Good Buy ? ........or goodbye!

By John Whitney

In the past I have spoken often on the wisdom of acquiring a practice through purchase rather than going through the, "associate", route; or worse, starting from scratch. If you do a pro forma comparison you will quickly realize that purchasing rather than starting from scratch is a, very financially sound, way to acquire a practice.

Inherent within the most opportune offerings-for-sale, are certain characteristics.

1.   Usually a retiring doctor selling a practice is more desirable than a "young lion" who is simply re-locating
2.   Seller financing is available
3.   Seller financing at 10% interest or less
4.   Low down payment (10%) or no down payment
5.   Clearly supportable performance numbers (historicals)
6.   Use of a broker
7.   Buyer/Seller compatibility
8.   Professionaly trained staff who know the practice

Setting the value of a practice can be very tricky. Generally, the value of a business is viewed from opposite perspectives by buyer and seller. The seller wants a current market price for his fixtures, equipment, and leasehold/real estate. The seller also want compensation for his inventory, the name he has established, and all the time, sweat and tears that went into making his practice what it is today. And from his point of view, making a little profit along the way couldn't hurt either.

In terms of the buyer, she is looking for an investment that will prove profitable to her. Usually, she wants a practice that will provide her with a fair salary plus 20 to 30 percent return on her investment. For example, if a buyer invests $150,000, and takes a $30,000 salary to run the practice, that practice should be able to provide another $30,000 to $45,000 in annual earning power before taxes. Otherwise, why take the risk in the first place? To figure out the return on investment,(ROI) take the gross, minus all expenses, and divide by the down payment.


FINANCIAL STATEMENTS

Before you can place a cash value on a practice, you'll need to ook at a number of the seller's financial documents. The Profit & Loss Statement,(aka Income Statement) is the initial document you will want to analyze. It has little value except as an indicator. Why? If done professionally, the P&Ls should be a work of art, that for tax reasons show the business in the worst possible light. But you need not be concerned about whether the present owner is managing to charge personal telephone bills, car payments, and insurance against the business. Your interests are deeper than that. You are keenly interested in a few provable facts and some hard fixed costs.


1.   Monthly gross- try to obtain a minimum of three years data with as much detail as possible. This information is invaluable for future projections. In addition to checking data in the P&L, you may want to check tax reports and IRS/Revenue Canada statements. Be sure to cross check any single source against a second source to verify the validity of these numbers. As you are dealing with a service business in which no sales tax is collected, only the federal income tax statement will provide sufficient information.

2.   Overhead -generally regarded as fixed and variable expenses plus doctors salary. This can be based on comparison with national (ICA/ACA/CCA) averages or from the Hsaio Report: DC salary=50%, employee wages=16%, rent=11%, equipment and supplies=12%, malpractice cost=4%. This information will help determine an accurate profit margin for the practice in question. Sometimes owners will inflate the cost of overhead expenses by including a lot of personal expenses and services, to create a lower profit margin for tax purposes. Your first task is to, "normalize", the expense statement; i.e. remove all the sellers personal expenses from practice expenses. For this you will need his cooperation and candor.

3.   Rent- specifically, terms and conditions of the lease. You can also find this data in the lease agreement. Cross-check the lessee's numbers and agreements with those of the lessor.

4.   Salaries/Commissions- other than the owner's. Also check with the IRS/Revenue Canada. Every employer has to file tax information on all employees, whether permanent, part-time, or sub-contractors.

5.   Utilities/Insurance/Miscellaneous expenses- To verify, look through the company cheques/checks and year-end tax statements.

6.   Profitability- can be determined by subtracting the cost of goods from monthly gross services to arrive at a gross profit. Next, add together all the operating expenses (overhead), and then subtract those from the gross profit, and your result will be the net profitability of the practice. Be careful, however, we are dealing with sole proprietorships and partnerships. They do not actually produce a definable net profit. They produce an income for the owner. This may not be listed in the P&L. In order to determine profitability in these instances, you need to check the owner's total income from the practice. If the owner is serious about selling the practice, there should be no problem in the disclosure of this information.

For example, let's look at a practice whose estimated annual gross business is $200,000.

Gross Annual Services	$200,000
Cost of Goods	1,000
Gross Profit	199,000
Rent.	14,400
Salaries	65,000
Utilities, Insurance, Overhead	10,000
Owner Salary	40,000
Operating Costs	129,400
Less Debt (10% note a month. 3 yr.)	11,600
Total	$141,000
Net Profit	$ 58,000

Another financial document you will need to review is the Capitalization Schedule which provides an accurate accounting of all fixtures, equipment, real estate (if any) or leasehold improvements, and all other assets owned by the business. Because practice owners gear these documents for their own tax purposes, they may not provide a completely accurate picture of what the equipment is worth. You'll have to look beyond these documents to the real situation at hand.


TO VERIFY INCOME

Take one month at random from the appointment book and follow through with each entry. Did the patient arrive, what service was rendered, was it accounted for, what was paid (cash-cheque-credit card), what was outstanding, does the deposit slip(s) for the week match appointment book income? Many offices do not report all income, but "skim" the cashpayments. This, of course, is income tax evasion; but so common, the doctor may talk to you openly about it. If this is the case it is very difficult to evaluate the practice. The accounting will show one thing and the doctor's testimony indicates something different.


PROPERTY AND IMPROVEMENTS

Assessing the value of a business is usually accomplished byplacing a value on any property and equipment, then adding a cash value to that. If any property is involved, this price can be determined by adding the land value to the value of improvements made thereon. Land value is determined by a review of the tax-assessed value compared to what like-sized parcels in similar locations have sold for in the current market. All real estate mustbe evaluated separately from the practice.

Evaluating improvements is another matter entirely. One way to takecurrent build-out costs for the type of building, (typically $35- $50 per square foot) and multiply that price per square feet times the number of square feet. The more realistic approach, which would appeal to a banker, is to calculate everything as a function of cash flow. To illustrate: the amount of rent a seller could get by leasing this space out, minus expenses (taxes, insurance, repairs.)

Once the value of the land improvements has been determined, a broker must estimate the value of any leasehold improvements, fixtures, and equipment. Leasehold improvements refers to those things attached to the building that are not easily removed, such as partitions, toilet facilities, special electrical wiring, and he like. Fixtures are carpeting, shelving, special lighting, counters, and so on. Equipment refers to any freestanding objects necessary to conduct your practice. Normally, a broker will give them a value that is below their replacement value but above their resale value.

Normally, a seller will want to add to that figure the broker's fee and a few thousand dollars more for negotiating room. This then will be the asking price.


RETURN ON INVESTMENT

The most common means of judging any practice is by its return on investment. Return on investment is not necessarily the same as profit where buying a practice is concerned. The first factor in determining ROI has to do with the money the buyer puts into the enterprise, and the second has to do with the performance of the existing practice.

For example let's say a practice is valued at $100,000 and requires a $40,000 down payment. If that practice makes $20,000 a year, (over and above the doctors, reasonable, salary) the return of investment is 50 percent.

Typically, a practice should return anywhere from 30 to 50 percent on investment. This is the average net in after-tax dollars. Depreciation, (Capital Cost Allowance), which is a device of tax planning and cash flow, should not be counted in the net because it should be set aside to replace equipment.


CAPITALIZED EARNINGS

Valuing a practice based on capitalized earnings is the reverse of the return-on-investment method of assessment. Certain practices won't show any value at all even though they are showing a profit; or they have very little value relative to the profit they make. In this regard, if you use this method of valuing a practice you should have some idea of capitalization rates, or you may be in trouble.


PROJECTED EARNINGS

Another frequently practiced way to valuate a business, particularly large-size practices, involves pricing the practice based on what it will make in the future. Generally, this method is used for practices that are growing. For this method, the ultimate price is contingent on its reaching that profit level. Most brokers do not base a practice price solely on its projected earnings.


INTANGIBLE VALUE

Looking at the value of intangibles is essential when valuating a practice. Some intangibles will be seen as assets while others will be negative factors affecting the price of the business. Factors such as willingness to train, ease of operation, excellent location, consistent profits, time length in business, terms of loan, owner financing, reputation of doctor, number of times practice sold, quality of staff, business practices (cash), transition time allowed (minimum of two months), transition protocol, and willingness to introduce to all valued contacts.


GOODWILL

Essentially goodwill is the difference between the asking price and the sum of all tangible and intangibles being purchased. Occasionally I hear people say that the idea of goodwill is nonsense. And that all one is purchasing is "a bunch of files"; further, one cannot sell/buy patients, blah, blah, blah. If you are using an advisor who holds such an opinion, you've chosen unwisely (just another example of well-meaning people who don't know what they are talking about)

Goodwill is usually the largest component of the price of a practice; it has to do with the practices reputation (and numbers). Goodwill is indeed worth something and it should be considered an asset. here is a potential problem about listing it as an asset, however. It has to do with taxes (like everything else in your life). The tax man may treat "goodwill" differently for a buyer as opposed to a seller (not in the US however) when it comes to taxes, - herein lies a possible problem.

In an effort to deal with this problem you may notice some brokers do not even list goodwill amongst the practice assets. Instead they put a very heavy price on the "covenant not to compete' clause instead,- and don't even deal with goodwill. The selling price does not change but the allocations of value do (and so may the tax implications).

How does one evaluate goodwill? Here are three highly controversial ways of making good-will evaluations:


1.   Total office visits (last 12 months) X $3.00 e.g.   30 X 17 days/Mo. X 12 X 3 = $15,300

2.   Last year's net income divided by 4 + 50% e.g.   42,000/4 = $10,500 + 5,250 = 15,750

3.   Last year's gross income divided by 4 + 1 0% e.g.   42,000 / 4 = $10,500 + 1 0% = 14,700


Please do not believe for a minute that this is gospel. These are simply arbitrary ways of trying to come to a fair price. Many accountants will laugh at these simple formulae, but they are a rough ballpark figures, and will likely be very close to what an accountants convoluted figures produce. Existentially, a practice will sell for exactly whatever a seller is willing to pay. That is only fair, and is the basis of our entire economy.

There are several subtle factors that must come to bear on "good will". For instance how good is it? Consider the length of time in practice, how many times has the practice been sold in the last 5- 6 years, is the lease a good one, location the best, doctor's reputation in the community, is the site aesthetically pleasing, socioeconomic level of practice and its geography, is this deal between people of the same general nature, gender, personality. These questions and more have bearing on good-will.


BROKERS

Brokers are matchmakers, they provide the expertise to make a deal work, make suggestions, dig out the complete truth, make suggestions for creative financing and act as a buffer to buyer and seller. The fact is that if the deal is being brokered it has an excellent chance of being consummated and buyer and seller walking away happy. However in the deals where buyer and seller try to do it themselves, 70% fail to consummate. That should tell you something. It's like trying to sell your own house. It is possible but.........perilous.

The cost of the broker is, most often, born in the form of a 10% commission, by the seller. More and more deals however are being brokered that contain the provision of "equal representation". Equal representation means the buyer and the seller both pay part of the broker's fee. That is not unfair. Both parties are benefiting from the broker's service; it is not unfair for both to pay for the service (it is a little unusual, however, that's changing.)

The bottom line? Get a good broker/consultant and work closely with them. Pay them their fee, and realize the time and aggravation saved - possibly the whole deal - is well worth the cost.


COMPATIBILITY

It should go without saying , but requires reinforcement, compatibility of techniques, philosophy, gender, sexual orientation, and personality are vital to make a deal work. For instance it is almost impossible for a male to buy and successfully take over a female D.C.'s practice. In addition, a suitable "transition protocol" should be engineered to correctly introduce a buyer to the sellers practice and patients. This is a retention strategy. If properly designed and executed, a retention strategy will ensure a high retention rate of those patients that are purchased as a part of the "goodwill".

In any case, the buyer should be prepared to emulate the seller in every conceivable way; at least for the first several months. The whole idea is not to traumatize the practice by anything new or different. The transition will be optimum if it is seamless, and shows no signs of anything different than what the patients have come to know and expect. This is the tough part for the buyer. Unfortunately it is common for the buyer to be convinced that what they think, act and do is a direct message from Universal Intelligence. They can hardly contain themselves from thrusting their wonderfulness onto this practice and the unsuspecting patients. It is common for the incoming doctor to want to change everything from the technique to the decor as fast as the seller can get out of the door. This is a shining example of a new graduates hubris; in reality this misguided force is nothing more than a hungry ego seeking expression. Friends, this behavior ain't rational . Stifle it. (Check the next section,"Transitional Protocol", to help you avoid this, all-too-human, pitfall.


WELL TRAINED STAFF

Not enough can be said about the value of a professionally trained staff who really understand the practice. I have seen it so often; the new graduate is really a babe in the woods, and the staff carries him/her for the first several months. Without a strong staff the practice would often collapse due to the relative inexperience and false expectations of most new graduates. This is a neglected area when doing practice valuations. The staff can, and often does, make or break the new graduate buyer. You have been warned.

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