What’s the difference, and what impact does it have on practice buyers and sellers?
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 those assets of a practice that exist but not in a physical form, the most important being, Goodwill. Goodwill can be further divided into two categories:
• Personal Goodwill (aka Professional Goodwill) which attaches to an individual doctor rather than the business the doctor owns.
• Enterprise Goodwill (aka Business Goodwill) is derived from the characteristics specific to that particular practice regardless of who operates or owns that practice.
Why is the distinction important? Because it can have a profound effect on the value of the practice and can be useful in certain entity structures to mitigate taxes associated with the sale of the practice. We can illustrate the difference between the two using the following examples. Assume there are two similar practices in the same community, Mainstreet Animal Clinic and Sidestreet Pet Hospital. They are three 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 case load and revenue generation almost equally amongst all the doctors since the doctors have rotating shifts and commonly interchange clients. Sidestreet is different, its located on a side street in a quiet neighborhood and offers appointment-only exams which are 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%.
Contrasting the two practices we see that Mainstreet’s earnings are tied directly to the business enterprise itself, including its location and how overall revenue is generated almost equally by all of the doctors. Clients are bonded to the business and its offerings, including the convenience of walk-in appointments and competitive pricing. Therefore, the owner of Mainstreet derives much of his profits as a result of Enterprise Goodwill, profit derived from the business itself. Sidestreet on the other hand derives most of its profit from the effort of one particular doctor, clients are bonded to the actual individual doctors themselves evidenced by the common request for doctor-specific appointments and the toleration of higher fees charged by Sidestreet. 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.
What does all of this mean regarding the future sale of these two practices? First, we need to address the fact 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 a longer post-sale employment and transition of the seller, 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. In general 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 (ie. 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 since the majority of goodwill resides in the company itself, not Dr. Smith. 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 from repeat clients always requesting her over other doctors. She works five days a week and takes an active hands-on role in 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.
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 have an effect on the sale structure and tax treatment of the sale 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. In carefully selected situations it may be possible to mitigate the double taxation by separating the sale into two segments, corporate assets along with 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 the double taxation although now the entire transaction may create 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 goes beyond the scope of this article.
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 buyer of a practice, 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 safe-guards have been put in place to facilitate the transferability of goodwill. 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 be sure to give a critical look at how closely the buyer’s medical and business operational philosophies matchup with the current owner’s.
In the case of Sidestreet Pet Hospital, Dr. Jones will have two options to consider. She can keep things the same as they are, and then work closely with the buyer to facilitate the transfer of her personal goodwill, but a quick exit after the sale is not likely to be acceptable to a buyer. Her other option is to start transforming the business model in advance of the sale date. She could work to redistribute clients amongst the other doctors reducing her individual revenue production by concurrently increasing the production of the other doctors in the practice. Changing her personal prominence in marketing efforts and dividing and delegating operational and management responsibilities to others within the practice would help. Appointing one of the other doctors as the medical director, further empowering the practice manager with authority to act independently but with supervision and divorcing herself from involvement at the micro-management level all would help shift goodwill from Personal over to Enterprise. If this occurs, transferability of the goodwill from the seller to the buyer will be more easily achieved in a shorter period of time and since purchasing Enterprise Goodwill has a lower perceived risk than purchasing Personal Goodwill it may actually facilitate a buyer making a higher offer. 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, where 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. 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 those practices that are of the size and nature to be Corporate Consolidator targets one of the key limiting factors of the purchase decision as well as the price paid is the degree of Personal Goodwill residing in the seller. 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 risk of purchase to high. 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/sold and therefore has a profound impact financially to buyer and seller alike.