Of the over $200,000,000 in transactions LPS will close in Q2 2021, all have an earn-out component. An earn-out pays doctors additional consideration for future performance in the year or years, after an initial transaction.
I quit college in 1978 to take my first job in the financial industry as a commodity broker’s assistant. At the time, the hot topic was the Hunt Brothers entry into the silver market. I worked for their personal broker and watched silver rise from $5.62 in September of 1978 to over $50.00. It was an educational and profitable experience. Silver has always been my favorite asset! (Long X-ray reclamation business story goes with this…)
Thanks to COVID, many dentists who are interested in monetizing a part of their practices before the Biden “soak the rich” adventure starts, have a LARGE SILVER LINING to achieve extraordinary values in excess of 2019 levels. Due to COVID, most practices’ 2020 performance was below 2019. IDSOs interested in partnering with larger practices today in virtually every transaction includes an important element in their deals which includes a future “earn-out” provision. An earn-out pays doctors additional consideration for future performance in the year or years, after an initial transaction.
Earn-Outs are Opportunities for Growing Dentists
Earn-outs are available in many different forms, but when structured correctly, they can result in a growing practice ultimately achieving higher values of 20% to 30% and more than the initial value of a practice today. Of the over $200,000,000 in transactions, LPS will close in Q2 2021, all have an earn-out component.
Some IDSOs today are offering structures in which practices are valued on 2020 or even annualized Q1 2021 performance but repriced one, two, or three years after the initial transaction. Some of these transactions use the initial valuation metric, but it is applied to the future performance of the practice. A growing practice which can benefit from a new partner’s resources to accelerate their growth can see dramatic gains in overall value realization through these structures, if they grow. It is all upside and no downside when structured correctly.
Earn-Out Tax and Structure Tricks
While long-term capital gains tax treatment (20% Federal) may not exist in 2022 and beyond, it will still pay to structure an earn-out on the assumption that they will remain. If simply structured as a performance bonus, it will be taxed at ordinary income rates, which by then could be well above 53% in California and NYC and over 40% in at least 44 states.
There are a few tricks to structuring the earn-outs including whether to tie the performance increase to top-line revenue or bottom-line profit, caps or no caps, and in what currency the achieved performance is paid; cash, equity or both. Proration is also a critical point to negotiate.
Doctors are advised to choose a competent advisor to structure a transaction to take advantage of this short-term anomaly which will not last long. Until COVID, large earn-out potential transactions were rare and were actually prohibited by many of the lawyers advising the larger IDSOs. It is amusing to see how fast the “law” changed to allow earn-outs at virtually every IDSO.
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