It’s Not Rocket Science! Practice Valuation Topics Even We Can Understand

David B. Gerber, DVM, BA
Simmons Northwest
Larry McCormick, DVM, MBA, CBA
Simmons Mid-Atlantic –

Is My Veterinary Practice Worth One Year‘s Gross?

Ever heard this before?? This is probably a brand new concept to everyone, especially those who graduated more than twenty years ago!!

In the past, our profession routinely tried to tie practice value to gross income. That was before the time of high student debt, increased competition, and the current level of business savvy that we see in today‘s veterinarians. There are many, many factors that create value most of which have little to do with the gross revenue of the practice. Below is a chart showing the selling price of practices as a percentage of gross income. It doesn‘t take long to see that there is virtually no correlation between the two.
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What determines practice value? The impact of gross income is mostly psychological because many people STILL try to correlate it with value. If a practice is priced above a year‘s gross revenue, there is artificial market resistance. Conversely, if it priced at a small fraction of a year‘s gross there may be a false perception that it is a “good deal.

It is profit (what remains after all expenses, including the owner‘s salary) that forms the foundation for determining practice value, because these are the dollars available to pay for the practice. Practice growth contributes an intangible value as does geographical location. If competition is stiff or if there is no competition, it must be considered as an influential part of value. Tangible asset value is the value of the equipment and the inventory. It is income that buyers want, not “stuff. Of course certain equipment is necessary, but too much equipment does not increase value.

Long term, loyal, skilled employees add value, as does a reasonable transition period by the selling doctor. A small, “high touch, boutique practice has more loyal clientele than does a high volume, “low cost practice. A practice in a permanent location as opposed to a mobile practice will have more transferable goodwill because the clients will more easily remain with a fixed-location practice, hence, more value.

Averaging the last 3 years? Some appraisers use the average numbers from the past three years. This works if the three years are essentially the same, but if the practice is growing or shrinking to a significant degree, that method is dangerous and highly inaccurate. Weighted averages that give more weighting to the most recent years are a much more accurate method of determining value. In other words, the most recent years are a MUCH better predictor of the future than 3 or 4 years ago, thus the most recent year or two are weighted more heavily.

Value and price are not necessarily the same thing. Simply because a practice has a certain, calculated “value, does not mean it will sell for that price. For example, mixed practices in undesirable areas, with no emergency service available, are extremely hard to sell, and usually will require a very steep discount in order to entice a buyer to purchase. Practices in sought-after areas with good facilities and all the “bells and whistles will often sell at a premium. We have found that the MOST important factor in the marketing of a practice is geographic location.

How is Investment Value Different from Fair Market Value?

Investment value has been defined as “the value specific to a particular investor for individual investment reasons, and “the value to a particular investor based on individual investment requirements and expectations. This differs from Fair Market Value (FMV) in our scenarios since FMV assume no specific buyer or seller, but, rather, the “average buyer and “average seller.

As an example, if the “average buyer needs $85,000 to live, a FMV price for a practice should provide that amount of income to the buyer after paying all debt and expenses. However, if a specific buyer has unusually higher personal needs (huge house payment, large student debt, other unusual financial obligations) and needs $120,000 to live, then THAT buyer cannot pay the FMV price, but can only get his/her $120,000 income if he/she pays less for the practice. Does that mean the practice is overpriced? Certainly not, but it does mean that this particular buyer is unable to purchase it for the asking price.

Why Does it Matter When I Buy New Equipment or Remodel the Hospital?

In general “less is more”, meaning that if Dr. Allen can generate $300K in profit with $100K of equipment and it takes Dr. Baker $200K of equipment to do the same thing, Dr. Allen is actually doing more with less. Also what if Dr. Baker‘s payment on his equipment is higher than Dr. Allen‘s? If one buys a $30,000 ultrasound that costs $800/mo in payments but it sits in the corner, gathering dust, it is a financial liability and really does NOT add significant practice value. Yes, a practice might have $150K vs $100K in equipment, but if the profit is no higher, or worse, even lower, that doesn’t make the practice with more equipment worth $50,000 more. Also, consider the expertise needed to operate this expensive equipment. Many buyers may not possess the skills to use the equipment in the practice; therefore, it will have little value to them. A practice with good solid equipment that one would find in any progressive practice will get more return on that investment than the practice that has every new, state of the art piece of equipment, especially if some of this equipment is not generating sufficient income to the practice.

New equipment needs time to produce income for the practice. The first question before making an equipment purchase is, “Will this equipment pay for itself and produce a profit? If the answer is not a strong yes, then the equipment is probably nothing more than a high-priced toy. Toys depreciate and do nothing to contribute to the value of the practice. Equipment will give you a tax deduction AND contribute to the bottom line and thus to the practice value. Most large equipment purchases are done with a five-year lease or note. In either case, but especially with a lease, be sure it is transferable to a new owner and/or there is no prepayment penalty. In a lease, a prepayment penalty is the norm (regardless what the salesman tells you) so read the fine print or bypass it all together and borrow the money from your bank.

Why Should the Value of the Real Estate Affect Practice Value?

With the exception of mobile practices, every practice needs a facility, either as a leased space or a space owned by the practice owner. If it is leased, there is a monthly cost to the practice for that space. The higher the lease, the more it reduces the profit of the business. Less profit equals less value.

The same is true if the building is owned by the practice owner. There STILL should be a monthly expense for the building. If it is a new purchase, there is a mortgage expense. If the mortgage has been paid off, there STILL should be a rent amount paid or allocated by the practice to the owner of the building, even if it is the same person.

If you own both the practice and the real estate, you have two separate investments. First, you have invested in a veterinary practice and expect a reasonable return on that investment. Second, you have invested in a piece of commercial property and should also expect a reasonable return on that investment as a landlord. So, you are, in essence, renting from yourself. The rent paid to you by the practice is a legitimate practice expense, exactly the same as in a leased facility.

As an example, let‘s assume that, in a given market, lease rates are at about 10%/year of the value of the building. Thus, a $400,000 building would lease for $40,000/year (this is ONLY an example!) That $40,000 becomes an expense to the practice. Now let‘s assume that the very same practice is in a building worth $700,000. The lease rate would now be $70,000/year, or $30,000 more than in the first case. The profit of this practice would now be $30,000 less than in the first case. Thus, with the lower profit, the practice value would be less. Real estate value directly affects practice value.

How Do Non-Competes Affect Practice Value?

Not having non-compete agreements with all professional staff can be a “deal breaker for many buyers. The loss of value in a practice without non-compete agreements in place is almost not calculable. When a buyer is investing a large sum of money and his or her future in a practice purchase, there need to be some assurances that the popular associate will not open or move to a competing practice. Any non-compete agreements currently in place need to be reviewed by an attorney familiar with non-compete agreements to be sure they are not only enforceable, but also transferable to a new owner. One might also want to consider non-compete agreements with other key staff members such as practice managers or technicians. The caveat is that non-competes for associates and support staff are not legal in all states, so it is important to enlist the assistance of a knowledgeable attorney.

A seller absolutely must be ready to sign a reasonable non-compete agreement with the buyer and to honor it. Without such an agreement, there is little or not goodwill value. A reverse non-compete agreement should also be included to cover the possibility of a buyer‘s default. In this instance, the non-compete restricts the buyer if the seller has to take the practice back in default.

A Short Short-Course in Improving Your Understanding of Financial Statements

A common thread seen in many no-value and low-value practices is the ineffectual use, and in many cases, the total lack of use of financial statements. Practices which ineffectually utilize the information that can be gleaned from the financials are at a severe management disadvantage. In years largely gone by, it was easier to achieve adequate profit levels using seat-of-the-pants management. This is not longer the case—to nurture and to create profits and thereby create value requires an understanding of financial statements. What follows is a quick and dirty introductory discussion of financial reports. The focus is on the setup of your practice‘s accounts in order to be able to generate meaningful reports

A. What is the objective of financial statements?
to record the businesses‘ income and expense transactions
to record and characterize the flows of money through the business

B. The very basic mechanics or setup of the financials
The manner by which the financials are set-up are critical to understanding the financial reports
1. Chart of Accounts (COA)
need enough detail to provide meaning to the financials. It is easy to make the COA too detailed.
COA detail test: Ask, “Do I give a darn?
If no, omit the account.
If yes, leave the account in place.
Provide accounts for revenue breakdown along with matching expense accounts

Income
Professional Services
Laboratory Services
Pharmacy Services
Dentistry Services
Surgical Services
Dietary Services

Costs of Professional Services (costs of good sold)
Professional Expenses
Laboratory Expenses
Pharmacy Expenses
Dentistry Expenses
Surgical Expenses
Dietary Expenses

2. Ordering of the accounts the overlooked key to understanding financials
– alphabetical ordering is the worst
– re-order or break the COA into logical expense categories or groups; learn to think in terms of logical groups of expenses
– most simple financial statements have one total at the bottom; the logical group type of re-ordering expenses provides a means to monitor multiple subtotals.

C. Monitoring the Business Cash Flows
1. Primary reports
Income statement (P&L) – measures a period of time; i.e., year, month, etc.
Balance sheet measures a point in time; i.e., Dec 31, 2007.
2. Focus initially on the income statement. In the beginning, works with percentages and ration rather the absolute dollar amounts. Keep it simple. Learn 5 or 6 key ratios or percents to monitor. Use published norms as an initial reference, but ultimately your own practice data will often be the most relevant. Be sure to track these over time to observe trends.
3. Some starter measures
Laboratory: depends on importance of laboratory data in the practice; most practices have 13-15% of their income. Whatever the income, if fees are adequate, lab revenue is generally 4.5 to 6 times lab expense.
Monitor the ratio of diet income to diet expenses. You may be surprised to learn just how low the return often is on selling dietary products.

Cost of Professional Services (Cost of Goods Sold)
Cost of Professional Staffing including owners as DVM
Cost of Support Staffing (boarding, admin staff will inc)

4. At least annually, monitor your practice‘s true profitability using AVPMCA‘s NoLo Practice Threat Advisory Worksheet which can be downloaded from www.AVPMCA.org .

Acquisition Mergers: A Missed (and Misunderstood) Golden Opportunity

A retiring neighboring long-time solo practitioner, who has been unsuccessful in finding a buyer for his practice, comes to you ask if you would be interested in buying his practice‘s medical records. The common response, heard from most potential buyers, is a “knee-jerk negative response similar to the following, “Why should I pay for your database when I will probably get a certain percentage at no cost anyway.

Not wanting to miss an opportunity, if indeed one exists, you now contact a couple of consultants in the industry telling them of your medical records purchase opportunity and you inquirer, “Should I consider purchasing these medical records and, if so, what is a record worth? Again, with rare exception, the consultant‘s response echoed your impression of why purchase what you will get (at least in part) for free. As for the value of a medical record, the consultant probably would answer that he had heard they were worth some specific amount per record. Wrong answers!

Traditionally, the decision to purchase or not to purchase another practice‘s medical records should not be based only on examining the associated costs. Instead, the decision to perform an acquisition merger of another practice‘s medical records should be driven by the likelihood or not of being able to realize the exceptionally high-level profits potentially generated in such a merger. Why are acquisition mergers so profitable?

The Basic Math: The primary reason relates to the fixed costs of the acquiring practice. Consider what expenses change when clients begin transitioning into the acquiring practice? Certainly the variable expenses such as drugs and supply will increase as well as portions of the more semi-variable expenses like costs of employment will necessarily increase with the increased work load. However, the fixed costs are an entirely different story. Will the insurance costs increase as increasing numbers of merger clients transition into the practice? Utility costs? Vehicular expense?, accounting costs? etc. The answer is there will be little or no change in the fixed costs.

When a practice with sufficient excess capacity undertakes an acquisition merger, the fixed expenses DO NOT change at all or only on a very minor basis because of the merger. The reason is that the practice‘s fixed costs are already accounted for by (or pre-paid for by) the revenue generated from the existing pre-merger patient load of the practice. In the typical practice, these fixed costs conservatively account for 20% and more probably more like 25% to 30% of every revenue dollar generated. Because the majority of the merger practice‘s fixed costs are “pre-paid for by the merger practice‘s pre-merger client base, the revenue generated from the transitioning practice‘s patient load enjoys a distinct advantage in that this revenue does NOT need to account for the usual 20% to 30% contribution toward fixed expenses.

Now, add in the normal practice profitability of 12% to 15% and we can appreciate the exceptional profit earned on the transferring clients is 2 to 3 times that of the normal practice profits.

Two Key Questions: There are two keys that should be addressed by a prospective buyer.
Key Question #1: Does the acquiring practice have sufficient excess capacity to accommodate the influx of additional business created by the merger?

It is important to evaluate your practice‘s ability to adsorb the influx of new clients and patients that will likely be transferring to your practice. While it is the unusual practice that does not have some unused capacity, it is important to address this question before acting on a records merger opportunity. Two forms of excess or unused capacity should be assessed, staff related capacities and facility capacities. There are no simple formulas to assess these capacity issues. The primary limiting factor for staffing capacities is the professional staff and possibly the availability of part-time doctor staff. Limiting factors for the facility are usually related to insufficient hospitalized patient space and possibly exam room availability.

Key Question #2: Is it reasonable to believe that the majority of the liquidating practice‘s clients will make the transition from the original practice to the acquired practice?

The answer to this question is not always easy, but obviously critical to the success or failure of the opportunity. The discussion here focuses on the physical location relationship between the two practices, what is the degree of overlap of their respective trade areas, the client drive time differences, the culture differences, the reputation of the acquiring practice in the community, whether the telephone can be transferred to the acquiring practice and will the seller write a letter to his or her clients explaining their departure from practice and encourage their clients to transition to the new practice. Obviously, the greater the migration of acquisition clients, the greater is the likelihood to realize the excess profit opportunity.

Other things to do which generally help in the decision process:

Evaluate the character of the seller’s clients: most computer management system can provide reports with much of the needed data– ACT, AVG $ spent per client per year; visits per year; examine trends: revenue trends, new clients per month, etc.
Are the cultures of the two practices similar–one of the best ways to get an impression of the culture is to physically sit down and read the selling practice’s patient records; alternatively, have the selling practice print copies of invoice for several weeks and review. Reviewing 2-4 weeks of invoices is another way to derive an impression of the type of practice the seller’s clients expect.
The obvious major task is to forecast the percentage of clients who are likely to transition to the buyer‘s practice. Because of the significantly greater profitably associated with the transferring clients, the break-even point is generally low- generally around 35% to 40%. Once the initial baseline calculations are completed, it is beneficial to recalculate the model with varying levels of transferring clients. This type of “what-if” analysis can provide impressions as to how sensitive the deal is to variations in the number of clients transferring. What if 60% of the clients transfer? What if only 30% transfer? This process can provide major insights into the reasonable nature of the opportunity.

Concluding Comments: The opportunity for acquisition mergers, a type of merger where one practice acquires the intangible assets, medical records and goodwill of another practice, will be more common in the future. Buyers are starting to recognize that such practices, under the right circumstances, can be superb, highly profitable buying opportunities. Sellers, especially those owning otherwise poorly salable No-Lo type practices, may be able effect a buyout of their practices at a significantly greater price than is otherwise possible.

Acquisition mergers offer rare “win win opportunities for both the seller and buyer.

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