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What should I pay when buying or buying into a practice?
Considering six value segments can help the buyer and seller arrive at an approximate price.
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“Anything that just costs money is cheap.”
– John Steinbeck
“For just over my price range, I can get something way under my quality expectation level.”
– Jarod Kintz
“Look beneath the surface; let not the several quality of a thing nor its worth escape thee.”
– Marcus Aurelius
It is a fluid time in Eye Care Land. The leading edge of baby boomer-aged doctors is heading for the door. Hospitals and emerging corporate outfits are back in the market buying practices, having gone dark since the ’90s. And practices are merging or otherwise consolidating at the fastest clip I have observed in 20 years.
As might be expected at a time like this, practice values are in flux and being pressed simultaneously both downward and upward, depending on the setting and circumstance.
- Valuations, and especially goodwill component values, are generally depressed by two key factors: the current uncertain health care business environment and the fast-rising ratio between available partner-track jobs and partner-worthy providers.
- But practice values in selected settings are holding and even rising, particularly in urban markets where an excess number of providers, and the concomitant competition for managed care contracts, is creating a mild seller’s market.
Hard to pinpoint a value
So what’s “the number” if you are buying or selling a practice today? Frustratingly, it depends. This is not an environment like residential property valuation, where every house on the market has scores of potential buyers and can be benchmarked against abundant neighborhood “comps.” Nor is this like buying or selling a car, with a finite universe of models and years, dealers where you can do a little comparison shopping and an online Kelley Blue Book to reference.
Instead, the practice you are buying or selling has only a very narrow market of potential dealmakers and little or nothing in the way of local brokerage support. And for every five practice appraisers, there can be 10 different value opinions because each appraiser’s report boils down to, “On the one hand, the value of the subject practice is $X, but on the other hand, the value is $Y.”
There are numerous conventions for valuing medical practices, which have been derived from the general business universe. The problem is that tens of thousands of retail stores and dry cleaning shops transfer hands every year, while there are only about 7,000 or so private ophthalmology practices and mere hundreds of deals written a year, only a few of which are memorialized in the public domain. Most transactions are archived only by the advisers on each side of the deal, and we keep our cards pretty close.
Because there is so much hand-waving about value (and to be sure, fist-pounding, too), I will endeavor here to boil practice valuation to a loose, simple rule of thumb. Realize that in what follows there is a lot of “Kentucky windage.” But this summary will provide you with a first approximation of practice value, allowing you to see if you and the party you are negotiating with are close enough to take the next step of hiring a professional to work out the fine points of the transaction.
The basics
- First, consider that, simplistically, every practice is a composite of just six value segments:
- Capital equipment, facility build-outs and related tangibles
- Inventory (medical supplies, drugs, frames, contact lenses on hand)
- Accounts receivable
- Working bank accounts
- The goodwill or “intangible” value
- Offsetting liabilities (debt, trade payables, tax liabilities)
- If we derive a value for each of these segments and add them up, the whole is roughly worth the sum of the parts. Simplistically, adding up A through E and subtracting F derives a ballpark answer.
- Only rarely are there buyer-seller disputes regarding practice tangibles. There are two common ways to ascertain their value. One approach is to hire an on-site or off-site appraiser who is familiar with the market value of used ophthalmic equipment. For the typical two-doctor practice with six or eight exam rooms, it can cost about $3,000 to $5,000 to fly in an appraiser, or about half this or less to have the job done from off-site. The other approach is to apply the convention of depreciating the value of all equipment on a straight-line 10-year basis for 8 years, leaving a residual 20% value, even 10 years or 15 years post-purchase for older equipment. For example, a desk or instrument purchased 6 years ago for $1,000 would be valued at $400 today and $200 in another 2 or 3 years (20% is the floor value). This approximating method tends to overvalue furnishings and computers and undervalue ophthalmic instrumentation, but the resulting total figure, which costs much less to derive than hiring an appraiser, commonly comes very close to the figure determined by a formal paid opinion.
- Goods sold, such as frames and contacts, and medical supplies and drugs, within expiration date, are simple to value: Just look up their cost on the relevant invoices.
- Accounts receivable are readily valued at their recoverable amount based on the consensus of the billing staff and the practice accountant. Determining this figure may vary from one practice to the next. In a practice that stays on top of billing and carries very few open accounts beyond 90 days, simply multiply the still-fresh receivables by the practice’s historic gross collection ratio (ie, the percent of gross charges that the practice has been collecting over the past year or two).
- Cash on hand in the practice’s working bank accounts is obviously added in at face value.
- Goodwill is, of course, the most common sticking point in practice purchase transactions. In about a third or less of current buy-in and buy-out transactions, there is little or no goodwill. It is reasonable to discount or eliminate goodwill in several circumstances: when practice performance is waning sharply or profit margins are chronically low, and in less-popular rural markets, where it may take years to find a buyer at any price. The majority of the time, when goodwill is charged, it ends up at ±50% of annual practice profits (defined here as the cash-basis profit available for total MD compensation).
- An accountant reviewing your transaction can readily comb through the balance sheet, ask a few questions and true up real vs. phantom liabilities. Any real liabilities to be assumed by the buyer are obviously an offset, reducing the practice’s fair market value.
All of the above does not address two supplemental value components: any associated real estate or an ambulatory surgery center. If a practice building or office condo is part of the deal, this unit can be readily appraised by one or more local appraisers.
The nuances of ASC valuation are beyond the scope of this month’s column, but the general convention is to value an ophthalmic ASC that is being conveyed from one surgeon to another at between two times and four times annual earnings before factoring in the costs of interest or tax payments or any depreciation or amortization (otherwise commonly referred to as EBITDA).
As the old man used to say, “It’s not the price, it’s the terms that count.” So even after you and the party you are negotiating with have decided on something close to an approximately fair price, the next round of horse trading will include things such as financing terms, the seller’s post-transaction role and a fair apportionment of tax liabilities.