Byron Farquer, DVM, CVA
Each veterinary practice has two main assets classes — tangible and intangible. Tangible assets include items you can pick up and carry around like furniture, trade fixtures, medical equipment, and supplies. Intangible assets are the practice’s assets that exist but not in a physical form, the most important being goodwill. Read on to learn more about this asset category and why it matters so much in your veterinary practice.
Understanding Goodwill
Goodwill can be divided into two categories:
- Personal Goodwill, a.k.a. Professional Goodwill, attaches to an individual doctor rather than the business the doctor owns.
- Enterprise Goodwill, a.k.a. Business Goodwill, is derived from a practice’s specific characteristics regardless of who operates or owns that practice.
The difference between goodwill can profoundly affect the practice’s value and be useful in certain entity structures to mitigate taxes associated with the practice sale. We can illustrate the difference between the two using the following examples.
Enterprise vs. Personal Goodwill
Assume there are two similar practices in the same community — Mainstreet Animal Clinic and Sidestreet Pet Hospital. They are 3 miles apart, offer similar services, have nearly identical equipment, revenue, and net income (profit).
Mainstreet Animal Clinic is located at a busy intersection, surrounded by shopping centers and high-density housing. They allow walk-ins, are very price competitive and split caseload and revenue generation almost equally amongst all the doctors since the doctors have rotating shifts and commonly interchange clients.
Sidestreet is different. It’s located on a side street in a quiet neighborhood and offers appointment-only exams, often booked out a couple of weeks in advance, and clients commonly book appointments with a specific doctor. One of the doctors at Sidestreet outproduces the average transaction fee of the other 3 by nearly 200%.
Enterprise Goodwill
Contrasting the two practices, we see that Mainstreet’s earnings are tied directly to the business enterprise itself, including its location and how all doctors generate overall revenue almost equally. Clients are bonded to the business and its offerings, including the convenience of walk-in appointments and competitive pricing. Clients are also bonded to the individual doctors, evidenced by the common request for doctor-specific appointments and the toleration of Sidestreet’s higher fees. Therefore, Mainstreet’s owner derives much of their profits from Enterprise Goodwill, which is profit derived from the business.
Personal Goodwill
On the other hand, Sidestreet derives most of its profit from the effort of one particular doctor. Sidestreet has a strong Personal Goodwill component as part of its value, and a large portion of the Personal Goodwill resides in just one of the four doctors working there.
Goodwill Transferability
What does all of this mean regarding the future sale of these two practices? First, we need to address that one of the most important considerations for a buyer is the transferability of the goodwill from the seller to the buyer. If the perceived risk or difficulty of capturing the seller’s goodwill is high, buyers will pay less for that business or perhaps require other terms and conditions associated with the sale, such as extended post-sale employment and seller transition, seller participation in financing, or other risk-mitigating strategies like withholding some of the sale proceeds until a future date, payable if and only if the goodwill transfer was satisfactory, all of which the seller may be unable or unwilling to agree to do.
Enterprise Goodwill Transfer
In general, the transferability of Enterprise Goodwill is easier than Personal Goodwill. When Dr. Smith offers to sell Mainstreet Animal Clinic, the buyer recognizes that no single doctor, single activity (i.e., a specific service), or business operation style is unique or more important than any other.
Many clients that come to Mainstreet Animal Clinic are unaware that Dr. Smith is the owner, and many have only had him as the attending doctor for their pet a few times. When it comes time for a buyer to take over ownership of Mainstreet, the transition of goodwill should be relatively smooth as the majority of goodwill resides in the company itself, not Dr. Smith.
Personal Goodwill Transfer
Over at Sidestreet Pet Hospital, Dr. Jones, one of 4 doctors there, is not only an owner but produces nearly 65% of the revenue in the practice, due in part to repeat clients always requesting her over other doctors. She works five days a week and takes an active, hands-on role in the management of the practice, including overseeing all staff training and financial management. When it comes time to buy Sidestreet, the buyer will need to work closely with Dr. Jones if the buyer hopes to capture all of Dr. Jones’ Personal Goodwill. If the buyer does not, post-sale revenue could plunge and profits plummet.
Legal Factors Affected by Goodwill
Other factors are affected by the type of goodwill in question. In divorce cases, 24 states and the District of Columbia do not include Personal Goodwill in the marital estate, while 19 others do, and 8 states have no formal precedent. Personal vs. Enterprise Goodwill can also affect the sale’s structure and tax treatment in certain situations. Most notable is the sale of a business structured as a C-Corp due to the concern over double taxation of the sale proceeds.
Separating the Sale
In carefully selected situations, it may be possible to mitigate the double taxation by separating the sale into two segments — corporate assets and its associated Enterprise Goodwill in one, and then another segment addressing purchasing the Personal Goodwill of the selling doctor. This second segment would be taxed singularly, whereas the first segment, purchase of the corporate assets and Enterprise Goodwill, would still be subject to double taxation.
Practice Valuation
However, now the entire transaction may create a substantially less overall tax burden for the seller. The challenge, of course, is determining how much of the business value is Enterprise vs. Personal Goodwill. An experienced business valuator should be able to split the two up appropriately based on a number of factors that go beyond the scope of this article.
Determining the Practice’s Goodwill
How do you tell what type of goodwill exists in a particular practice? The chart below helps illustrate some common differences between Enterprise and Personal Goodwill.
As a potential practice buyer, you should assess the degree of Enterprise vs. Personal Goodwill and then use that assessment in your purchase planning. Should it affect the price you pay? Not necessarily if safeguards have been put in place to facilitate goodwill transferability. Recognize that it will likely be easier to transfer Enterprise Goodwill vs. Personal Goodwill so that assessment should then carry over into other aspects of the purchase structuring, such as the post-sale transition time of the seller, size and duration of the restrictive covenants, and taking a critical look at how closely the buyer’s medical and business operational philosophies match up with the current owner’s.
Considering the Options
In the case of Sidestreet Pet Hospital, Dr. Jones has two options to consider. They can keep things the same and then work closely with the buyer to facilitate the transfer of their Personal Goodwill, but a quick exit after the sale will likely be unacceptable to a buyer.
The other option is to start transforming the business model in advance of the sale date in the following ways to help shift goodwill from Personal to Enterprise.
- Redistribute clients amongst the other doctors to reduce individual revenue production.
- Increase the production of the other practice doctors.
- Change their personal prominence in marketing efforts
- Divide and delegate operational and management responsibilities to others within the practice.
- Appoint one of the other doctors as the medical director, further empowering the practice manager with authority to act independently but with supervision.
- Divorce from involvement at the micro-management level.
If this occurs, goodwill transferability from the seller to the buyer will be more easily achieved in a shorter period. As purchasing Enterprise Goodwill has a lower perceived risk than purchasing Personal Goodwill, it may facilitate a buyer making a higher offer.
Goodwill Conversion
Is it necessary to convert Personal Goodwill to Enterprise Goodwill? Not necessarily. In some instances, it’s not feasible. For example, in the case of the consulting radiologist or orthopedic surgeon, the Personal Goodwill of the individual isn’t convertible to any extent. Even for certain generalists that practice in specific categories, such as the sole large animal ambulatory practitioner, conversion to mostly Enterprise Goodwill is equally unlikely.
Structure the Sale Terms Appropriately
When conversion is not reasonably achievable, one simply needs to be aware of the differences and limitations of Enterprise Goodwill vs. Personal Goodwill and then structure the sale terms and post-sale transition period appropriately. For practices of the size and nature to be considered corporate consolidator targets, one of the key limiting factors of the purchase decision and the price paid is the degree of the seller’s Personal Goodwill. On many occasions, consolidators have passed on purchasing an otherwise good practice stating that too much of the goodwill resided in the selling-doctor, making the purchase risk too high.
Simmons Is Your Guide to Understanding Your Practice’s Sale
Goodwill is certainly not the only thing to consider or concern yourself with when buying or selling a practice. However, from a cost standpoint, it is commonly the most expensive asset being purchased or sold and therefore has a profound financial impact financially for the buyer and seller alike.
Having a grasp of your practice’s goodwill can help you approach a sale and transition plan more confidently. When you have questions, trust the company that has helped veterinary practice owners like you for over 4 decades. Contact us to connect with a Simmons Veterinary Practice Sales and Appraisals representative who can help you get the information you need.
