Among the top 3 questions that always come up when you purchase a practice, one of them is “how much?” Clearly, the price of a practice is often a major, if not the, determining factor in whether or not to ink the purchase contract.
A lot of variables go into the determination of a purchase price, but here, we’ll boil it down to its simple essence. We’ll also give you some rules of thumb for making a good practice purchase so that when you close, the practice is producing income for you right away – unless you’ve bought a fixer upper.
Before getting into any part of the purchase process, please understand this: the starting point for you in negotiating a purchase price is NOT the seller’s asking price. Rather, your starting point is your own independent evaluation and computation of price. If the asking price for a practice is $500,000, and your independent assessment is that the practice is worth $300,000, you should have no problem passing and looking for other opportunities. On the other hand, if the asking price is $500,000 and you value it at $750,000, we have a winner.
Let’s break down the process of determining the value for a practice:
The starting point
A lot of conventional wisdom advises to set a purchase price equal to the last 12 months of collections or some function of the last 12 months of collections. And that may be very useful and effective. For me, the true value of any practice is how much income it will generate for the new owner. Based on this thought pattern, the purchase price should be a function of expected operating income.
Under this way of thinking, a practice generating $1 million of revenue with a $200,000 annual loss would be essentially worthless. On the other hand, a practice generating $300,000 of revenue with a $150,000 profit would have substantial value. But even when a practice is losing money, that practice should still have value, right? Yes it should. Please read on.
From my experience, that multiple typically should range between 3 and 6 times operating profit (profit before debt service and payment to the owner). So, if a practice generates $100,000 of annual profit, the purchase price would be $300,000 - $600,000.
We’ve introduced a couple of nebulous concepts here: expected operating income and the multiple of that operating income. Let’s examine each of them more closely to bring some visibility.
Expected operating income
To determine expected operating income, start with the operating income from the financial statement procured from your due diligence work. From there, you want to make adjustments for what you expect income to look like when you are the owner. Let me give you some examples. Let’s say that you see that a practice has a contract with a software provider with a fee of $30,000 per year for ongoing service and maintenance. But you know that you are going to get rid of that software system and put your own in place at a cost of $5,000 per year. You can add $25,000 to potential operating income in your assessment. If you plan to reduce staff upon completing the acquisition, add those cost savings to your potential bottom line.
Things work in the other direction too. Let me give you one example from an acquisition we did in California. The due diligence revealed that the practice had an operating profit percentage of 80%. You never see a practice with an 80% profit margin. This practice had the doctor’s wife and daughter as the office manager and clinical supervisor, respectively. Neither took a salary paid by the practice. The doctor owned his office building so there was no rent due. The purchasing doctor could not expect free service from the office manager and clinical supervisor. Nor should he expect free rent. The expectations had to be adjusted downward.
Taking a look at our example of a $1 million revenue/$200,000 loss practice, we can see how this would come into play. Perhaps the office is losing money because of overstaffing or poor scheduling or some bad supply contracts. You need to determine if you can fix those things to generate a profit for the practice. If you cannot find a way to make the appropriate adjustments, move on. If you can, compute your expected value based on that recomputed profit.
Just to be conservative, I do not adjust revenue upward when coming up with expected profit. You may elect to do so if conditions merit.
Multiple of expected operating income
Earlier, we gave you a fairly wide range of 3 to 6 times expected operating profit. How do you narrow this range down to get more directly to a number? Here’s there’s a bit more art than science. The multiple you are willing to offer depends on how you expect the practice to perform in the future. Like a publicly traded company’s stock price, the multiple of profit in the purchases is a reflection of expected profit growth.
Consider a common situation: a retiring doctor is looking to sell his or her practice. That doctor may have had his practice in a steady state for a number of years or declining as a new purchaser was sought and the operations simply slow. The practice is not in a high demand area and will need some maintenance. In that case, you would assign a lower multiple, say 3 times. Now, let’s say you have a situation where the potential office is in a high traffic area, looks great, has been growing and a Target is being built 2 doors down from this office. The selling doctor is simply selling because he or she is moving to another area of the country. Growth potential is very high here and so the practice would merit a multiple of 6.
The answer usually falls somewhere in between. A lot of it depends on your assessment for the potential growth in the practice.
Make your adjustments
Remember the adjustments we talked about a while back. You may need to remodel the office or replace a major piece of equipment. Make sure you adjust your valuation downward for that.
Don’t forget the tax considerations
As we discussed earlier, tax implications can be significant. A practice may have more or less value because of the tax impact of doing that deal. That depends substantially on your personal financial situation, your tax advisor and the structure of the deal. If you can get some serious tax benefit from doing a deal, you may want to adjust your valuation accordingly.
Compare your independent valuation to the asking price
At this point, you can compare your valuation to the asking price to determine whether or not the purchase is worthwhile. I will not attempt to describe myself as a negotiator by any means, but if you come up with a valuation of $750,000 based on the criteria above and the asking price is $600,000, you should not going in with an offer of $725,000. Come down to something around the asking price and enjoy the opportunity to generate income from that practice. If the numbers are reversed, you’ll need to decide whether or not it makes sense to negotiate downward to your value or simply look for a new deal.
As always, we stand ready to assist you in this process. We’d be more than happy to make our assessment of value and expected profit for you at no charge. Just contact us.
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