Identifying the risk in a business investment is crucial, especially when the business is controlled by one person. Tune in as Michael and Brad share the story of a physician client who was charmed into investing in a dental deal that went from smoke to a full blown dumpster fire. We discuss dental deals, dental support organizations, and understanding investment risks. You will not want to miss this episode!
Listen to the full episode using the player below, or by visiting one of the links below. Below is the episode’s transcript which has been edited for readability. If you have any questions or would like to learn more, email us at firstname.lastname@example.org.
Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues simplified through real client stories and real world experiences. Creating simplicity in three, two, one.
Brad: Welcome back to another episode of Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my cohost Michael Byrd.
Michael: Thanks Brad. As a business and healthcare law firm, we have some amazing dumpster fire stories. A dumpster fire essentially means a mismanaged situation that results in utter disaster. I think the definition should be changed to say a dumpster fire is the year 2020. Absolutely. I agree with you on that.
Brad: And in today’s episode, we’re going to talk about a dumpster fire for a client who was charmed into investing in a dental deal that went bad to worse and years later, this fire has not been completely extinguished.
Michael: Speaking of Brad, do you remember when the packs of gum would say nine out of 10 dentists say that gum is good for your teeth? [00:01:00]
Brad: That literally had nothing to do what we were just talking about, but yes, I do remember often seeing that. And that one dentist, why did he, or she hold out? What do they have against gum? Do you know?
Michael: I have no idea. I chew the same gum today. In fact, I had to look at my gum and see that the message is adjusted. They’ve gone away from the 9 out of 10 to now it just says chewing gum after eating and drinking cleans and protects the teeth. But when going through all this reminded me of growing up and I really remember my mom telling me that if I drank too much Coke, it would rot my teeth.
Brad: Okay. How does drinking Coke rot your teeth? Actually, I’m not sure I want to know. I want to know if 9 out of 10 dentists agree that Coke rots your teeth.
Michael: Well, based on the pictures that came up, when I Googled whether Coke is bad for your teeth, I’m guessing it’s closer to 10 out of 10. I can’t unsee some of the images of decay that popped [00:02:00] up.
Brad: Well, maybe you should start chewing gum after you drink Coke. All right I want to stop talking about dental hygiene. Michael, let’s talk today about our dumpster fire story.
Michael: Okay. Well, many years ago, I had a physician call me excited about the opportunity to invest in a dental practice. That’s right. There are doctors always looking for deals and it’s not the first time we’ve had our doctors invest in dental deals and vice versa. This dental practice already had 10 plus locations, had a great brand identity. I instantly knew the name of the dental practice and was excited to look at this opportunity.
Brad: Yeah I remember getting involved on the front end in this investment was for a DSO with a vision to scale the business for a multiplier, eventually with an exit strategy for a huge private equity deal to buy them all out.
Michael: Yeah, this was the beginning of the heyday for huge private equity deals in the dental market. Brad, you used the [00:03:00] term DSO. I think that’s the first vocabulary word for the day. What is a DSO?
Brad: Sure. So DSO is a dental support organization. This is a model that allows non dentists to own a dental practices are more to the point legally tap into the flow of funds of a dental practice. In reality, a DSO is just really the back office of the business, managing these dental practices. The DSO owns a brand name, does the marketing, the leasing, accounting, the staffing, and all these other functions that a dentist would need for running their dental practice. The DSO typically ends up capturing some profits from this dental practice through which is known as a dental support agreement via these management fees paid to the DSO from that dental practice. But to be clear, the DSO does not own the dental practice.
Michael: Yeah I want to add to that too. The DSO world has really developed, I mean, DSO’s nationally have their [00:04:00] own lobbyists, their own trade association. And for those who can’t quite picture what we’re talking about if you see a chain dental office, and no matter where you are, there is one that likely is a DSO. So this investment opportunity presented to our client was to invest into the DSO. The founder of the DSO was a dentist who also owned the dental practices that were being managed.
Brad: Yeah and this is a pretty common scenario for a DSO to work you must have a dentist own these dental practices and it’s common for the same dentist that may have some ownership or significant ownership in the DSO too. And we’ve helped many dentists and DSO set these up over the years so we had a good flavor for this. Tell our audience about this founding dentist that was so key to this particular model.
Michael: Oh, man. I don’t know quite where to start. We could spend an hour telling stories about what we learned eventually about the founder. [00:05:00] Let’s call him Dr. Nose.
Brad: All right. Dr. Nose seems like a terrible name for a dentist. Um, we are talking about people and their teeth.
Michael: I’ve told you before, my dad wanted me to be a doctor until I took ninth grade anatomy. But that’s not why we’re going to call him. Dr. Nose. It’s not my failure to understand what a dentist does.
Michael: Well, Dr. Nose liked a different kind of coke than what we talked about earlier. Brad, the good news is that the coke he liked did not rot his teeth. The bad news is that it did end up eventually costing Dr. Nose his dental license and destroying his business.
Brad: So he preferred Coke products over Pepsi products?
Michael: If perhaps Pepsi is an analogy for meth, I don’t know. I’ve never heard of him drinking Pepsi, Brad, but yes, he [00:06:00] did enjoy Coke.
Brad: So blind taste test he preferred Coke products. Well it wasn’t always chaos. I remember being quite excited at the beginning. In fact, our client had so many great stories about going to Vegas with Dr. Nose. I’m not sure we could actually even talk him out of doing this investment even if we tried.
Michael: Yeah you know, if you’re an attorney trying to help a client on a deal, and he’s already been on Vegas trips with the person he’s going to invest in, you’ve got an uphill battle. Our client swore he never saw Dr. Nose using any Coke products when he was on these Vegas trips. There was more than one, but from the stories about private planes, clubs, casinos, and all the debauchery that implies there seemed to be plenty of distractions to our client even noticing whether Dr. Nose was partaking in Coke products or Pepsi products.
Brad: True. [00:07:00] And we could get into greater details as to these Vegas stories, but I think we’d end up getting a massive explicit rating for this podcast and the audience probably would not believe half the things we would say that really ended up happening in Vegas and what happened outside of the Vegas. So we’ll just kind of keep moving forward. But a lot. Michael, we actually met Dr. Nose a few times and he was extremely likable. He was outgoing, charming, beaming with confidence, had a very robust way in which he carried himself. More importantly I remember being pleasantly surprised when I reviewed the investor packet for our client. It was professionally done, it addressed many of the concerns that we would have if we had addressed it or reviewed it and it was typical things that we want to see in a private offering as it relates to a DSO model or arrangement.
Michael: Yeah, I totally agree. I mean Dr. Nose was likable and you could see why, you know, [00:08:00] he had that charm about him. And to your point, I remember we had the typical questions and there was some negotiation on the deal, but the investor documents, the ownership documents, even the financials didn’t create any red flags and our client invested and a pretty significant amount. As the aftermath of the ink drying, we started to hear whispers. It would be whispers of frustration that there is a cash shortage, there needed to be another round or, you know, talk a little bit more Brad, about some of the other things mew were hearing.
Brad: Yeah. I mean they just weren’t hitting their financial targets of these new locations that our client had spent significant money in, were suffering, actually losing money. And the dentists that we’re supposed to be helping run those locations kept leaving.
Michael: Yeah. And for context, the growth plan for a DSO [00:09:00] model works when the DSO can build out a location and then basically go hire a dentist to treat the patients at the particular location. We hear them say, you create the entire setup and even put the butts in the seats and you go employ a dentist to pay him to come in and actually provide the treatments. Dr. Knows was mostly running the DSO and not treating patients at this point. Well, at least that was what the message was to the investors.
Brad: That was the message. But then the lawsuit started and we had vendors and dentists and they start suing the DSO from missing payments and other issues. And then Dr. Nose ended up getting personally sued for a bunch of really crazy allegations. So it started to unwind pretty quickly.
Michael: Yeah, it started getting dark fast and we would [00:10:00] start to hear whispers of Coke products. We started noticing a trend where there were people that really hated Dr. Nose out there. And so it was in retrospect, a good learning lesson. It was amazing that people were either in camp Dr. Nose and loved him or people that swarm off and would never talk to him again. Or in many cases we were learning or starting to sue him. And I think the final straw was the dental board investigation that started alleging substance abuse and this cloud hung over the business. I mean, Dr. Nose was the face, even though he was on the DSO side, he was on the dental side, but the brand was so associated with Dr. Nose and eventually as that investigation was going on at the dental board [00:11:00] level, Dr. Nose decided to give up his dental license rather than comply with the dental program that was put in place.
Brad: Yeah, that this is such a dumpster fire. With Dr. Nose is no longer a dentist, which means that it’s required for a DSO model. Our client had spent significant funds. He had read up a couple of times into this DSO. So everyone, let’s hold our breath and we’ll try to sniff out the legal issues after the break.
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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host, Brad Adatto with my cohost Michael Byrd. You’re still here, Michael. We just heard a great, interesting story about Dr. Nose who basically snorted away our client’s money. How did he do it?
Michael: Well, apparently Brad, Coke is expensive and you need cash for that. And we quickly started learning that the cash problems of the DSO were not a coincidence to the enjoyment of Coke that Dr. Nose was enjoying. And so we started trying to figure out what was going on and our client was trying to figure out how to save his investment and Dr. Nose was off the grid at this point. And so we started looking into things and [00:13:00] we found it a couple of different ways that Dr. Nose was siphoning cash out of the business. We found that he outsourced a lot of the ancillary services to entities that he owned and never disclosed. So for example, The DSO may pay a premium for a dental implant to a dental implant company that coincidentally this dental implant company was owned by Dr. Nose.
We found a handful of companies like this. They were never disclosed. They showed up on the financials as just run of the mill expenses like you would expect. And even the amounts of money going through, there were not enough to create a flag, but over time, I guess it supplied plenty of Coke products. He also was periodically showing up to locations to perform implant cases. Dr. Nose would have the [00:14:00] patients write a check directly to Dr. Nose instead of to the practice.
Brad: Yeah. So for context, for those not following what Michael’s talking about, these implant cases are extremely expensive. You’re talking about upwards of $50,000 and besides being directly compensated for services that he was rendering, ultimately these funds were supposed to go to the DSO. And then when we started learning that Dr. Nose would sell off portions of these particular practices to the dentists that were working those chairs. To be clear, many of these times or almost every single time the assets were actually owned by the DSO, not by Dr. Nose and in addition, they were secured by banks that the DSO had taken out loans on. But these dentists thought they were getting great deals because Dr. Nose either convinced the local dentist just to pay them like, hey, how about $50,000? And you can own a 20% or 30% of this company or [00:15:00] more. And some of them were like, oh, well, will you sign an agreement? And they say, sure. And he’d sign whatever’s in front of him because he actually didn’t have the ability to sell anything.
Michael: And we actually had a couple of examples of people not signing anything and just writing a check for a quote deposit. Just pause for a minute and imagine how charming Dr. Nose must have been to be able to convince someone just to blindly sign something and even more blindly write a check is crazy. So we talked about this in other episodes of the season, bad people do bad things. What could have been done differently here?
Brad: Yeah, I think first it’s important to recognize the risk that goes with investing in a business where essentially it’s controlled by in this case, one person, Dr. Nose. These situations where if the founder goes down, the business goes down the documents traditionally planned for an investor protections if the founder dies or just [00:16:00] abled. It’s less traditional, but important to incorporate into deal structure contingencies if in the event, the investment opportunity starts to change in the fact that the founder is no longer with them.
Michel: Yeah and you know, kind of more importantly,
Brad: He’s not doing what he’s supposed to be doing.
Michael: Yeah. I mean, this probably falls in the bank of traditional, but there’s reps and warranties that go into what he’s saying, but also it sounds like you’re talking about not meeting financial benchmarks and as I said, untrue representation.
Brad: Yeah. We spoke in a prior episode about the protections that you can get from reps and warrants so those are very important. And then additional strategy would be to structure the investment as a debt that can be later converted to equity. This creates a path for the investors that have security interests and foreclose and benchmark those financial ones that you just mentioned are not being met.
Michael: And what I like about it is that it typically gives [00:17:00] the investor a priority to get paid back ahead of the owners until the investor makes the decision to actually convert the debt into equity.
Brad: Exactly. That goes back to something our client struggled with at the beginning. Our client was ready to write a check after being charmed by Dr. Nose. He didn’t have the appetite for time and energy it would take to structure this investment. Given the amount of money involved, there was a real opportunity for our client to have done this.
Michael: Now I want to circle back to something you said a few minutes ago. You spoke about the risk that goes with investing in a business controlled by, like you said, in this case by one person we had Dr. Nose who was the face and he was the one person. And there’s a human element to preventing or identify how to mitigate your risk. Even when everything looks right. The fast-talking charming [00:18:00] hurry up to get this done founder should kind of in of itself, create a red flag and make you hit the pause button. It’s not quite the it’s too good to be true adage, but it’s similar.
Brad: Absolutely. I agree with that. And the investment documents held up. If in the sense of you’re being charmed into a deal and you have a founder in control of the whole thing I’d be more inclined to push for some more shifts kind of like you said, on deal protections that we just discussed.
Michael: Yeah. I mean, it would have been really easy if we would have had our client and we’re able to convince our client to just slow down and not be so like, this is the greatest thing ever, and even having a debt converting to equity type structure he could have taken over long before this fire was burning like crazy and [00:19:00] almost out of control. Not almost it was out of control. But Brad, did the story have a happy ending?
Brad: No, it did not. Unfortunately, like you said, this season we will have stories without these happy endings. Not only did our client lose the investment and the multiple times he rented into. This is one of those deals that just well, there’s a lot of aftermath. Our phones started ringing off the hook with other attorneys who had heard about what was up to Dr. Nose so they were asking us if we had an insight information, we had the banks calling us because they were trying to find out some more information, if we had anything on Dr. Nose. And finally, last but certainly not least, more recently when I say recently, pretty darn recently, the FBI called me up and asked me for some information on these transactions. So every time our client thinks he gets out, he [00:20:00] gets sucked back in. Michael. Any final thoughts?
Michael: Well, the dumpster fire season as a whole is a good reminder of the human element. When measuring the risk of a situation, everything may make sense and worthy of a calculated business risk, but you interject a bad actor and it completely tilts the risk scale.
Brad: Yes. And remember kids, Coke can rot more than your teeth. Please join us next week when we talk about Embezzlement From the Top.
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