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Chip Fichtner

Timing and Earn Outs; Get Paid for Your FUTURE Performance

by | Mar 13, 2024 | Insights

Since the onset of Covid, four years ago, every one of the IDSO partnerships created for LPS clients ($1.0+ billion in the last 24 months) has included an Earn Out component. Doctors get paid for their incremental growth in EBITDA or collections in the two years AFTER closing.

How Earn Outs Work

Most Earn Outs functionally reprice a transaction at the one- year anniversary of a closing and again at the two-year anniversary. The Earn Outs were originally (2020) designed to entice doctors who were reluctant to partner with an IDSO until they returned to 2019 performance levels, prior to the impact of Covid in 2020 and 2021. Today, Earn Outs are a multi-million-dollar incentive for doctors to accelerate their growth, not slow down to manage their freshly minted millions.

In 2022, 2023 and now 2024, Earn Outs became gold mines for doctors who grew after completing an IDSO partnership. An Earn Out allows a doctor to lock in today’s record multiples which will be applied to their future incremental EBITDA growth in the two years AFTER their initial partnership with an IDSO.

Earn Outs Can be Worth Millions of Dollars

Earn Outs pay additional purchase consideration, based upon growth in the 24 months after partnership. Any doctor considering an IDSO partnership in the next two years would be better served to complete an IDSO partnership NOW to lock in current record values.

Take a look at this hypothetical Earn Out situation. It’s a nice dental practice valuation for sure, and there are many practices out there that can realistically see offers like this:

  • Practice EBITDA: $1 million
  • Value Multiple: 10x EBIDTA
  • Initial Valuation: $10 million

Now let’s calculate the value of an Earn Out for this dental practice:

  • In the first 12 months after the transaction, EBITDA grows to $1.1 million:
    • 10x (multiple) multiplied by:
    • $100,000 (incremental growth) =
    • $1 million Earn Out bump
  • In the second 12 month period after the transaction, EBITDA is $1.2 million:
    • 10x (multiple) multiplied by:
    • $100,000 (incremental growth) =
    • $1 million Earn Out bump

As you can see, the Earn Out generated an additional $2 million or 20% to the doctor. That’s a significant increase in value!

Earn Outs are all Upside. There is no Downside.

There is no benefit to waiting for an improved EBITDA over the next 24 months, no matter how fast they expect to grow. The Earn Out will pay you for future growth.

If two years from now value multiples have declined, this was a risk-less, winning strategy to lock in high 2024 value levels on future EBITDA growth. If multiples continue to increase, you might have left money on the table. No one I know is betting that multiples will increase from today’s record levels, but I could be wrong!

However, the investment income on the millions in cash you get at closing now (S&P up 24% in 2023 and T-Bills at 5.0% risk free today) should also be included in the cash now vs. waiting for growth calculation. Note that Earn Outs are all upside, no downside. If your practice declines, you will not get the Earn Out, but you will also not be penalized.

Earn Outs are Receding

Several of the quality IDSOs are now making offers without Earn Outs. We will close our first transaction in four years without an Earn Out later this quarter. This client traded a record 11x EBITDA multiple on $5.0 million in EBITDA ($55 million) for a structure with no earn out. I expect other IDSOs will return to pre-Covid deal structures without Earn Outs later in 2024. I hope not, but time will tell.

Bottom Line

Practices hoping for higher EBITDA numbers in the next two years, and waiting for a higher initial valuation, are potentially missing out on today’s record values. If your horizon is two years or less, waiting makes no sense. In addition, your future EBITDA after your initial IDSO partnership will benefit from your partner’s resources of lower costs, higher reimbursement rates, new patient marketing and recruiting assistance.

Chip Fichtner
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