By Craig S. Steinberg, OD, JD
Jan. 26, 2022
“Should I sell my practice to private equity (PE)?” That is one of the most frequently asked questions in optometry today. Every practice owner considering selling his or her practice will think about whether it is best to sell to another optometrist or to PE instead. It is important to understand how those options differ.
Indeed, having represented dozens of optometrists selling their practices, a good deal of my time is spent discussing this topic. For practices grossing $1 – $1.5 million dollars, or more, on a purely economic level, the answer is usually PE.
Differences in valuation are usually the reason given for selling to PE and not another optometrist. One of the most important differences between selling to another optometrist and selling to PE, however, concerns “holdbacks.” Holdbacks may affect the “bottom line” sale price. The most important questions are: What are holdbacks? Will you get your money? And how large will the holdbacks be? Getting reliable information is not always easy.
Unlike most sales to optometrists, PE divides the purchase payment into two, and sometimes three, buckets. The first is cash at closing. This is the upfront, non-contingent, payment that goes into the bank at closing. This is usually about what you would be paid for selling to an optometrist.
The next bucket, which is not always required, but may be offered, is an investment in the PE itself, called “rollover equity.” Most PE allows an investment of 5-20 percent of your valuation. This isn’t technically a “holdback” at all. It is a speculative investment in the hope the PE will be sold, and you will receive your investment plus a healthy gain. My advice? Don’t invest money you may need to retire comfortably. This is a speculative, high-risk/high-reward investment.
3 Types of Holdbacks
True holdbacks break down into three categories: Indemnity-based, non-contingent and contingent.
Typically about 5-10 percent of the valuation, this is money the PE holds onto to pay any undisclosed debts, equipment repairs the seller agreed to cover, working capital shortfalls (for instance, if your inventory value is lower than required at closing) and other expenses the PE incurs after closing that are the seller’s responsibility. At the end of the holdback period whatever is left in this bucket is paid to the seller. Sellers usually receive all, or nearly all, of this holdback from the PE when promised.
This is a deferred payment of the purchase price. The deferred payment is often about 15-20 percent of the purchase price, and the holdback is paid to the seller in 2-3 equal payments on the yearly anniversaries of closing. It is essentially an interest-free loan to the PE because, though the money is not contingent on the occurrence or non-occurrence of any event, it is also not earning any interest and you can’t use or invest it. Deferred payments carry a hidden risk – the risk of the PE becoming insolvent – because deferred payments are usually not secured. If the PE goes bankrupt, deferred payments are an unsecured debt, and there is a good chance you will not recover the money. An experienced attorney should try to negotiate securing this debt so that you are a secured creditor in the unlikely event of a PE bankruptcy. That said, in my experience sellers will receive this payment as promised. PE bankruptcy is unlikely if for no other reason than the practices PE buys are themselves successful practices, or the PE would not be buying them.
The final type of holdback seen in a PE transaction is the one sellers must pay the most attention to. Like non-contingent holdbacks, this holdback is also commonly 15-20 percent of the purchase price. But unlike non-contingent holdbacks, these holdbacks require the occurrence or non-occurrence of an event, or you lose some, or all, the money that is held back. The events are usually that the seller does not breach a non-compete agreement, continuing employment (you don’t quit working before the end of your employment agreement), working a designated number of hours each year of your employment agreement, and/or the performance of the practice meeting specified targets (the target is often the gross revenue that the valuation was based upon).
Of these, the practice performance contingency is the contingency of greatest concern. Sellers can control whether or not they violate an agreement or work the required hours (though you’ll want to negotiate exceptions for events such as a health crisis), but practice performance is in the hands of the PE after closing.
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Sellers cannot control how the PE runs the business or the economy generally. Thus, a performance-based contingency is an uncompensated transfer of risk from the PE buyer to the seller, and I consider it to be a high-risk/low-reward contingency. This is the least desirable condition for a seller to agree to and is often the subject of considerable negotiation to mitigate the risk. Sellers should be comfortable that the non-contingent aspects of the purchase price meet or exceed the value of a sale to an optometrist before agreeing to a performance-based holdback.
Here then is a hypothetical example:
Assuming a practice is grossing $2,750,000, it may have an adjusted EBITDA of about $500,000, giving it PE valuation of about $3,500,000 (assuming a modest 7x multiplier). The payment of the purchase price might break down like this:
Rollover Equity 10% $350,000, invested in the PE.
Indemnity Holdback 5% $175,000, payable in 12-18 months.
Remaining Holdback 15% $525,000, paid 1/3 each year for 3 years.
Cash paid at closing 70% $2,450,000
The holdback provisions in PE sales are among the most important and most complex aspects of the transaction. They are an important difference between selling to PE and to an optometrist, and are a principal reason optometrists need experienced counsel before proceeding with a PE sale. That said, with good counsel, PE sales are often far more financially profitable to sellers than sales to an optometrist.
Craig S. Steinberg, OD, JD, practices optometric and healthcare law in his own firm, Craig S Steinberg, O.D., Esq. Optometric & Healthcare Law. To contact him: firstname.lastname@example.org