Structuring Your Dental Practice Transaction and Elements of the Purchase Agreement

In our previous article, we described the due diligence process, including what a buyer would look for in your practice. Once due diligence is under way, the next step is the purchase agreement, which is usually prepared by the buyer’s attorney.

A purchase agreement is the main document for the transaction and describes its structure. For example, are you selling the practice’s assets or the equity of the professional entity that operates your practice? Although the transaction’s structure is defined in the Letter of Intent, certain terms could change because of the due diligence process.

This article assumes that your practice operates in a state whose laws prohibit the corporate practice of dentistry (e.g., New York) and that you are selling your practice to an established dental services organization (DSO).

General Structure – Asset Sale, Stock Sale and Additional Considerations

A typical DSO transaction will be structured as a sale of the practice’s non-clinical assets (e.g., equipment, office furniture, non-clinical inventory and non-clinical contracts such as your real estate lease and vendor contracts) to the DSO and a sale of the practice’s clinical assets to a captive professional entity that is affiliated with the DSO. In addition, at closing, your non-clinical employees would be transferred to the DSO and your clinical employees (e.g., other employed or contracted dentists, dental assistants, etc.) would be transferred to the captive professional entity. Following the closing, all of the non-clinical assets and non-clinical staff would be leased back to the DSO’s captive professional entity pursuant to an administrative services agreement. Following the closing, your practice’s professional entity would be a shell with no assets, so you would eventually be able to wind up and dissolve the entity in due course.

In some instances, your practice might have certain licenses, permits and/or contracts (e.g., payor contracts) that cannot be assigned/transferred from your professional entity to the DSO or its captive professional entity, or cannot be obtained by the DSO or its captive professional entity on their own behalf. In those scenarios the transaction may still have the non-clinical assets of your practice transferred to the DSO but a dentist that is “friendly” to the DSO might purchase 100% of the equity or stock of your professional entity from you. The DSO would then enter into an administrative services agreement with your professional entity (which is now owned by the “friendly dentist”).

You will want to discuss the structure and business terms with your accountant and other financial/tax advisors to determine that the transaction is being structured in the most tax efficient manner as possible for you.

Elements of the Purchase Agreement

The purchase agreement can be a complex document, but your legal counsel should be able to explain it to you and identify material issues and risks for you to consider. Below are summaries of some high-level matters common to all transactions so that you have an idea of what to expect.

Purchase Mechanics

First and foremost, the purchase agreement will detail what is being purchased. In an asset sale, the agreement will detail the general categories of assets that are included in the sale (e.g., furniture, fixtures and equipment, intellectual property, inventory, specific contracts etc.) and those that are excluded (e.g., cash, insurance policies, your bank accounts, personal property, artwork, etc.). If the transaction is structured as a purchase of the equity/stock of your professional entity, then the agreement would detail the type and quantity of equity being purchased.

One particular asset that may be important for you is your accounts receivable. Will it be a purchased asset or an excluded asset? Some buyers want your accounts receivable because they need a source of working capital to help pay short-term expenses following the closing (e.g., payroll). If accounts receivable are a purchased asset, is it included in the purchase price, or will the buyer pay you a specified amount in addition to the offered purchase price? In some situations, the buyer will ask that you deliver a certain level of accounts receivable at closing and your purchase price will be adjusted depending on if you are above or below that threshold. Or if you will be paid additional amounts for the accounts receivable it could be based on the aging of the accounts receivable and what the buyer believes is collectible. Also keep in mind that if you retain your accounts receivable, you may still need assistance with collections efforts post-closing and the buyer may ask for certain restrictions relating to those collections efforts to prevent you from potentially tainting any ongoing relationship (e.g., you need their approval to send a patient to collections).

In addition to specifying which assets will be included and excluded from the sale, the purchase agreement will also specify what liabilities of your practice the buyer is willing to assume and those it is not willing to assume.  Typically, a buyer will not assume any of your pre-existing liabilities and only assume the ones that arise once the buyer takes over operations (e.g., your lease payment obligations after the closing). In a transaction structured as a sale and purchase of the equity/stock of your professional entity, then the buyer automatically inherits all of your practice’s liabilities – this is a reason why this type of structure is typically avoided by buyers.

Representations & Warranties

The DSO will ask you to make fulsome representations and warranties (i.e., factual statements) regarding the historical operations of the practice in the purchase agreement. These representations and warranties can cover everything: who owns the practice/professional entity, who has ownership and title to the assets that the DSO is purchasing, the types of contracts the practice is a party to and if there have been any defaults, whether the practice has been operated in compliance with all applicable laws (e.g., healthcare laws, labor and employment laws, privacy laws, environmental laws, etc.), whether the practice is involved in any prior or ongoing litigation, whether the practice has paid its taxes, if there have been any employment-related disputes and what types of employee benefits the practice offers.

The more sophisticated your practice, the more extensive you can expect the representations and warranties to be. Oftentimes, these representations and warranties will make up the bulk of the purchase agreement and they can be extremely tedious and overwhelming for a non-lawyer to parse through. Although the DSO will learn a great deal about your practice through its due diligence efforts, these representations and warranties will help to identify potential liabilities or issues relating to prior operations and will also serve as a basis of recourse in the event those representations and warranties are not true and the DSO suffers damages as a result of the practice’s past operations. With these things in mind, this is an area where you will want to pay close attention and work with your attorney to fully understand the statements you are making. The broader the scope of these representations and warranties, the greater risk and potential liability you will have if something is untrue.

Your attorney should explain the various representations and warranties to you, help you identify any that either may not be true or accurate and limit their overall scope. In addition, your attorney should be able to help you identify and disclose any past events that might make the representations and warranty untrue because once you have disclosed the past issue, the DSO cannot claim the representation and warranty is not accurate and you are in breach. It will also help the parties determine if there are any potential post-closing risks related to the matter.

Indemnification

Regardless of how the transaction is structured, a DSO will ask that you indemnify them from any damages that they incur as a result of the transaction and your prior operations. In simplest terms, this means that if the DSO purchases your practice and they incur damages as a result of something that occurred during your operation of the practice, then you will pay for those losses (which may include any attorneys’ fees that they incur in resolving the issue). Specifically, these indemnities might include matters such as (i) breaches of your representations and warranties, (ii) breaches of any covenants you provided in the purchase agreement, (iii) any particular liabilities of your practice that the DSO identifies in diligence that are of considerable concern (e.g., a previous billing audit or HIPAA breach) and (iv) any matters that relate to pre-closing operations of your practice (this is a broad catchall). For example, if you made a representation that your practice was in compliance with rules and regulations regarding billing and coding, and then six months after the closing the DSO is told that the practice is being audited by a payor for non-compliant billing practices that occurred while you owned the practice, the DSO may claim you breached that representation and you may be responsible for covering any losses the DSO incurs in defending the audit. Keep in mind it is also standard practice for the DSO to indemnify you for breaches of its representations and warranties and covenants it provides in the purchase agreement.

Indemnification is typically a heavily negotiated aspect of the transaction because the DSO will want the most protection for its investment and you will want to limit your risk of having to cover potential losses going forward. In addition to negotiating the specific indemnification matters (like those mentioned above), there are ways your attorney can limit your indemnification risk. Specifically, your attorney can negotiate “baskets” and “caps”. A “basket” is a specified dollar amount of losses that the DSO must reach before it can come to you for indemnification. It can be structured so that once the threshold is met then the DSO is able to recoup all of its losses (i.e., a “tipping basket”) or only those losses above the threshold (i.e., a “deductible” similar to an insurance deductible). A “cap” is a specified dollar amount above which you will not have any liability to the DSO. Baskets and caps are usually heavily negotiated in terms of what types of indemnities they cover (e.g., only breaches of representations and warranties, all indemnities or only certain specified indemnities) and the specific dollar thresholds, which are usually set as percentages of the overall purchase price (e.g., baskets can range from 0.5% to 1% of the purchase price and caps could be 10-20% of the purchase price). In addition, your lawyer can attempt to limit the period of time which your representations and warranties will survive the closing and the DSO can claim a breach of your representations and warranties. The time limit typically depends on the type of representation and warranty. For example, representations and warranties regarding your payment of taxes will typically survive longer than representations and warranties regarding the contracts to which you or your practice are a party.

Finally, DSOs will also try to protect themselves against the risk that you default on your indemnification obligations. The DSO can request that you escrow a portion of the purchase price for a period of time (e.g., 12 to 18 months). This is very common, but your lawyer can help you negotiate the proper dollar amount and time period of the escrow.

Other Considerations

In addition to the matters discussed above, there are some other general topics that both parties will want to keep in mind when negotiating a transaction, as they could delay the closing.

First, will you need to provide any notices to a third party or obtain consents from a third party to sell your practice? This issue typically arises if your practice is a party to certain contracts which need to be assigned to the DSO at closing, but the terms of the contract require you to either provide notice or obtain consent of the counter-party prior to assignment. If the contracts are material to your practice, it is likely that you will need to obtain these consents or provide the notices. This can often present timing concerns in a transaction because either the notice needs to be provided or the consent needs to be obtained “x” days prior to closing and/or the counter-party could delay providing you with its consent, thus holding up a closing. In addition, you will need to decide whether there is any risk of providing the notice or attempting to obtain a consent before having a signed purchase agreement. In other words, do you want to tip off the counter-party that you are selling your practice without assurances that the DSO is committed or obligated to close the transaction?

Second, if you lease your office location(s) from a third-party landlord, then you and the DSO will need to consider the following. Should the lease be assigned to the DSO or is the DSO interested in trying to negotiate a new lease with the landlord? If the lease will be assigned, what are the terms and conditions in the lease that govern assignment. Do you need to obtain the landlord’s consent (this is almost always the case) and, if so, much like the contracts discussed above, when will you try to obtain that consent. Also, will the DSO ask for any amendments to the lease in connection with that assignment (e.g., options to renew the lease)? If so, this can prolong the process of obtaining that consent. In the alternative, if the DSO wants to attempt to negotiate a new lease, then this could certainly hold up a closing, particularly if your landlord is a tough negotiator and the DSO is seeking material changes.

As you can see, the purchase agreement will be filled with details and nuances that will appear intimidating at first; however, an experienced attorney will not only be able to negotiate the transaction on your behalf, but will also be able to help break down and simplify these matters for you so that you are able to understand them and evaluate the potential risks and rewards that are associated with them.