-tax dollars for the dentist). At buy-out, the practice gets to deduct the deferred compensation, which evens out the tax benefit.
If the practice pays a part of the buy-out price through a promissory note, the maturity of the note should be long enough that it does not overburden the practice yet short enough so the departing dentist does not wait too long for closure (e.g. 2-4 years).
Competition After Buy-out
A California practice can impose a non-competition clause on the departing dentist. In California, a non-competition clause is legal if it occurs as part of a bona-fide buy-back of the dentist’s shares. Some practices take very seriously the threat of competition, but other practices don’t really care. It depends on the nature of the practice and the market.
If a practice does not demand a non-competition clause, it should at least regulate the process by which the departing dentist leaves. The practice should control how the dentist communicates with referral sources, employees and patients. The practice needs an orderly and professional process for separating the dentist from the practice. You don’t want either side (whether the departing dentist or the dental group) to poison the other’s well.
For more on non-competition clauses, read May a dentist compete against his or her former practice? and also, Stealing employees.
The practice’s corporate documents should state the terms of the buy-in and the buy-out. Ordinarily you cover the buy-in in a Purchase Agreement, and the buy-out in a Shareholders Agreement. See also, Shareholder buy-sell agreements for dental corporations.
To learn a little more about the process by which a dental group should bring in a new dentist, read Bringing a new dentist into a dental practice.
You need an experienced attorney to implement my rule for buy-ins & buy-outs. Do not do this alone because there are many considerations and choices that I don’t have time to cover in this short article.