Over time practice appraisers and brokers will invariably become aware of a disturbing phenomenon in the veterinary medicine profession — a significant number of practices valued substantially lower than expected.
Since practice value is closely tied to profit, these practices have meager profitability. But what is even more disturbing is that most of these practice owners are completely unaware that a problem exists. Traditionally, many veterinarians have relied on their practices and real estate for the bulk of their retirement funds, so this is especially alarming.
No practice type is immune. However, two common threads are very little profit and an almost universal owner unawareness.
VetPartners’ Valuation Committee addresses this emerging trend of low profit/low valued practices and has dubbed them “No-Lo practices.”
There have always been practices with little or no value, but these are typically low-grossing and often rural “mom and pop” practices. But larger practices aren’t immune either. On the surface, they may even appear excellent in every way. And they are often model practices but with shallow cash flows and, therefore, low values.
The spectrum of No-Los range from small practices with low revenue to high-quality, multi-doctor practices with modern, well-equipped facilities. These practices fail to manage for profit or appreciate that profit is dropping. If the issue is low money generation, these circumstances are reversible, but a resolution is more challenging if the problem is high expenses. Read on for 2 examples of this phenomenon.
This doctor graduated in 1978 and has practiced small animal medicine in a small Oregon town since. They are the sole practitioner, take their own emergency cases, and are a pillar of their community. When times get tough for the locals, they readily extend credit and trade for services. They have grown kids, are debt-free, and take a weeklong vacation every year. Otherwise, they lead a frugal but contented lifestyle on their $100,000/year income. The practice revenue has grown steadily over the years to $700,000.
When they graduated, everyone knew what practices were “worth:” one year’s gross revenue plus the real estate value. Over the years, they assumed that they planned adequately for their retirement and saved minimal extra.
Last year, they decided it was time to hang up the stethoscope and sell the practice. The real estate appraised for $500,000, so they figured about $1,200,000 to use for their retirement, along with social security income. When they had the practice valued in sale preparation, they were devastated to learn that the total value was little more than the value of the tangible assets. They couldn’t believe it and, of course, are now unable to retire — they will need to work for the foreseeable future.
So, what went wrong? First, as a sole proprietor, their “net profit” of $100,000 is the total amount they take out of the practice, including production pay, management pay, rent, and profit. And, yet, because of their lifestyle, they are comfortable and wonder why a buyer can’t also live nicely on $100,000/year as they have done. They haven’t considered that a buyer would have substantial monthly payments to buy their practice and real estate. Sadly, they haven’t had the tools or guidance for analyzing the true practice profits over the years properly and have not stayed abreast of current practice valuation methods. Why should they?
This veterinarian managed for profit with an eye on the bottom line, well-defined financial goals, the confidence, and determination to reach those goals, and had planned a return on their investment.
Another doctor owns what they are convinced is in the top 1% of all the nation’s practices in terms of facility, medicine quality, technician-to-doctor ratios, compliance, staff and client satisfaction, and community service. How can you go wrong with a $1.9 million, 10,000 sq. ft., state-of-the-art hospital, complete with VIP boarding and a swimming pool for the boarders? It was awarded “Veterinary Economics Hospital of the Year,” enjoys 4-year AAHA certification, an employee 35-hour workweek, full benefits, including health, dental, and eye care, generous sick and vacation leave, fully financed doctor and staff CE, profit-sharing, and a matching 401K program. They want to avoid short-staffing, so there are plenty of employees available at all times. They have all the latest equipment, including ultrasound, laser surgery, and digital radiography.
This doctor is thrilled to offer their clients and staff the very best. They are the “poster child” for generosity and want to “share the wealth.” After all, this $1,5000,000 practice provides the veterinarian $325,000 every year, and they are debt-free.
As with the previous example, this doctor decided last year that it was time to retire. They have made a comfortable income and, when coupled with the substantial sale price expected from the real estate and practice, they should be able to live quite comfortably and still leave a healthy estate to their children.
Imagine their shock and dismay when the practice appraiser said the practice could support only a little more than $204,000 in value. Again, their entire career, they had assumed that one year’s gross was the average value of a practice. This came as a $1,296,000 shock. As with the previous doctor, they are now forced to work for several more years and delay retirement.
So, what could have gone wrong with this model, award-winning practice? Let’s take a closer look. This doctor is a sole proprietor, so their tax return reports a “net profit” of $325,000. Similar to the other doctor’s situation, this $325,000 includes the total amount of compensation they receive.
An owner should be paid four ways.
- Pay for producing income
- Pay for management
- Rental income if they own the building
- Profit simply for being an owner (the basis for practice value).
If there is nothing left for #4, the practice has little or no value because there is no money available for a buyer to use to pay for the practice loan.
Let’s look at the details.
The practice’s gross revenue is $1,500,000. The real estate value is $1,900,000, and the owner’s income is $325,000.
- The owner produces $600K, so, at a 22% compensation rate, he/she deserves $132,000.
- Management compensation should total 3-4% of gross, which is $15,000. They have a full-time manager, so they only get 1% of the gross.
- Rental income on $1,900,000 @ 8% of building value is $152,000.
- So, the remainder (profit) is $26,000.
- Total to owner = $325,000
So, how much practice can the $26,000 profit buy, assuming reasonable lender terms?
Typical current terms for practice purchase:
- 5.0% Rate
- 10-year loan term
The monthly payment available is a function of the $26,000 profit. The monthly payment available (26,000/12) is $2,167.
This example is the payment on a $204,000 loan! This is the most the profit can support, but the actual practice value is probably even less.
Naturally, when this doctor is confronted with a practice valued at only 14% of gross revenue, they are dumbfounded and angry. After all, they “make” $325,000. Unfortunately, the money they take home simply because they are the owner is not profit. Even though a corporate purchase may be available at a higher price, that price will still be drastically lower than otherwise would have been if the practice was not a NoLo.
This doctor was consumed by an overwhelming desire for quality, status, and comfort above all else. They believed that you should “Do what you love, and the money will follow,” and they failed to focus on the bottom line.
Why Do Veterinary Practice Owners Allow This to Happen?
The key difference between the examples above is profitability. A practice must be profitable before it can be valuable. These are examples of both ends of the spectrum of No-Lo practices, but any practice can fall into this category.
Owner Thinks They “Make Enough”
Most veterinarians are compassionate and caring, not greedy. When they make more money than others in their practices, they want to “share the wealth.” They don’t feel pressured to keep profits at an optimum level. This is not wrong, but it needs to happen intentionally, not accidentally.
There are other reasons to maintain profitable businesses. Owners are responsible to clients to reinvest in the practice to keep current with new equipment, CE, and staffing. They are responsible to their families. Since we never know when we will need to exit, it is important for the financial security of their family to maintain a profitable and, hopefully, valuable practice. And, finally, they are responsible to colleagues. If they sell services for little or no profit, surrounding practices will pressure them to charge substandard fees.
There are two reasons for low profit, either too little revenue or too many expenses.
Since it is often impossible to control expenses to increase profit substantially, the solution rests with inadequate revenues.
- Fees not high enough
- Excessive discounting
- Excessive (giveaways)
But, it is not all about revenue. It may be possible to increase profit by reducing expenses as well.
Employees that are overly compensated and “over-benefited” result from the owner’s need to share the wealth. It brings them joy to pay top wages, provide top-quality health and dental insurance, send staff to CE, have a generous vacation policy, and contribute liberally to employee retirement plans. But, again, there is a cost to the business’s profit. If it is undesirable to cut staff costs, then we go back to the revenue issue — there is not enough to support this level of staffing costs.
When there seems to be enough money to go around, it becomes straightforward to add services and “extras” that don’t add to the ultimate practice profit. Some enhance the business, resulting in more enthusiastic clients and repeat business, but some make little difference to clients. Once again, if you are unwilling to cuts costs here, you MUST increase the revenue to support this level of service.
Lack of True Profitability Analysis
Many owners receive their monthly financial statements, see a positive number at the end and throw the statements in a drawer. Nobody ever showed us how to analyze true profitability, so it becomes difficult to track if you don’t know where to look. In essence, most owners have not been given the tools to properly read their financial statements as management tools.
Managing for Profit
The lesson from the preceding examples is that the ideal circumstance is a veterinarian who manages for profit with an accurate measurement. Failure to measure leads to a rude awakening when it’s time to sell and an inadequately funded retirement plan.
Managing for profit offers the following benefits.
- Reward for investment risk
- Reward for effective management and leadership
- Return on your educational investment
- Provision for your doctors and staff
- Ability to invest in equipment and facility upgrades
- Provision for your family and those important to you
- Provision for your retirement
You must consider the risk vs. the reward. The safer the investment, the lower the return; the riskier the investment, the higher the return. A safe investment is a certificate of deposit with a rate of return of 1-3% per year. An intermediate investment is a mutual fund indexed to the market (e.g., S&P 500 Index Fund) with a 10-12% rate of return over the long haul. And more risk is a veterinary Practice, for which your target should be 12-20%.
Simmons Helps You Stay On Top of Your Practice’s Value
If you are unsure of your veterinary practice’s profitability, use the No-Lo Threat Advisory Worksheet to calculate your true profitability — not tax return profit. This worksheet is the first step in deciding if your profit is reasonable or dangerously low. We encourage you to go through this exercise to assess the financial health of your practice. Do it now before you are forced to exit your practice. Awareness of the problem is the first step to a cure.
At Simmons Veterinary Practice Sales and Appraisals, we help you ensure the value of your practice with our comprehensive appraisal services. And when it is time to enjoy your well-deserved retirement, we are there to help you sell. Contact us today to connect to an advisor who can help you know about your veterinary practice’s value.