Doyle Watson, DVM, Simmons Southeast
The Great Heartbreak!
A practice is grossing say $1.2 mil, offers quality service and medicine, high single digit growth, primo demographics, all the toys—-the perfect veterinary practice! Except for one key ingredient—-After all the real and necessary annually recurring operating expenses, including professional staffing and management, there is very little left over as a return on the investment. I.e. low earnings.
Although the veterinary practice appraisal industry has recognized this problem over the past many years, it is becoming more commonly recognized at “Simmons” and other practice appraisers. While low earnings have always been a real problem in low grossing practices, we do not expect the higher grosser to have this problem. To the contrary, well-managed higher grossing practices (exceeding $1 mil) commonly earn in the high teens to low 20’s as a percentage of gross revenues.
To understand how this problem can occur, let’s review some simple and fundamental appraisal math. First, a business’ (veterinary practice) earnings are defined as that amount remaining after all true and reasonable operating expenses (as distinguished from capital expenses) have been met including a reasonable fair market salary for the managing chief of staff doctor (typically the owner). To say this another way, the earnings represent the return on the investment considered as if it were a cash investment (as in the stock market). Another way to conceptualize earnings is that the owner of a practice (not including real estate—just the practice) receives income from two sources. One is an earned salary commensurate with the professional service provided to the practice (and this should be on a fair market basis just as an associate is paid—by production or whatever the local market demands). The other income source is that by virtue of ownership, a return on the investment— I.e. Earnings.
It is the earnings which almost entirely create the intangible (goodwill) value of a practice. The common factor of all income approaches to business value is capitalization of the earnings. To keep the concept simple, it is not uncommon to see veterinary practices appraising and selling for 4.3 to 5.6 times earnings (FYI, the reciprocal of the multiple is a capitalization rate of 23% to 18% respectively—- but beyond the scope of this article). This asset value and price would include all the functional, revenue-producing equipment, a reasonable (going concern) amount of drug and supply inventory, and all the goodwill.
Although it is not the purpose of this article to analyze the cause of the problem, but to identify it to the profession, quite simply the cause is that the expenses are not managed for profitability. High revenues are there, but so are high expenses. Although the excessive expenses may involve several categories, the common problem areas seem to be in salaries (lay and professional), supplies and rent. Often doctors are not as productive as should be ($500K to $800K annual professional production per doctor). Lay staff should typically range in the high teens to mid 20% percentage more or less depending on the quality of service offered. Supplies should be in the same range more or less determined by the amount of non-doctor and OTC revenues. Likewise a reasonable fair market return on real estate investment is maybe 8 -11% of its value. So the rent should reflect that amount triple net; and this should be treated as an arm’s length transaction as if there are different owners of the practice and real estate. Therefore, whenever the real estate value approaches and exceeds the practice’s revenues, we begin to see excessive rent eating into earnings.
So the upshot of all this is that, while the high-grosser is generally expected to sell for a higher percentage of gross due to higher earnings, a practice with low earnings will be a value and price disappointment to its owner. Again let’s say that all risk factors have been considered and the appraiser has determined an appropriate capitalization rate of 22% (4.5 times earnings) for each of two subject practices A and B grossing $1.2 mil. each. Practice A is earning 21%, or $252K; B is earnings 9%, or $108K.
Here’s the math:
Practice A: $252K X 4.5 = $1.135K (95% of gross)
Practice B: $108K X 4.5 = $485K (41% of gross)
Obviously a heartbreak and stunning blow to the latter owner.
Having said all this, I am referring here to value achieved by standard means of an appropriate capitalization of earnings, not necessarily the price negotiated between a buyer and seller. While the actual price may not vary much from the value, there are mitigating circumstances which may lead a buyer to pay more. A great factor would be an attractive area location, such as many parts of Florida. Others may be the quality of equipment and services offered and the prospects of improving earnings with more efficient management policies. Another may be a particular buyer’s incentive to pay more depending upon that buyer’s specific interests and motivations.
Nevertheless the price must “cash flow” before a buyer can afford to pay for it and get it financed. —The topic of another article.
Solution: At least three years before the point of sale, have your practice appraised by a competent veterinary practice appraiser. A proper appraisal will tell you whether your 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 to the proper level to get the price you should expect.