Published on November 1, 2024 5:26 PM GMT
There are million dollar bills lying on the ground for those with eyes to see them.
I'm in Miami today, visiting a friend who is opening a dental practice. Chatting with someone very knowledgeable about a niche industry is an interesting experience because you get to learn about just how insane everything is behind the scenes. For example, dental practices benefit significantly from scale, yet the overwhelming majority of operations are small private practices.
My friend (let's call him Jeffrey for the purposes of this post), is likely going to be able to do a few million in revenue the first year his dentistry office is open. The facility is sized to reach $15 million in annual revenue, which they expect to be able to achieve in the next couple of years. The expected EBITA of this business (earnings before interest, taxes, and amortization) are 40-50%.
That means if all goes well (and it appears to be so far), my friend will be making 3-6 million per year in profits in a couple of years, with the possibility of much more if he's able to open additional clinics.
What's perhaps most surprising about this business is he put in very little of his own money to get it off the ground. He didn't raise very much money: $400,000, mostly from friends and family.
The rest of the required capital came from a $1.7 million bank loan. The interest rate was 6.5%.
To anyone familiar with the startup world, this sounds absurd. Banks face asymmetric risk when lending money to new companies which heavily discourages unsecured lending.
New businesses frequently fail, putting loans into default. And when they succeed the bank sees none of the upside because a loan doesn't give them ownership rights over the business.
For this reason, when banks DO lend to startups it's often in the form of a convertible loan. Convertible loans are like regular loans, except when the bill comes due the value of the loan can convert into equity in the startup.
Who exactly decides whether the loan is repaid in cash or equity can vary somewhat from one loan to the next, but in most cases convertible loans provide significant upside for the bank in situations where the new company does well.
So when my friend learned that the bank would give him an unsecured $1.7 million loan at a 6.5% interest rate for his new business, he was somewhat surprised.
Why are loans for dentistry offices so cheap?
As it turns out, dentistry offices almost never default on loans. Largely as a result of the Balanced Budget Act of 1997, the number of graduate medical residency programs in the United States has a soft cap. So the number of dentists in the country is far less than what demand would dictate, and all but the very worst dentists have more patients than they can handle.
Despite this favorable situation for dentists, the average private dental practice does not have especially eye-poppping margins; they usually fall in the range of 10-15%.
Because the real money doesn't come from dentists.
The real money comes from oral surgeons.
Oral surgeons are the special forces of dentistry. They perform root canals, tooth extractions, sleep apnea surgeries, and a variety of other mouth-related operations. A good oral surgeon can single-handedly produce about $3 million in revenue per year.
These procedures are not especially time-consuming. Wisdom tooth extraction requires a significant amount of preparation, but the actual surgical portion takes about five minutes. At an average cost of about $2000, that means for the duration of the surgery, an oral surgeon is generating $24,000 per hour.
If an oral surgeon could do nothing but wisdom tooth extractions for 40 hours per week, they would generate $37 million of value per year and still take the summer off.
In practice, it isn't feasible to reach those kind of numbers; there's prep work, sometimes the procedures go wrong, and not every operation is as valuable per minute as wisdom tooth extraction. But it is in fact the case that most oral surgeons don't produce anywhere near the kind of value they are theoretically capable of generating.
A big part of the problem boils down to overhead. The average dental office isn't that large; perhaps 1000-1500 square feet. As a result, there just aren't that many patients that need oral surgery. The oral surgeon can travel between offices (and in fact they frequently do), but this eats into their $24,000/hour value generation.
The solution, as anyone could have guessed, is scale; if you bring more patients into the same dental office and prepare each patient on a schedule, the oral surgeon can travel from one chair to the next performing surgery after surgery, generating 3-5x the value that they would otherwise be capable of.
And this is exactly what Jeffrey is doing. His new dental offices are 4200 square feet, over twice that of an average private office, allowing the oral surgeon to generate significantly more value.
Why weren't dental offices already set up this way?
Any time I am faced with this kind of shocking inefficiency, I ask myself a simple question: why was no one doing this before?
Part of the answer is "people are doing it, and in fact private dental practices are shrinking by about 7% per year." Private equity is buying up dental offices at a substantial clip and agglomorating them into Dental Service Organizations (or DSOs) that benefit from this kind of scale.
The largest of these, Heartland Dental, has 1650 practices across 38 stataes and is still growing.
But dentistry has been around for in its modern form for many, many decades. Why wasn't anyone doing this before that?
Like most headscratcher questions, there seem to be a few answers.
DSOs became somewhat more necessary after passage of the affordable care act because the law's imposition of additional regulatory requirements made it more difficult for regular dentists to handle it themselves.
And part of the reason that things have moved so slow is because a lot of dental practice owners just aren't very keen to sell their business to private equity firms. So consolodation is slow.
But a big part of the answer here seems to just be "there was a model that worked ok, and there weren't enough businesses savvy people who understood enough of the details to really scale the DSO model."
Normally that can be solved by venture capital, but in this case the basic business proposition for someone like Jeffrey can't scale to produce the 100x returns that venture funds count on. So with VCs on the sidelines, it was left to private equity to buy up dental offices as their previous owners slowly retired.
Is dentistry a venture scalable business?
Like most good stories, this one ends with many unanswered questions. Why did it take so long for the DSO model to take off? Why aren't dental offices spending more on advertising? How much value COULD an oral surgeon generate if an office was actually set up to optimize their efficiency?
But perhaps the most interesting is "Why isn't venture capital isn't interested in funding a DSO startup?"
The playbook of "make a larger dental office so an oral surgeon's skills can be more efficiently amortized over a larger numbe of patients" seems incredibly scalable.
And while there is a lot of overhead involved in hiring doctors and building new clinics, it really isn't that clear to me why a business that did nothing but this couldn't scale to at least a few billion in annual revenue. Dentistry brings in $478 billion per year in the US alone.
Even 1% of that would be enough for healthy venture returns.
Private equity certainty finds this area interesting, which is why they're buying up so many dental practices. But venture seems content to sit on the sidelines.
Maybe the answer here is one of growth rate; hiring doctors and building out new clinics takes time. Perhaps that limits the maximum growth rate in a way that makes the prospect unappealing for VC.
But it's not clear that's the case and there may be a billion dollar bill lying on the ground for any venture fund who figures out how to scale the "larger dental clinic" business model quickly.
Additional tidbits
A significant portion of dental clinics do buy paid advertisements. On average, clinics spend about $120 to acquire new customers. The lifetime value of a new customer is usually between $5000-$10,000.
This is completely absurd. What other industry has a customer acquisition cost that amounts to 1-2% of revenue?
So far as either I or Jeffrey can tell, this is completely irrational. While there is almost certainly a ceiling effect on advertising such that additional advertising won't lead to additional customers, it doesn't seem that the current industry is anywhere close to hitting it.
So expect to see a lot more advertisements for dental clinics over the next decade as people figure this out.
Discuss
