The SBA Just Made Phantom EBITDA a Loan Condition

On October 1, a rule changes that most dentists will never read and every dentist who sells a practice above $3 million with a bank behind the buyer will feel.

The SBA’s new standard operating procedure, SOP 50 10 8.1, requires an independent Quality of Earnings report on any 7(a) acquisition loan where the business purchase price is $3 million or more. The threshold is the price of the practice, measured before the buyer’s equity or a seller note is applied, and it excludes the real estate. Owner buyouts, ESOPs, and co-ops are exempt. Everyone else who fits the description gets audited.

Three things about the rule matter more than the rest. The report is ordered for the lender, and the SOP says in plain language that it may not be prepared by or for the borrower or the seller. The report must include a cash proof, which means bank statements reconciled to the income statement and the tax return for the trailing twelve months and the last two fiscal years. And the lender has to size the loan on the earnings the report supports, against a debt service coverage floor of 1.25 on an initial acquisition, with no credit for projections.

Read that last part twice. For years, a buyer’s bank underwrote the seller’s adjusted EBITDA, more or less as presented. From October 1, on the deals this rule covers, the bank underwrites someone else’s reconstruction of it.

The five rejection patterns

The lenders and QoE shops writing about this rule have already published the list of what gets a report rejected or the earnings reduced. It reads like this: add-backs with no proof, cash-basis books putting revenue in the wrong month, owner pay set too low, rent paid to the owner’s own company below market, and a good trailing twelve months hiding three bad recent months.

I have seen that list before. It is the accounting face of Phantom EBITDA, item for item, and it is what a DSO’s financial diligence team has been pulling out of dental practices for a decade.

In the practice I have used throughout this series, about $10 million of income, multi-provider, clean books, a CPA who did his job, the seller presented reported EBITDA of about $720,000. Two adjustments held. Three went the other way: the owner was drawing $50,000 below what a replacement dentist would cost, 1099 contractors doing W-2 work got reclassified with payroll burden attached, about $155,000, and the rent paid to the owner’s own building entity was roughly $40,000 under market. Normalized: about $595,000.

In a DSO deal, that $125,000 moves the price. At 7×, it took roughly $875,000 off before anyone opened a chart. In an SBA deal it moves the loan, because the lender is now required to run debt service on $595,000, not $720,000, and a 1.25 coverage floor has no room in it for hope. The buyer does not get a smaller deal. The buyer gets a smaller loan, and then a conversation with the seller about the difference.

The seller in that conversation has nothing to argue with. The report was not his. He could not commission it, he could not see it first, and by the time he learns what it says, the LOI has been signed for weeks.

What the report will not find

Here is the part that should worry buyers as much as the first part worries sellers.

A cash proof is a good tool for the question it asks: did the money the P&L claims actually move through the bank? For most small businesses that is the question. For a dental practice it is the easy question.

The same practice passed every revenue-cycle screen a lender or a sponsor would run. Insurance AR days of 21. A 93% clean-claim rate. Under $500 of rejected claims, all time. A cash proof on that practice ties out. The money moved.

Underneath the money that moved: $680,000 of coding-pattern exposure across six code families, every claim clean and every claim paid. $1.5 million of production booked under practice-created, non-billable codes that never entered the claims process. An insurance collection rate of 107% of net insurance production, part of it AR burn-down and the rest payer overpayment parked as credits and refunds. And a quarter of everything the practice diagnosed originating in one exam chair, the owner’s, the Point Guard, who is the person the buyer is financing the departure of.

None of that is in a tax return. None of it reconciles to a bank statement. The SBA’s report validates that the earnings were collected. It does not ask how they were generated, whether a payer will want some of them back twelve to eighteen months after close, or whether they survive the seller’s last day. Those are clinical ledger questions, and for a dental target they decide whether the number the bank just validated is still there in year two of a ten-year loan.

So a buyer with an SBA loan on a $3 million practice is about to pay $15,000 or more, on early market estimates, for a report that protects the bank. That is the correct use of the report. It is not a substitute for the buyer protecting the buyer.

The dental reality, without the drama

Most dental practice purchases will never touch this rule. Dental-specialty lenders finance the majority of them conventionally, often at 100% of the purchase price, and SBA SOPs do not govern those loans. And the sell-side advisors I talked to this week were blunt about the rest: a $3 million dental practice is a group or a DSO buyer’s deal, and there is very little appetite on the buy side for financing one through a 7(a) loan. The rule lands directly on a small number of dental transactions.

That does not make it small. It makes it the norm, written down. The federal guarantor of small-business lending has decided that on a larger acquisition, the earnings that size the loan must be reconstructed by someone who works for neither side. DSO buyers already underwrite that way. The sponsors behind them already underwrite that way. Conventional dental lenders will drift toward it, because once a standard exists for what “validated” means, nobody wants to be the bank that skipped it.

The audit that sellers were told they did not need has stopped being a buyer’s preference. On these deals it is a loan condition, and the seller does not get a vote on whether it runs. The seller gets a vote on what it finds.

What actually changes

It is tempting to read this as one more step in a transaction. It is not one more step. It is a step that changes what the other steps are for.

Until now, a dentist buying a practice from a dentist almost never commissioned a Quality of Earnings. The buyer’s advocate reviewed the P&L and the tax returns, the bank underwrote the seller’s adjusted number, and the word “diligence” covered a chart audit the buyer did himself with someone reading him the keystrokes. On a $3 million-plus deal with a 7(a) loan, that financial review is now done by mandate, by a CPA shop working for the lender, at the buyer’s expense. The financial face of diligence on these deals is supplied whether anyone wanted it or not.

Three things follow. The buyer’s diligence dollar has nowhere useful left to go except the faces the mandated report cannot open. Paying an advisor to re-review the P&L the bank’s QoE just reconstructed is paying twice for the same answer; the operational and clinical reads are the only diligence left to buy, and they are the ones that decide whether the earnings survive the seller’s last day. The lender is now holding a document that validates the money on a ten-year loan whose largest post-close risks in dental are a payer recoupment letter and the seller’s exam chair walking out the door, and neither one is in a cash proof. Lenders will not want the clinical addendum until the first loan is impaired by a pattern the QoE could not have seen; after that they will want it on every dental file. And for the seller, the accounting face is now enforced by regulation rather than by whether the buyer happened to hire a good team, which turns the advice to prepare early from a preference into a dated event with a federal effective date.

That is where this firm sits in the new structure, stated plainly. Not as the financial QoE provider; that report belongs to the lender’s accountants and it should. As the clinical layer underneath it: for the seller, the Sell-Side Baseline that decides what the lender’s report will find; for the buyer and the lender, Doctor-to-Doctor Diligence delivered inside the same window as the mandated report, reading the part of the practice the mandate does not touch.

Run it before the bank runs it

The remedy has not changed since The Three Faces. It is early rather than complicated.

Owner compensation reset to market for both roles, the clinical one and the management one, and the P&L run that way for a full year, so the normalized number is the reported number by the time anyone reconciles it. An invoice behind every add-back, because the cash proof works month by month and an adjustment that cannot be traced to a document is an adjustment that gets removed. Related-party rent and family payroll benchmarked and documented before a stranger benchmarks them for you.

Then the part the SBA’s report will not do and a dental buyer’s diligence will: the practice-management data reconciled to the claims. The internal codes mapped to CDT and claimed or written off. The ratios by provider benchmarked and the outliers explained or corrected. The credit balances refunded before they become a working-capital deduction. The assist matrix built, so the pipeline can be shown to be distributed instead of claimed to be.

And the trailing twelve months trended with the last six months shown separately, so a soft tail has an operating cause attached to it before a lender finds it and assigns one.

Twelve to twenty-four months out, every one of those is a fix. Ninety days after an LOI, every one of them is a finding. Inside twelve months of a sale the same work is Pre-LOI Defense, and the lender’s report arrives to confirm a number that was already documented.

For the buyer, the move is simpler. Budget the lender’s report and the three or four weeks it takes, and then spend the diligence money you would have spent on a financial review, which the bank just did for you, on the read the bank did not do. The money is validated. Somebody should validate the dentistry, inside the same window, not after close when the recoupment letter explains it.

The Bottom Line

Your EBITDA is a claim. From October 1, on a $3 million practice with a 7(a) loan behind the buyer, the audit of that claim is a federal lending condition, ordered by a bank, performed by someone who does not work for you, and used to size the loan that pays you.

It will find the accounting face. It will not find the clinical one. On these deals the first is now handled by mandate, which leaves the second as the only diligence a buyer can still choose to do, and the only one a seller can still prepare to survive.

The rule, read line by line for dental practices, with sources, is at precisiondentalanalytics.com/sba-quality-of-earnings-dental-practice.

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About the author — James DeLuca is the founder of Precision Dental Analytics and works in clinical data forensics and M&A defense: the independent Clinical Quality of Earnings for sellers, buyers, and lenders, run before the buyer’s team runs theirs. He is the author of Phantom EBITDA, The Dental Data Playbook, Hidden Levers, and Spartan Leadership. Meet the team →