Financing in the New Economy
Dr. Eugene W. Heller
Most new dentists I have the pleasure to speak with while lecturing at their dental schools continue to express a desire to become a practice owner as soon as possible after graduation. I typically survey each class at some point during my presentations to ascertain how many are intent on ownership and as a group, it is almost unanimous. Past American Dental Association surveys indicate 80 percent of today’s new graduates will be in an ownership position within five years of graduation from dental school. For most, ownership requires financing. Whether ownership takes the form of a partnership, an out-right purchase, or a start-up, bank (also referred to as “third party”) financing will be required.
As busy as these new dentists are and continue to be completing their final requirements for graduation, all are aware of the current banking crisis facing our nation. Whether one believes this crisis was as a result of the bank’s prior actions, or the bank’s problems are the result of the economy, the bottom line is still the same. The rules for future business lending have changed. The good news is, despite the headlines which read banks are “not” lending to businesses, dentists and dental practices are among the best “business risks” for lending in the U.S. As a result, and subject to new guidelines, lending to new dentists has continued unabated during our current economic crisis.
Transaction Related Lending Needs
Before we can discuss the new lending guidelines, we must define the type of transaction that requires funding. Dentists enter ownership in one of three basic ways. For about 15-20 percent of new dentists, ownership will be in a “group” practice and involve some type of co-ownership in a partnership, corporation, or limited liability company (LLC). The reasons for operating a group dental practice using one of these entities is to limit liability to the co-owners for the actions of one of the members in the group coupled with tax reasons for the type of entity selected.
These are the “legal entities” that actually own and operate the dental practice. The “owner” dentist(s) in turn own the “legal entity.” For most of these ownership arrangements, because of tax reasons related to the type of legal entity being acquired, the current owners and/or the legal entity must provide most of the financing for the new dentist buy-in. In this case, third party lenders are not really involved and the current economic situation has no bearing on the financing.
Despite the previous statement, there are, however, some instances when third party financing is in fact required and used. When this happens, the person or entity actually incurring the loan may be the new dentist, the new dentist’s ownership entity (if they have formed their own corporation or LLC prior to acquiring ownership), and/or the entity the new dentist is acquiring, with the new dentist personally guaranteeing the loan. If this is the case, i.e., ownership requires a third party lender and the new lending guidelines will apply.
The second ownership vehicle is the acquisition of a “solo practice.” Whether this acquisition starts out as an employment opportunity leading to a role reversal, i.e., the buyer acquires total ownership after a period of employment with the previous owner staying on as the new associate on a full or part-time basis until entering total retirement, or it is an outright sale with immediate retirement of the current owner, the lending guidelines are the same. More than 60 percent of today’s new dentists enter ownership this way, some immediately after graduation, and the rest after additional training in a GPR, or following an Associateship in the subject or another practice.
The final ownership vehicle is a dental practice started from scratch by the owner. While the start-up costs are less for this type of ownership, the reason is that the practice has no patients and subsequently has not built up a goodwill value. All that is required for financing is enough to purchase the equipment, supplies and some additional money which serves as working capital until the new practice starts generating its own cash flow. One of the first differences seen in this type of loan is that less money is offered by the banks for start-up loans and because of lack of cash flow and lack of experience in both clinical dentistry and business ownership, the guidelines for this type of loan are the most stringent.
Basic Loan Requirement Changes
The first change in today’s lending guidelines is a tightening of the definition of the required credit history of the borrower. Loans to new dentists have always required a good credit history. As few as three late payments or one debt written off by a creditor would automatically disqualify most new dentists from obtaining a loan. In addition, the borrower was required to have an acceptable credit score. The first condition, the requirement for on time payments of current debts, has not changed. What has changed is most lenders have increased their credit score requirements for loan consideration.
While 100 percent financing plus working capital is still readily available, more lenders are requiring a partial carry-back by the Seller of a portion of the loan. Obviously not popular with the Sellers, if this is the lender’s requirement and the Seller wants to sell, there is little choice. This is especially true of larger loans, typically those exceeding $600,000. The usual condition here is that the lender will re-consider the situation after one year, and if the borrower has performed satisfactorily, and the practice has performed as promised by the Seller, the bank will then fund the balance of the loan and subsequently cash the Seller out. The bank is attempting to spread the risk for larger loans.
In a further effort to spread the risk, more lenders are using Small Business Administration (SBA) loans as the vehicle of choice for lending. The majority of the face value for these loans is guaranteed for repayment by the SBA in case of default by the borrower. This guarantee is purchased for a fee paid by the borrower. The process for qualifying for this type of loan is complicated, requires an excess of paperwork, and can, if the lender has not attained preferred status with the SBA, take months to complete. Normally the borrower needs 10 percent down to qualify, another drawback.
The additional fees charged by a bank to handle all the paperwork, coupled with the SBA loan guarantee fee, also make this type of “guaranteed” loan more expensive than most loans. Furthermore, most loans do not have a fixed interest rate over the term of the loan. The rate is tied to the prime lending rate plus a certain percentage and adjusted every quarter. Obviously with prime currently at nearly 0 percent, the interest rate on this type of loan has nowhere to go but up. The SBA will only guarantee 85-90 percent of the loan, putting the lender at risk for a portion of the loan, but because the majority of the loan is guaranteed plus the borrower’s down-payment, this allows lenders to make loans they would not ordinarily consider.
Another change in dental loans is a tightening of the experience requirements versus the amount of the loan. This has always been a pre-requirement for larger loans, i.e., the lender would only make a larger loan if the borrower had a certain level of experience. Experience is defined as the time since graduation, and those rules have gotten more stringent. A requirement of more than two years of experience since graduation is common. If the new dentist has less than two years, this will decrease size of loan and the availability of financing. Furthermore, lenders are looking very closely at how much the borrower is actually producing in dollars versus the size of practice being acquired.
What Has Not Changed
The more experience a new dentist has, the easier it is to get loan. Experience translates into increased production. Increased ability to produce qualifies the new dentist for more money and subsequently allows the purchase of larger and more productive practices. These larger practices are necessary to provide the necessary surplus of profit to cover the new dentist’s ever increasing post-graduation debt levels.
100 percent financing remains fairly readily available. However, more restrictions have been placed to qualify for these 100 percent loans. Banks still realize the purchase of an existing practice is much less risky than start-up practices. In addition to this 100 percent financing, additional working capital is also readily available.
And finally, new dentists who apply for practice acquisition loans through an accountant, consultant, or dental practice broker have more success in attaining financing than those who go to the bank and try to do it themselves. There are a couple of reasons for this. First, lenders appreciate new dentists who admit they do not have all the answers and seek qualified assistance in areas of unfamiliarity (such as acquiring your first dental practice). In addition, these lenders are dependent on the referrals from professionals in the field and if they do not offer to provide the funding necessary as a result of too strict of lending guidelines, those referrals will not continue.
The rules have changed, but dentists continue to operate the most successful businesses in the U.S. and therefore are the best risks for commercial lending. ■
Dr. Eugene W. Heller is the vice president of Professional Practice Transitions, a nationwide dental practice sales and consulting organization. He can be reached at 1-888-477-8552.