Dentistry, Oral Surgeons, and the Inefficiency of Small Markets
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.
VCs are already doing this. They have offered to buy both the oral surgery practice and the dental practice I use in town.
The care they provide turns worse and worse because the model you envision turns a professional (someone who should have a fiduciary responsibility to the patient’s best interest above their own) into an employee of a non-professional corporation. All of the pre-and postoperative care that you envision being done by less highly paid individuals in order to free up the surgeon to “generate profit” gets done cheaply and more slapdash resulting in worse and worse patient care. Either the oral surgeon fights back and attempts to maintain the physician patient relationship and gets fired from their own practice that they sold out (pretty common already with Derm and Optho) or they don’t and you get the actual medical version of the plastic surgery chop shops common in Miami. This ethical problem is why non-lawyers cannot own a legal practice and yet we failed to recognize the same destruction of the professional relationship when it comes to physicians.
Aspen dental is a franchise based venture capital funded organization that already does this.
This is where rationalists fall apart. Everything you say makes sense, but it doesn’t take into account the sociocultural aspects that make a physician patient relationship different than the value extractive relationship that you propose.
Investors have offered to buy both, but why do you believe those investors were VCs? It seem very unlikely to me that they were.
Those kinds of VC-run business can also often have other problems. For example, Aspen Dental was sued for deceptive marketing.
This applies to a lot of the enshittification of the world. There used to be tons of small/family businesses, where “successful” for the owner was defined as “make a decent living, by working harder than average”. There was tons of value left on the table (or rather, lots of unmeasured surplus went to consumers). When things started getting moneyballed—optimized financially and reframed in terms of capital and returns, that surplus got squeezed out.
Well, as I understand it, the general belief is that...
The “scaled up” practices are relatively unpleasant to work in, and make people (who went through a lot of education expecting to get “prestige” jobs, mind you...) feel deprived of agency, deprived of choices about the when-where-and-how of their work, and just generally devalued.
The “non business savvy” people who actually generate the value believe, probably entirely correctly, that somewhere between most and actually-more-than-all of the increased income from that kind of scale-up will end up going to MBAs (or to the one or two theoretically-practitioners who actually own of a “medium-sized” practice), and not to them[1].
Healthcare facilities operated by private equity are widely believed, both based on industry rumor and based on actual measurement, to reduce quality of care, and people don’t like to be forced to do a bad job if they don’t have to?
Why would you voluntarily make your daily life actually unpleasant just to increase an already high income that you’ll probably have less time to enjoy anyway?
… and it may not drive prices down for the consumer as much as you might think, either, because many consumers have limited price sensitivity as well as very limited ability to evaluate the quality of care.
[The Simpsons] “I’m Not Made of Stone !”, Says Krusty the Clown
“Why would you voluntarily make your daily life actually unpleasant just to increase an already high income that you’ll probably have less time to enjoy anyway?”
IIRC, dentists have some of the highest rates of depression and suicide of any profession. As for if this means things could only get better under a new business model, increased earnings would translate to earlier retirements (and by extension lower supply of labor), or if dentists would prefer to keep their current earnings over trying a potentially more intensive job, I can’t say.
The reason most dental practices were owned by dentists and their families rather than by investors before the passage of the affordable care act is probably that the business is complicated enough that there is no practical way for the investors to tell whether the dentists running the practice are cheating them (e.g., by hiring his cousin to work at twice the rate at which the cousin’s labor is really worth).
In contrast, VCs (and the investors into VC funds) can trust the startups they invest in because they pick only companies that have a plan to grow very rapidly (more rapidly than is possible if revenue scales linearly with such a constrained resource as dentist labor or oral-surgeon labor). When the proceeds of an IPO or sale of the company are several orders of magnitude larger than the amount invested, any “self-dealing” on the part of the execs of the company being IPOed or sold become irrelevant—or at least easier for the investors to detect and to deal with.
Although private-equity funds gets paid mostly by IPO or sale-to-a-larger-company just like VC does, because they don’t limit themselves to investments that have the chance of growing by orders of magnitude, they have a more difficult time raising money. They must rely more on loans (as opposed to sale of stock) to raise money, and what sale of stock they do do is to a larger extent to high-net-worth individuals with an expertise in the business being invested in or at least an expertise in the purchase, sale and management of mature companies where “mature” means “no longer has a realistic chance of growing very much larger”.
During the dotcom boom, there was a startup out of LA whose plan involved search-engine optimization, but the young men running the startup decided to spend some of the money they raised to make a movie. When the investors found out about the movie, they hired private security contractors who teamed up with LA police to raid the startup and claw back as much of their investment as they could (causing the startup to dissolve). I offer this as an example that self-dealing is possible in a startup, but it is easier to deal with: when a private-equity fund gets together 100 million dollars to buy Kleenex Corp or whatever, then finds out that the execs at Kleenex are spending a significant amount of the corp’s money to make a movie (which they didn’t tell the investors about) they can’t just walk away from their investment: they have to fire the execs and hire new ones or step in and run the corp themselves, both of which will result in an interval of time during which the company is being run by exec still learning about the company.