Question: How can Anyone Afford to Buy my $1,000,000 Veterinary Practice?
Answer: Because it “Cash Flows”
Doyle Watson, DVM, Simmons Southeast
In a previous Advocate article (September, 07), we mentioned that a practice must “cash flow” before someone could afford to buy it or get it financed. We said it was the topic of another article. Here it is.
Although it is becoming less frequent, we do still often hear it said that “No one can afford to buy my practice”, or “I cannot afford to buy a high grossing practice. ” However the raw truth is that almost any veterinarian (assuming credit-worthiness) can afford to buy almost any high grossing practice, regardless of the personal down payment availability. The secret to the ability to buy lies in the practice “cash flow”.
The concept of cash flow has several perspectives. From that of the owner, it has to do with the amount of funds remaining from revenues after all the real and necessary daily/monthly/annual practice operating expenses have been met. Another way to say this is that amount of money the owner may take from the practice and spend at his/her discretion.
From the buyer’s perspective, cash flow is that amount of money available to serve two purposes:
- Debt service on the practice acquisition loan,
- Personal, pre-tax income.
From the commercial lender’s perspective, cash flow refers to the ability of the borrower to pay him or herself an adequate personal compensation and still have more than ample funds available to service the total acquisition debt payments. Although the buyer and lender perspectives and goals are ultimately the same, the determination of whether the cash flow is adequate is made from different approaches.
From our experience, we have identified two apparent goals common to most buyers. One is that the annual, personal, pre-tax, after-debt income (i.e. that income remaining from cash flow after the annual acquisition debt is serviced) exceeds $100K and 15% of gross under a reasonably leveraged purchase. Let’s consider the following example as a typically leveraged purchase and see how this applies to our two goals.
Practice gross—————————— $1,300,000
Practice price—————————— $1,250,000
Commercial note on Practice @ 8.5% / 10 yrs.–$1,050,000
Owner’s note @ 8% / 25 yrs. w/ balloon——$ 190,000
Cash Flow @ 31% of gross (given)—- $ 403,000
Less debt service on $1,050K——- ($ 156,000)
Less debt service on $190K——— ($ 17,000)
Annual After-debt income$ 230,000 (18%of gross)
So we see here that these goals would be/should be satisfactory to a buyer. In other words, this is an example of a deal that “cash flows” from the buyer’s perspective. It services the debt and provides excellent personal, after-debt income. And this is not at all an uncommon general scenario with a high gross, large price, low down payment, highly leveraged financing, but high after-debt income.
Although cash flow is determined by slightly different numerical criteria by a commercial lender, the concept is the same—debt serviceability and more then ample buyer after-debt income. In this instance, the lender will review the prospective buyer/borrower’s personal financial statement and determine the precise amount of annual personal income the buyer needs to pull from the practice to makes personal ends meet. For most buyers, this figure is around $60,000 to $80,000. The commercial lender will then look at the contract terms of purchase including the total annual debt service to the commercial lender and to the owner from the secondary financing note. The buyer’s necessary “ends meet” salary will then be subtracted from the cash flow. The difference should be at least 120% of the debt service (1.2 ratio) —a 20% buffer.
Considering the buyer’s necessary personal income is $75,000, using the above example, the math could look like this:
$403K cash flow – $75K salary / $173K debt service = 1.89 (189% of debt service)
The 1.89 exceeds 1.2 and will cash flow all day for any lender.
Assuming the deal cash flows to the commercial lender, the finance terms become very attractive. Typically the lender will add to the practice price (and real estate if applicable) all the borrowing and professional fees in addition to about $30,000 in working capital. In our example above, this figure could approach $60,000 – $80,000 depending on the location, lender and amount of working capital required. The lender will typically lend 85 to 90% of the total package price. In our example, let’s just say the package price, including price for practice and fees, could then be $1,320,000 (assuming $70K fees). If the lender lends 85% of the package price ($1120K—-$70K fees and $1050K principal), the balance of 15%, or $200K, must come from the seller and buyer. If the buyer has only $10K, the seller must finance $190K— simple as that. To minimize debt service, we try to structure the owner’s note for long term amortization (25 years or so) with a short term balloon payment, typically at the end of 3-7 years, depending on the size of the note and cash flow of the practice.
The only factor remaining is credit-worthiness of the buyer, and this is almost always completely satisfactory. In our experience, only in very rare instances have we had credit-worthiness issues with veterinary buyers.
This is not a bad deal for the seller when one considers that, before the early 80’s when commercial lenders discovered the general credit-worthiness of the veterinary profession and the fact that we almost always pay our debts, the seller would have received about 80% of the real estate value and financed the balance and practically all the intangible practice asset himself. Back then, a buyer indeed may not have been able to buy our example practice because the seller may have needed more cash and would not been in a position to finance such a large amount. Accordingly the primary buyers back then were the corporations who had sufficient cash down and the seller could then finance the difference.
But the good news has been for several decades and still is today that, with such attractive and competitive commercial lending terms, any private buyer can buy any practice; and the seller can come very close to cashing out. This is because it is well-known among lenders that we are a good lending deal. It is so much so that I have heard it said by a renowned commercial lender that veterinarians are “second only to chicken farmers” when it comes to business credit-worthiness.
Life is good!
Considering all said above and in the September Advocate article regarding low value practices, it greatly behooves any practice owner, especially those with high grosses, to have a “cash flow” analysis completed at least three years before the point of sale. This will tell you whether your cash flow, earnings and value are in line with your expectations and the market experience. If not, you will have ample time to correct the problem and increase earnings and cash flow to the proper level to get the price you should expect.