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Practice Valuation: What Does it Mean?
WHAT DOES IT MEAN? R O G E R K- H IL L , M .B .A .
aluing and selling your most valuable income-producing asset, whether whole or in part, requires a great deal of planning. A poor or inaccurate valuation can mislead buyers, damage relationships and ultimately bring down an other wise vibrant practice. Used properly, valuing becomes the primary tool for keeping a practice healthy, and for helping you achieve your personal or professional goals. MOTIVATION FOR VALUATION
The most common reasons for valuing your practice are: ■■ a present or future sale; ™ sale of an interest in the practice; ™ inclusion of an associate/ purchaser; ™ repurchasing an interest from a dentist who is leaving the practice; ™ retirement planning; ™ various types of litigation support. While the most common reason to value a practice is an impending sale, many dentists
ABSTRACT
A s s e s s in g th e v a lu e o f y o u r p r a c tic e r e q u ir e s c a r e fu l p la n n in g . T h is a r tic le d is c u s s e s th e r e a s o n s , m e th o d s a n d p itfa lls o f p r a c tic e v a lu a tio n . have begun to implement a more comprehensive plan. The plan brings an associate into the practice, values it and updates the value periodically while keeping the impending sale (either whole or in part) in mind. This type of delayed sale allows the seller to work extensively with the buyer before the sale and judge their appropriateness for your practice. The above reasons for valuation apply to group practices as well. However, a discount value for minority considerations may need to be applied depending upon the amounts of ownership among the various owners.
Many dentists plan the sale of their practice five or more years before they retire, and with good reason—the value of their practice (assuming a solo practice, whether general or specialty) follows a typical bell curve. Obviously, the best time to sell is before the curve drops and the nucleus of the practice dissolves. This sort of planning is in the best interests of the patients, the seller and the seller’s family. Sad to say, there are times when litigation may call for the practice to be valued. The most common litigation is in connec tion with divorce proceedings. A second type of litigation involves loss of profit or economic damages resulting from physical or financial injury. Other litigation involves dissenting shareholder suits, typically triggered by a minority shareholder who feels th at his or her rights have been substantially abused. THE MYSTERY DISPELLED
For an income-producing asset such as your practice, there are JADA, Vol. 124, March 1993
69
two widely accepted methods for establishing value. The first is the market approach. Simply stated, the m arket approach compares your practice to similar practices th at have sold recently. This comparison be comes the basis for determining the fair market value. However, since the sale of a professional practice is a private transaction, there is no central recording of these sales, compilation of relevant data or publication of comparable information. As a result, most valuation experts use another approach. This method uses a practice’s earning power to generate net income that exceeds the com pensation a non-owner dentist might receive in a similar or identical practice. This extra profit is the motivation for purchasers to take the risk of becoming an owner. Most commonly called an earnings or capitalization approach, this method combines two essential considerations that will concern any purchaser: reward and risk. Assessed separately, these two combined areas will provide the fair m arket value of your practice. Usually, the quality of the result is directly proportional to the experience of the individual conducting the work. The reward involves the net income (earnings) your practice generates after overhead costs and reasonable compensation have been met. Overhead costs are only those costs that produce income, and will not include benefits and perquisites paid for by the practice on behalf of the owner. Since this category also excludes amounts spent on equipment, notes, leases and interest paid on various types of debt, 70
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overhead is lower than most dentists anticipate. Reasonable compensation is the funding needed to hire a non-owner associate(s) to match the gross income th a t you produce. Because you are not going to pay this person as much as you can earn from the practice, net income will remain. This remaining net income is the reward for taking the risk of ownership. Also, it forms the basis for the earnings approach to value. The other factor for the earnings approach is assessing the amount of risk for the purchaser. This degree of risk is the amount of return necessary to entice an otherwise neutral investor (purchaser) to purchase, sometimes called the discount rate. Of course, as the degree of risk increases, the value decreases. The amount of risk is represented by a decimal fraction between 15 and 30 percent. Higher discounts may apply, but they are rare. The discount rate is made up of three parts: a risk-free component, a component for illiquidity and a risk-specific component. The risk-free component is the prevailing m arket rate of a governmentissued security, such as a fiveor seven-year treasury note. Since this investment cannot easily be converted into cash, a handicap is added for illiquidity. Illiquidity usually adds between 2 and 4 percentage points. The risk-specific component considers a list of variables which measure the relative risk of the practice compared with similar practices. Some risk-specific variables include: "■ location ■■ size of patient base
■* new patients ■■ lease — competition in area ™ retention of staff ■■ profitability "■ gross receipts ■■ growth potential ™ repeat visits ™ equipment ™ delinquent accounts ™ patient types ™ transferability ™ practice components rating (type of work). The combination of all these variables will produce an accurate percentage. This percentage becomes the riskspecific component. To illustrate the earnings approach to value, say your risk free component has an interest of 7 percent, and the component for illiquidity adds 3 percent. After assessing the variables listed above, your risk-specific component adds another 10 percent. The reward (after-tax profit) divided by the risk (or discount rate of 20 percent) will be the fair m arket value of your practice. The earnings approach to value is ideal because it focuses on the purchaser’s reward/risk orientation, and it can be applied to any type of practice in any location. SALES ALTERNATIVES
The practice valuation gives key support toward the pursuit of a personal and/or professional goal. The following four overviews are basic practice sales alternatives. A. Prototypical sale—The type of sale where the entire practice is sold. As part of the consideration, a cash down payment is made at the time of closing. The remaining balance is paid out over a period of time,
usually five to 10 years. Generally, the selling dentist will remain on a gradually decreasing work schedule for one to six months after the sale. B. D elayed sale—This is identical to the prototypical sale, except th a t a purchaser is on hand before the date you sell the practice. The sale is arranged in advance of a speci fied date for a certain price. This can be an option to purchase or a right of first refusal, with the first being more obligatory for both parties than the second. Frequently, in delayed sale cases, the previously established value may require adjustment depending upon the practice performance during the intervening period. Naming a purchaser in advance can serve the interests of both dentists quite well. C. Extended sale—This is similar to the prototypical sale, except that you will stay on as a commissioned associate for one to five years after the sale. Your involvement will often be on a part-time basis for cash flow purposes; however, you will continue to earn income as the associate in residence. There is usually less cash received at closing with this approach because there is less risk of lost patients and subsequent default on the financing. The extended sale can be particularly rewarding from both a financial and professional point of view. However, it does necessitate an emotional adjustment to a new role in a new setting. D. Partial sale—In this case, you are selling a portion of the practice to become a co owner. This method is ideal when you anticipate leaving the practice more than five years from now. If the practice is
incorporated, the tax disincentives of purchasing stock (as opposed to an asset sale) need to be addressed in one of several ways. Also, a buysell arrangement and income distribution formula should be worked out in advance. A buysell arrangement details the steps by which you or your co owner will purchase each other’s interest in the practice. An income distribution formula spells out how the profit after expenses is distributed among you. Simple formulas th at split profit proportional to each dentist’s production, or on the basis of percentage of ownership, are rarely workable. This formula is often more involved. Despite this, a partial sale remains a practical means of practice transition for longrange planning. POTHOLES TO AVOID
Benefiting from the experiences of others is an inexpensive way to learn. The following are some common traps th a t can easily be avoided. A. O vercom pensating an associate—Despite the penurious sounding assertion that associates are often overcompensated, such is often the case. If so, you will soon realize it, whether consciously or unconsciously, and the working relationship is doomed from that point onward. Moreover, an overcompensated associate sees less difference between their compensation as a non-owner and what they will realize as an owner. Ultimately, the incentive to purchase the practice will suffer. B. Selling the associate his or her own production—One of the most frequently cited
reasons for an associate not moving forward with an anticipated sale is th a t the market value includes a significant contribution on their part to the total gross income of the practice. They feel they are being asked to pay for a portion of the business they helped create. This is rarely an issue when associate contributions are small; however, when the associate has been in place two or more years, and is producing 25 percent or more of the practice gross income, this issue can destroy a working relationship. To avoid this, let the valuation process take the associate’s contribution into account so th a t they do not feel forced to pay for something they helped build. Ideally, a value should be established when the associate begins, and should be updated periodically. The value could be assessed without the associate’s contribution, or it could include a portion of the associate’s production based on patients being referred to the associate by the owner-dentist. The valuation is still useful when many years have passed before a sale but, as always, an ounce of prevention is worth a pound of cure. C. Income distribution formula failure—When two or more dentists jointly own the practice, a formula needs to be established so the distributable profits (after overhead) can be divided among them. A simple formula divides the profit on the basis of each dentist’s production as a percentage of the total. This method is not very accurate, however. First, the associate paid on a commission basis before the sale would have JADA, Vol. 124, March 1993
71
realized little extra by virtue of paying the purchase price for an interest in the practice. Second, the formula focuses on individual production instead of the practice as a whole. A successful income distribution formula will distribute a majority of the income based on productivity, but some income will be distributed based on their percentage of ownership. This ratio should be based on the financial structure of the individual practice. D. O verproduction of seller/associate—When the selling dentist remains as an associate, sufficient after-tax income m ust be available for the purchaser once the bills are paid. These bills include over head, debt service, the associate (seller) and personal income taxes. Generally speaking, practices producing less than $300,000 per year are not candidates for this type of sale. Further, you cannot hope to receive the equity in your practice while producing most of the income without providing the purchaser some extra ordinarily flexible financing terms. Usually, these types of sales work best if the seller is producing fifty percent or less of the gross income. The seller should also provide owner financing with an interest-only period ranging from six to 12 months following the date of sale, before reduction of the note begins. Tighter financial arrangements than this can set the purchaser up for financial disaster. E. Incom plete fore casting—The best way to test a proposed sale, whether
72
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prototypical or extended, is to run a set of projections known as an after-tax cash flow or pro forma. A pro forma is a financial overview of what the purchaser can expect to earn after meeting all overhead costs, debt service, seller/associate (if applicable) Mr. Hill is president and estimated of Business and personal Professional Associates, a firm income taxes. specializing in the In other words, valuation and sale of professional can the practices throughout purchaser live the United States. comfortably on Address requests for reprints to Business the remaining and Professional income during Associates, 6200 Savoy, Suite 400, the period that Houston, Texas the purchase 77036. price is being paid? F. Pattern incon sisten cies—The criteria for selling and repurchasing must be consistent, especially for group practices where new dentists are being added and other dentists are leaving. Surprisingly, this is not always the case. The result is a set of conflicting circumstances. Often a group will let a new dentist buy in for an incredibly low price and then expect Full M arket Value for the pro rata share of a retiring dentist. This inconsistency will ultimately destroy a group practice. Therefore, group practices must adhere to a precedent to maintain the viability of the group. G. Too m uch owner financing—Any buyer should
have a personal interest in the purchase of the practice. Even when a partial interest in the practice is being bought, the purchaser should have some personal money at risk. Carefully constructed banking and financing packages can draw enough cash for the seller at closing so th at the purchaser is motivated to succeed. Also, contract language should specify that, in the event of a default by the purchaser, the seller’s covenant not to compete is no longer in effect, and th at the purchaser provides a reciprocal covenant of equal size and duration from the date of default. The seller is loaning money to the purchaser by virtue of owner financing. Before financing, the seller should require a personal financial statement, quarterly financial statements on the practice after the sale, and life insurance from the buyer. Finally, a word of advice— keep a clear perspective. Leaving active practice can be an emotionally intimidating experience. Change is difficult for all of us and, after years of conditioning, the prospect of life afterward may seem unsettling. The real change comes with a change in attitude. Retirement is a form of letting go, but with it, you can channel your time and energy toward new goals on the horizon. ■ The opinions expressed or implied are strictly those of the author and do not necessarily reflect the opinion or official policies of the American Dental Association.
aluing and selling your most valuable income-producing asset, whether whole or in part, requires a great deal of planning. A poor or inaccurate valuation can mislead buyers, damage relationships and ultimately bring down an other wise vibrant practice. Used properly, valuing becomes the primary tool for keeping a practice healthy, and for helping you achieve your personal or professional goals. MOTIVATION FOR VALUATION
The most common reasons for valuing your practice are: ■■ a present or future sale; ™ sale of an interest in the practice; ™ inclusion of an associate/ purchaser; ™ repurchasing an interest from a dentist who is leaving the practice; ™ retirement planning; ™ various types of litigation support. While the most common reason to value a practice is an impending sale, many dentists
ABSTRACT
A s s e s s in g th e v a lu e o f y o u r p r a c tic e r e q u ir e s c a r e fu l p la n n in g . T h is a r tic le d is c u s s e s th e r e a s o n s , m e th o d s a n d p itfa lls o f p r a c tic e v a lu a tio n . have begun to implement a more comprehensive plan. The plan brings an associate into the practice, values it and updates the value periodically while keeping the impending sale (either whole or in part) in mind. This type of delayed sale allows the seller to work extensively with the buyer before the sale and judge their appropriateness for your practice. The above reasons for valuation apply to group practices as well. However, a discount value for minority considerations may need to be applied depending upon the amounts of ownership among the various owners.
Many dentists plan the sale of their practice five or more years before they retire, and with good reason—the value of their practice (assuming a solo practice, whether general or specialty) follows a typical bell curve. Obviously, the best time to sell is before the curve drops and the nucleus of the practice dissolves. This sort of planning is in the best interests of the patients, the seller and the seller’s family. Sad to say, there are times when litigation may call for the practice to be valued. The most common litigation is in connec tion with divorce proceedings. A second type of litigation involves loss of profit or economic damages resulting from physical or financial injury. Other litigation involves dissenting shareholder suits, typically triggered by a minority shareholder who feels th at his or her rights have been substantially abused. THE MYSTERY DISPELLED
For an income-producing asset such as your practice, there are JADA, Vol. 124, March 1993
69
two widely accepted methods for establishing value. The first is the market approach. Simply stated, the m arket approach compares your practice to similar practices th at have sold recently. This comparison be comes the basis for determining the fair market value. However, since the sale of a professional practice is a private transaction, there is no central recording of these sales, compilation of relevant data or publication of comparable information. As a result, most valuation experts use another approach. This method uses a practice’s earning power to generate net income that exceeds the com pensation a non-owner dentist might receive in a similar or identical practice. This extra profit is the motivation for purchasers to take the risk of becoming an owner. Most commonly called an earnings or capitalization approach, this method combines two essential considerations that will concern any purchaser: reward and risk. Assessed separately, these two combined areas will provide the fair m arket value of your practice. Usually, the quality of the result is directly proportional to the experience of the individual conducting the work. The reward involves the net income (earnings) your practice generates after overhead costs and reasonable compensation have been met. Overhead costs are only those costs that produce income, and will not include benefits and perquisites paid for by the practice on behalf of the owner. Since this category also excludes amounts spent on equipment, notes, leases and interest paid on various types of debt, 70
JADA, Vol. 124, March 1993
overhead is lower than most dentists anticipate. Reasonable compensation is the funding needed to hire a non-owner associate(s) to match the gross income th a t you produce. Because you are not going to pay this person as much as you can earn from the practice, net income will remain. This remaining net income is the reward for taking the risk of ownership. Also, it forms the basis for the earnings approach to value. The other factor for the earnings approach is assessing the amount of risk for the purchaser. This degree of risk is the amount of return necessary to entice an otherwise neutral investor (purchaser) to purchase, sometimes called the discount rate. Of course, as the degree of risk increases, the value decreases. The amount of risk is represented by a decimal fraction between 15 and 30 percent. Higher discounts may apply, but they are rare. The discount rate is made up of three parts: a risk-free component, a component for illiquidity and a risk-specific component. The risk-free component is the prevailing m arket rate of a governmentissued security, such as a fiveor seven-year treasury note. Since this investment cannot easily be converted into cash, a handicap is added for illiquidity. Illiquidity usually adds between 2 and 4 percentage points. The risk-specific component considers a list of variables which measure the relative risk of the practice compared with similar practices. Some risk-specific variables include: "■ location ■■ size of patient base
■* new patients ■■ lease — competition in area ™ retention of staff ■■ profitability "■ gross receipts ■■ growth potential ™ repeat visits ™ equipment ™ delinquent accounts ™ patient types ™ transferability ™ practice components rating (type of work). The combination of all these variables will produce an accurate percentage. This percentage becomes the riskspecific component. To illustrate the earnings approach to value, say your risk free component has an interest of 7 percent, and the component for illiquidity adds 3 percent. After assessing the variables listed above, your risk-specific component adds another 10 percent. The reward (after-tax profit) divided by the risk (or discount rate of 20 percent) will be the fair m arket value of your practice. The earnings approach to value is ideal because it focuses on the purchaser’s reward/risk orientation, and it can be applied to any type of practice in any location. SALES ALTERNATIVES
The practice valuation gives key support toward the pursuit of a personal and/or professional goal. The following four overviews are basic practice sales alternatives. A. Prototypical sale—The type of sale where the entire practice is sold. As part of the consideration, a cash down payment is made at the time of closing. The remaining balance is paid out over a period of time,
usually five to 10 years. Generally, the selling dentist will remain on a gradually decreasing work schedule for one to six months after the sale. B. D elayed sale—This is identical to the prototypical sale, except th a t a purchaser is on hand before the date you sell the practice. The sale is arranged in advance of a speci fied date for a certain price. This can be an option to purchase or a right of first refusal, with the first being more obligatory for both parties than the second. Frequently, in delayed sale cases, the previously established value may require adjustment depending upon the practice performance during the intervening period. Naming a purchaser in advance can serve the interests of both dentists quite well. C. Extended sale—This is similar to the prototypical sale, except that you will stay on as a commissioned associate for one to five years after the sale. Your involvement will often be on a part-time basis for cash flow purposes; however, you will continue to earn income as the associate in residence. There is usually less cash received at closing with this approach because there is less risk of lost patients and subsequent default on the financing. The extended sale can be particularly rewarding from both a financial and professional point of view. However, it does necessitate an emotional adjustment to a new role in a new setting. D. Partial sale—In this case, you are selling a portion of the practice to become a co owner. This method is ideal when you anticipate leaving the practice more than five years from now. If the practice is
incorporated, the tax disincentives of purchasing stock (as opposed to an asset sale) need to be addressed in one of several ways. Also, a buysell arrangement and income distribution formula should be worked out in advance. A buysell arrangement details the steps by which you or your co owner will purchase each other’s interest in the practice. An income distribution formula spells out how the profit after expenses is distributed among you. Simple formulas th at split profit proportional to each dentist’s production, or on the basis of percentage of ownership, are rarely workable. This formula is often more involved. Despite this, a partial sale remains a practical means of practice transition for longrange planning. POTHOLES TO AVOID
Benefiting from the experiences of others is an inexpensive way to learn. The following are some common traps th a t can easily be avoided. A. O vercom pensating an associate—Despite the penurious sounding assertion that associates are often overcompensated, such is often the case. If so, you will soon realize it, whether consciously or unconsciously, and the working relationship is doomed from that point onward. Moreover, an overcompensated associate sees less difference between their compensation as a non-owner and what they will realize as an owner. Ultimately, the incentive to purchase the practice will suffer. B. Selling the associate his or her own production—One of the most frequently cited
reasons for an associate not moving forward with an anticipated sale is th a t the market value includes a significant contribution on their part to the total gross income of the practice. They feel they are being asked to pay for a portion of the business they helped create. This is rarely an issue when associate contributions are small; however, when the associate has been in place two or more years, and is producing 25 percent or more of the practice gross income, this issue can destroy a working relationship. To avoid this, let the valuation process take the associate’s contribution into account so th a t they do not feel forced to pay for something they helped build. Ideally, a value should be established when the associate begins, and should be updated periodically. The value could be assessed without the associate’s contribution, or it could include a portion of the associate’s production based on patients being referred to the associate by the owner-dentist. The valuation is still useful when many years have passed before a sale but, as always, an ounce of prevention is worth a pound of cure. C. Income distribution formula failure—When two or more dentists jointly own the practice, a formula needs to be established so the distributable profits (after overhead) can be divided among them. A simple formula divides the profit on the basis of each dentist’s production as a percentage of the total. This method is not very accurate, however. First, the associate paid on a commission basis before the sale would have JADA, Vol. 124, March 1993
71
realized little extra by virtue of paying the purchase price for an interest in the practice. Second, the formula focuses on individual production instead of the practice as a whole. A successful income distribution formula will distribute a majority of the income based on productivity, but some income will be distributed based on their percentage of ownership. This ratio should be based on the financial structure of the individual practice. D. O verproduction of seller/associate—When the selling dentist remains as an associate, sufficient after-tax income m ust be available for the purchaser once the bills are paid. These bills include over head, debt service, the associate (seller) and personal income taxes. Generally speaking, practices producing less than $300,000 per year are not candidates for this type of sale. Further, you cannot hope to receive the equity in your practice while producing most of the income without providing the purchaser some extra ordinarily flexible financing terms. Usually, these types of sales work best if the seller is producing fifty percent or less of the gross income. The seller should also provide owner financing with an interest-only period ranging from six to 12 months following the date of sale, before reduction of the note begins. Tighter financial arrangements than this can set the purchaser up for financial disaster. E. Incom plete fore casting—The best way to test a proposed sale, whether
72
JADA, Vol. 124, March 1993
prototypical or extended, is to run a set of projections known as an after-tax cash flow or pro forma. A pro forma is a financial overview of what the purchaser can expect to earn after meeting all overhead costs, debt service, seller/associate (if applicable) Mr. Hill is president and estimated of Business and personal Professional Associates, a firm income taxes. specializing in the In other words, valuation and sale of professional can the practices throughout purchaser live the United States. comfortably on Address requests for reprints to Business the remaining and Professional income during Associates, 6200 Savoy, Suite 400, the period that Houston, Texas the purchase 77036. price is being paid? F. Pattern incon sisten cies—The criteria for selling and repurchasing must be consistent, especially for group practices where new dentists are being added and other dentists are leaving. Surprisingly, this is not always the case. The result is a set of conflicting circumstances. Often a group will let a new dentist buy in for an incredibly low price and then expect Full M arket Value for the pro rata share of a retiring dentist. This inconsistency will ultimately destroy a group practice. Therefore, group practices must adhere to a precedent to maintain the viability of the group. G. Too m uch owner financing—Any buyer should
have a personal interest in the purchase of the practice. Even when a partial interest in the practice is being bought, the purchaser should have some personal money at risk. Carefully constructed banking and financing packages can draw enough cash for the seller at closing so th at the purchaser is motivated to succeed. Also, contract language should specify that, in the event of a default by the purchaser, the seller’s covenant not to compete is no longer in effect, and th at the purchaser provides a reciprocal covenant of equal size and duration from the date of default. The seller is loaning money to the purchaser by virtue of owner financing. Before financing, the seller should require a personal financial statement, quarterly financial statements on the practice after the sale, and life insurance from the buyer. Finally, a word of advice— keep a clear perspective. Leaving active practice can be an emotionally intimidating experience. Change is difficult for all of us and, after years of conditioning, the prospect of life afterward may seem unsettling. The real change comes with a change in attitude. Retirement is a form of letting go, but with it, you can channel your time and energy toward new goals on the horizon. ■ The opinions expressed or implied are strictly those of the author and do not necessarily reflect the opinion or official policies of the American Dental Association.