Now and Then – an analysis of current and past DSO models

Exclusive Content – Analysis of the “Orthalliance” Management Model in Relation to the Current Model

Then

Throughout the 1990s, the first generation of dental management companies, including Orthalliance, Orthodontic Centers of America (“OCA”), New Image, Apple Orthodontics, and a few others, were formed with a business model that has been characterized by many courts as a “stock play” for the dentists and as a purchase of a long-term revenue stream by the management company. By 2001, all of the above companies had been acquired by OCA and were operating under consolidated management.

These companies would typically locate highly profitable, successful orthodontic practices, and, by providing substantial upfront consideration in the form of cash, company stock, or both, the companies would entice the owner dentists to enter into long-term management agreements. The dentists would receive upwards of a million dollars, usually split between cash and stock in the management company. In return, the dentists would execute a 30-year management agreement that required the practice to pay 17-22% of its gross revenue to the management company for the duration of the agreement. The management companies aggressively marketed the concept that the “stock would double” and the dentists would then receive even additional consideration.

A typical million-dollar practice would receive around $1 million in upfront consideration. In return, the practice would have to pay approximately $220,000 per year in service fees for 30 years. Although the monthly fees were purportedly for “comprehensive practice management services,” only de minimus services were provided by the companies in reality. Most practices ran the exact same way they always did, with the exact same employees and procedures – the only difference being the management company now employed and paid the employees with funds earned by the practice and the practice was now saddled with a substantial service fee. One expert opined that the value of the services actually provided to the practice per year were under $10,000. To make matters worse, the companies’ stock did not do well – the companies’ stock typically lost over 50% of their value during the two-year terms of the “lock up” agreements executed by the dentists.

By 2001, many owner dentists were extremely dissatisfied with these relationships because the value of their stock had been decimated and they were still required to pay 22% of their gross revenue for non-existent services. A group of over 150 orthodontists banded together and filed numerous lawsuits throughout the country against these companies. The orthodontists claimed, among other things, that these agreements should be declared void and illegal under the corporate practice of dentistry and fee splitting doctrines. The companies were presented numerous offers to settle the litigation by allowing the doctors to be emancipated from their agreements. However, the companies could not do this because the entire model was based on earning a revenue stream. Beginning in early 2003, courts in Texas, Washington, Colorado, and California began invalidating these agreements. Although a Florida court and a Georgia Court upheld the validity of these agreements, a jury in each of these states ruled that the management company had breached its contract with the dentists by failing to provide “comprehensive practice management services” and relieved the doctors of any further obligations to perform under the agreements.

Shortly after the first courts declared Orthalliance’s agreements illegal, the stock of OCA began to further plummet in value until it was eventually delisted. At that point, a series of shareholder derivative lawsuits were filed by investors who lost substantial money investing in the company. The investors alleged, among other things, fraud on the part of the company in making its financial disclosures to investors. Between 2003 and 2006, the companies’ agreements were invalidated in over ten states. In 2006, Orthalliance filed for Chapter 11 bankruptcy protection. A criminal investigation was initiated shortly thereafter and at least two company officers were indicted. Orthalliance emerged from bankruptcy in 2008 and is attempting to continue its failed business model in Europe and Japan, which do not appear to have as rigorous a regulatory scheme. However, U.S. courts and appellate courts have continued to invalidate the companies’ domestic agreements.

Now

The current model used in the industry is significantly different from the “Orthalliance” management model in that:

1. There is no upfront consideration paid to the practice owners;
2. Comprehensive management services are actually provided; and
3. The practice owners are “friendly” to the company and are fairly compensated.

As a result, the current model allows the management company the flexibility to allow any unhappy practice owner to be emancipated from their agreements with the company and to either install a new practice owner or form a new practice with which they could install a new owner and continue on with the practice. This was generally not possible under the Orthalliance model because of the companies’ reliance on the continued revenue stream from the practices. Under the Orthalliance model, it was to the economic advantage of the company to keep the model intact to the detriment of the practice owners. However, with the current model, it is generally to the mutual economic advantage of both the practice owner and the management company to keep the model intact. The economic incentives appear to favor the continuation of the “friendly” relationship between the practice owners and the management company and do not seem to encourage litigation or discord between the parties.

Based on the foregoing, the business risks (unhappy dentists willing to litigate) associated with the Orthalliance model do not appear to be present with the current model. While some legal risks concerning compliance with the regulations are still present, they are mitigated by the fact that there is no upfront consideration being paid and the fact that comprehensive practice management services are actually being provided. Therefore, the risk of a second mass litigation by practice owners appears somewhat remote given the friendly relationship and economic incentives between the parties, so long as the management company maintains its friendly relationship and continues to provide sufficient economic incentives.

colaoBrian A. Colao is the Director of Dykema’s Dental Service Organizations Industry Group.  Brian specializes in representation of DSOs nationwide in all matters of litigation and regulatory action, industry compliance, due diligence, and assisting PE investors in buying, selling, or investing in DSOs.  Brian is located in Dallas, TX and can be reached by phone:214.462.6409 or email: [email protected].

 

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