Readying Your Business for Transition

Significant decreases in the number of laboratories over the past few years have impacted the industry as the market consolidates and offshore has its affect. Yet, it is rumored that the larger laboratory groups are not acquiring other laboratory businesses right now. Nothing could be further from the truth. Since the author returned to a full-time role with Microdental-DTI with oversight for mergers and acquisitions, DTI has purchased and integrated several dental laboratories during 2011 and will close on a couple more by the time this article goes to print.

Preparing your laboratory for an appropriate exit strategy and implementing these practices will help you operate your business more efficiently, more effectively, and more profitably right now. They will also bring a higher valuation to your business upon exit, regardless of whether you sell to a family member, another laboratory, a group of employees, or one of the large laboratory groups.

Make sure to include in the design of your profit-and-losss (P&L) statement all revenue sources by product type—removables, PFMs (porcelain-fused-to-metals), and full-cast, as well as all ceramic, implant, and alloy sales. Show everything as actual dollar values and percentages of the total revenue. Then organize the first level of expenses as the cost of goods sold (COGS) or direct costs. This includes anything directly related to the manufacture of the products sold—porcelain, alloy, teeth, implant fixtures, materials, direct manufacturing labor (inclusive of benefits and taxes), and outsourcing. The resulting number will be the business’ gross profit. It tells the buyer how efficient you are at making the products you sell. Below that will be a wide variety of sales and general administrative expenses (SG&A) or indirect costs. These costs include rent, administrative and sales staff, advertising, marketing, bank fees, utilities insurance, etc. Once those costs are subtracted from the gross profit, the resulting number is the laboratory’s operating income or earnings before interest, taxes, depreciation, and amortization (EBITDA). Your owner compensation and benefits should be allocated into the COGS or SG&A based on how much time you spend at the bench versus in the office.

Once a year, exercise putting all of the beneficial expenses to you or your family back into the business. Replace the tax-driven designed allocations and expenses for anything that you would not likely have after you sell the laboratory to someone else. Redistribute those costs and expenses so that you can show the truest version of what the business was generating in terms of operating income to a prospective buyer. This demonstrates the most valuable income potential to the new owner. We now have a “normalized” P&L, COGS, gross profit, and operating income. If you then add back all of your other compensation, the result would be the pre-compensation laboratory operating income.

Now we can look at what your laboratory may be worth by taking back out the compensation you expect to receive after you sell the laboratory, which is your post-compensation laboratory operating income. You are very likely to enjoy lower income and perks than you would have been afforded with full ownership because you “sold” the equity value of the enterprise for cash and/or stock. Be conservative yet realistic on how much you really need, not want, to live on going forward. If you take out too much income, there will be little left to multiply by a valuation factor and pay you for the
laboratory. The multiple used for the post-compensation laboratory operating income to valuation exercise is determined by several things—percentage of the deal that is cash or stock, location, mix of services, cash flow, trend analysis, and desirability.

This one is more a behavioral equation than mathematics. Laboratories generally get higher multiple valuations if they are growing, have a desirable mix of goods and services, are in the right location, have better cash flow, etc. Time your transition well and put strategies and tactics in place that help present the laboratory most favorably prior to the decision to sell. Declining revenues or a poor operating income year after year does not help you get the best return for your business.

When buyers look at prospective dental laboratories, those with little or no debt are usually more attractive. This is not to imply that all debt is bad. Many laboratories purchase equipment (and take on debt). However, if that equipment is not used near capacity and does not provide a good return on investment, this challenges the cash flow of the business. In this case, outsourcing may have been a better strategy. Try to make those capital expenditure decisions using careful financial analysis rather than emotion. When asked why they bought, many laboratory owners have replied that they wanted to control that step, or they could not find an outsourcer that provided the quality they wanted. Some of these owners suffer significant drops in income because they chose to be paid in equipment rather than cash.

Gerber was right. From the moment we open our doors we should begin to think, “How would we want to run this business if the intent were to sell it someday?” In fact, maybe that is how an equity enterprise should be operated each and every day. Doing so would yield a more rewarding result today, tomorrow, and into retirement.

Mark T. Murphy, DDS, is the vice president of sales and education for Microdental-DTI.