Reorganization and Restructuring Options for Professional Practices
In previous weeks, we’ve written about a new business recovery tool, SBRA, Subchapter V of Chapter 11. We have explored reorganization and restructuring scenarios that some businesses are facing as a result of COVID-19. Perhaps you see yourself in one of our examples and can visualize how using this new business recovery tool might help you. Today we are focusing on professional practices and a small dentist office in particular.
Professional practices are another business category that has been dramatically impacted by COVID-19. Those hit the hardest are practices involving close personal encounters with customers. As one example, the Health Policy Institute predicts that “U.S. dental care spending could decline by up to 38 percent in 2020 and 20 percent in 2021.” A similar story is playing out across other professional practices too, from veterinary services to physical therapy and general medical practitioners. Below, we look at an example of the business reorganization and restructuring adjustments that these organizations are considering in an effort to remain financially viable for both the short- and long-term future.
Pre-COVID Profile – Dental Practice
Family Dental (FD) is a single location dental practice that has been in business for five years. They have continued to make incremental year-over-year gains in establishing themselves in the community where they operate. Below is a summary of FD’s pre-COVID profile:
- Entity Structure: Single location, sole proprietor LLC
- Expense Ratios (ranges):
- Employee = 24-28%
- Facility = 10%
- Clinical Costs = 12-14%
- Other = 11%
- Discretionary Costs = ~2%
- Profit Margin = ~31% before owner compensation
- Average Patients Seen Daily = 30
- Revenue = Just over $900,000 (with a 98% AR collection rate)
Additionally, the practice leases offices in a medical complex, carries a $300,000 bank note at 5.25% interest, and generates an annual net profit of approximately $276,000 before owner compensation.
Impact of COVID-19 and Current Situation
The COVID-19 shelter-in-place restrictions for residents in FD’s service area have caused the average number of daily patients to plunge by ~40%. After some time, the shelter-in-place mandates were lifted but persisting concerns and reported spikes in new infections continued to depress demand. Patients are postponing both critical and elective care procedures to uncertain future points in time.
Before COVID-19, FD was operating at a 31% profit margin (before owner compensation). The decrease in daily patients seen (from 30 to 18) has devastated the practice financially, resulting in a net annual loss of $117,000. There is no certainty as to when historical patient volumes will normalize and the broader economy recovery will occur. What is certain is that the LLC and the owner personally do not have the liquidity to sustain losses of this magnitude.
Steps for Moving Forward
Before it enters into conversation with creditors, FD must form a clear and realistic picture of the months ahead and gain an understanding of the pros and cons that would result from their various alternative paths forward.
Step 1: Assess Current Liquidity and Evaluate Expense Reductions
FD first needs to prepare a financial forecast revenue model for the twelve months ahead that:
- Reasonably quantifies potential net losses for the practice by considering a most likely case as well as a worst case set of assumptions.
- Identifies additional sources of liquidity if any (The bank is FD’s $300,000 noteholder and will not extend additional credit in the current climate)
- Identifies potential staff reductions that could be made, and
- Eliminates all non-essential expenses
In this instance, vetting all additional sources of liquidity and quantifying all potential expense reductions within their sole control still shows FD operating at a net loss and with negative cash flow. They are going to have to seek some relief from their debt and lease obligation to survive.
Step 2: Assess Available Options
FD’s range of options includes:
1. Reducing staff and eliminating all discretionary and non-essential expenses. FD cannot reduce staff enough to achieve breakeven with no relief on their debt and lease obligations.
2. Renegotiate the debt and the office leases outside of a court approved plan. This will reduce fixed costs and help the practice compensate for its reduced patient load. FD would have to partner success for this with a reduction in staff to achieve breakeven.
3. Sell the Practice. This option should be evaluated by a qualified business broker. Given current financial performance and the ongoing COVID-19 environment, a sale will most likely not sufficiently satisfy all creditors. FD is unlikely to find many buyers for small dental practices in the current environment, and those that are buying are likely bottom fishing.
4. Restructure Outside of Bankruptcy. This option would require:
- Cooperation of the lender to release assets or accept a reduced note repayment
- Vendor agreement to reduce FD’s outstanding balance or to freeze their current balance for repayment over time while continuing to provide current supplies for current payment
- Renegotiation of lease obligations to reduce the current payments significantly in exchange for larger payments in later years, an extended term, or other modifications
- Preparation of a retention plan for key practice leaders and team members
This option is unlikely to succeed unless FD can demonstrate to creditors that their forward plan delivers a high probability of success. The management team will also need to be capable of handling the necessary plan preparation and negotiating with affected creditors.
5. Request Bankruptcy Protection Under SBRA Subchapter V of Chapter 11. This process is so different from traditional bankruptcy, it should have a new name. It is a significantly simplified process for small businesses to reorganize and retain ownership of their companies. This provision is quite new having been enacted in February of 2020 for the purpose of significantly streamlining the reorganization process and minimizing expense for small businesses. As originally enacted, companies with debt of up to $2,725,625 can use it. The CARES Act, passed in April of 2020, raised the debt limit to $7.5 million for filings through March 27, 2021. This was done specifically to help many more small businesses, impacted by COVID-19, to qualify for this fast track court approved reorganization. FD is a perfect candidate for this program.
To gain approval, FD must present a business plan that:
- Is “fair and reasonable” and in sufficient detail for monitoring by a court approved trustee
- Applies “free cash flow” to the repayment of debt over an extended period of time (generally 3-5 years)
Additional advantages of SBRA Subchapter V include:
- It is relatively fast (approved in 90 days)
- There is no creditor committee involved
- Far less expensive than traditional bankruptcy, primarily because of the speed, the reduced documentation, and not having to create and negotiate with a creditor’s committee
- Requires quarterly monitoring
- Enables a business owner to retain 100% ownership if the plan is fulfilled. This is a key advantage to this process, especially to business owners who have been pushed into this position by COVID-19.
- Maintains the judge’s option to liquidate if the plan is not met
- Prohibits further collection activity from vendors while operating under bankruptcy rules
Often, the secured lender (e.g. the bank) will push for liquidation if the outstanding debt is approximately equal to the inventory liquidation value as they will receive cash more quickly via liquidation. This is another reason to be prepared with an SBRA filing. If liquidation is undertaken, the business must:
- Notify vendors of their plans to liquidate
- Prepare for the liquidation sale
- File for Chapter 7 bankruptcy protection
Step 3: Implement the Chosen Course of Action(s)
After considering all available options, FD decided to attempt a negotiation with creditors outside of a court approved reorganization but be prepared to file under SBRA if unsuccessful. FD should prepare a detailed pitch for the bank, their landlord, and any other key creditors. Given that their fallback position is SBRA in the event they cannot secure satisfactory agreement outside of a formal process, it is recommended that an SBRA filing and first draft restructuring plan be prepared before entering into substantive conversations with creditors. FD may find they need to file their SBRA application before negotiations are complete.
Understand the Options and Their Impact
Leaders of professional practices, along with the rest of the world, did not see COVID-19 coming and have had virtually no control over the financial impacts it has had on their business, the industry, and the economy as a whole. What business owners do have some control over is how they move forward to maintain financial solvency for the long term. Bankruptcy is almost never the path of first choice. SBRA Subchapter V of Chapter 11 is so different from traditional bankruptcy, it should have a new name. It is a significantly simplified process for small businesses to reorganize and retain ownership of their companies.
Need assistance in determining the best path to reorganizing and rebuilding your practice or business? Request a free consultation from a vcfo expert who can determine whether the SBRA or another option is right for you.