Valuing Specialty and Emergency Practices INTERNATIONAL VETERINARY EMERGENCY AND CRITICAL CARE SYMPOSIUM 2010 Lorraine Monheiser List, CPA, CVA Summit Veterinary Advisors, Littleton, CO, USA 2010 Used by permission of the author 20446141 Valuation of veterinary practices is an art, not a science, and reasonable values depend on extensive training, thoughtful analysis, and sound judgment. Rules of thumb (good or bad) have existed for years, and veterinarians who have bought and sold practices have developed a sense (right or wrong) of how buyers and sellers look at these transactions. There have been articles in various veterinary publications for well over twenty years suggesting various methods of evaluating small animal practices. In addition, there is an increasing number of sources for practice benchmarks for wellness practices, i.e., there are guidelines for what is "normal" in terms of operating results, staff levels, compensation, etc. Compared to wellness practices, however, specialty and emergency practices are a fairly new breed. While there have been some specialty practices in existence for many years, new ones are popping up everywhere. More and more specialty practices are taking existing associates into ownership and adding new specialties by offering ownership to outside specialists. At the same time, multi-owner practices are being sold to a single buyer, and single owners are selling to multiple specialists. Emergency practices were frequently started by groups of general practitioners who were looking for quality emergency care for their clients as well as quality of life themselves in not having to take those calls personally. Now many of those owners are retiring and looking to get out of practice ownership. As a result, the demand for specialty and emergency practice appraisals is growing, but many appraisers still have limited experience in this area. Some shy away from these valuations because there are so little market data available and such limited history about ownership transitions in these practices. In short, we lack the safety net which comes from experience with many transactions and reliable statistics to set reasonable parameters. In its simplest terms, valuation is an estimate of the cash price that a willing and knowledgeable buyer would pay a willing and knowledgeable seller in order to own a particular practice. But how is that determined? VA LUA TION THEORY IN GENERA L There are three possible approaches to business valuation: The Market Approach When determining the value of a practice, it would be extremely helpful to know what the marketplace has determined as the value of other comparable practices. Only limited transactional data are available through certain databases since most sales are private and data concerning those sales are not readily available to the general public. Therefore, finding comparables for veterinary practices is extremely difficult, especially for specialty practices. Until there are enough public data available to make meaningful comparisons, particularly for emergency/specialty practices, appraisers cannot generally use a market approach to practice valuation. The Asset Approach Some types of businesses are sold on the basis of the value of their assets. For example, a business which consisted solely of marketable securities could be valued by determining the current value of each asset and then summing those figures. Similarly, if a company were being liquidated, then its value would be based on the price the tangible assets (such www.vin.com/members/proceedings/proceedings.plx?cid=iveccs2010&category=&pid=56892&o=vin 1/5
as equipment and inventory) would command on the open market, but no value would be placed on either business' intangible assets (like goodwill). Because goodwill is not included, the asset approach is generally not a good choice for valuing an on-going practice, since the value of the practice lies in its ability to use its assets to generate profits. In most veterinary practices, the single largest asset is goodwill, and the calculation of the value of that goodwill must be done using some other methodology. The Income Approach The third approach used in valuing businesses is based on net income and values a practice by using the stream of income it is likely to produce in the future, determined in part on the basis of historical results. Generally, this adjusted net income, or benefit stream, is then capitalized (divided by a rate which represents risk and the expected return on investment) in order to produce the value of the company overall. This benefit stream represents the return on investment of both the tangible and intangible assets, and no attempt is made to determine what part of the net income relates to which kind of assets. Stated differently, the benefit stream is the result of operations using the practice's actual pool of assets, which consists of cash, inventory, equipment, staff, facility and goodwill. This method is more theoretically sound in valuing a veterinary practice (if based on true economic profits) where the purchaser's intent is to provide for a return on investment over and above a reasonable amount of compensation, and future benefit streams or earnings are likely to be fairly even. (Sometimes appraisers use a different income approach called the discounted future earnings method, especially when there is little history and earnings are expected to fluctuate or have uneven growth rates in the future. An in-depth discussion of that method is beyond the scope of this seminar.) In its simplest terms, the capitalized income approach is as follows: Adjusted Annual Profits A Capitalization Rate To maximize value, the most important part of this calculation, and the part you can control, is Adjusted Annual Profits. Practices with higher profitability will have higher values. Stated differently, buyers will pay the most for practices with steady growth in gross revenue and consistent, above average profitability (generally greater than 13% of gross revenue, after all expenses, including reasonable owner(s)' compensation). That's not to suggest that you should sacrifice good medicine or great client service in generating those profits, but that you should operate your practice efficiently, set your fees appropriately, and monitor the practice's financial results regularly. WHA T'S UNIQUE ABOUT SPECIA LTY A ND EMERGENCY PRA CTICE VA LUA TIONS? 1. There is a smaller pool of potential practices and buyers. These practices are struggling to find qualified specialists to hire, let alone specialists who want to be owners. No practice owner wants to promise ownership to an associate he or she has never worked with, and so there must be at least a trial period while everyone gets comfortable with each other. Also, there are many associates who simply don't aspire to practice ownership. They are content to be well-paid doctors who steer clear of the responsibilities and perceived headaches associated with ownership. To further complicate the issue, many specialty centers deliberately concentrate ownership and control among one or only a few owners, regardless of the number of specialties and specialists. They shy away from management by committee, and so they are very hesitant to take in more owners. That makes it more difficult for specialists interested in ownership to buy into existing practices. 2. In most cases, specialty practice clients come from referrals from other veterinarians, not from the general public. Emergency practices are dependent on referrals as well, but they also have walk-in clients. For both kinds of practices, however, the relationship between referring veterinarians and the practice is critical. It can take years to build the quantity and quality of referral relationships which will provide a steadily growing caseload. But once a referral relationship is damaged, it is extremely difficult to rebuild it. How does an outside appraiser assess the quality of those relationships and the impact on the value of goodwill? If the current owner(s) are leaving the practice, what are the chances that the referral www.vin.com/members/proceedings/proceedings.plx?cid=iveccs2010&category=&pid=56892&o=vin 2/5
relationships will continue as in the past? 3. A specialty associate who builds strong referral relationships and then leaves a practice represents a major threat to the former employer, since specialists draw clients from a much wider area than general practices. If the associate has no noncompete with the former employer (either through owner oversight or because state law prohibits such agreements), then the specialty center is very vulnerable to turnover among its doctors. What's the practice's goodwill worth in that situation? 4. In the struggle to attract and retain good doctors, many practices end up overpaying associates, i.e., paying them too high a percentage of the revenue they are actually producing. While associate production in a specialty practice is higher than in a general practice, there is still a limit to what the business can afford to pay. A specialist can produce more revenue than a generalist in absolute dollars, so these associates are automatically going to earn more than a generalist, even if the percent of production being paid is the same. Yet specialists and ER doctors are demanding higher and higher compensation. But how much higher a percentage can the practice afford to pay? If you've shopped lately for the kind of equipment and facility that these practices must have to be competitive, you know that the costs are higher than in wellness practices. 5. In a perfect world, we would have reliable statistics that would tell us what percent of production is "normal" to pay an internal medicine specialist versus a dermatologist versus a surgeon or an ER doctor. But we don't yet have those statistics. Several organizations and associations are trying to collect them, but most are anecdotal and do not summarize data which are similar enough to make the resulting comparisons reliable. If the rate of pay in a particular specialty appears to range from 23% to 35% of production, for example, what's "normal"? And even if a practice appears to be overpaying its doctors, can the appraiser lower that pay hypothetically to increase profits (and practice value)? Why would a buyer be willing to assume that these same associates would work for less money under new ownership or that replacements would be content with less pay? 6. If a specialty or ER center overpays its associates and that, along with higher equipment and overhead costs, impairs profits, why would an associate even want to become an owner? In some practices the bulk of the profits are already going out to owners and associates in the form of compensation, so getting a piece of the profits isn't much incentive to take on the risks and responsibilities of ownership. Lower profits result in lower goodwill and total practice values, so what's a practice really worth? Some associates would have to take a cut in pay (at least in their guaranteed base) in order to become owners. Would they be willing to do that at the same time they are taking on significant additional debt to buy in? 7. Veterinary practice valuations always require the appraiser to assess whether the practice's goodwill relates to the owner(s) as individuals or to the practice overall. In one-doctor practices, the goodwill largely rests with the owner, but as those practices grow and add associates, the goodwill shifts more toward the practice itself. The same issue exists with specialty and emergency practices, but because of the strong relationship between the specialist and referring veterinarians, it is harder to transfer goodwill away from the doctor and to the practice. If goodwill can't be transferred, intuitively it has less value to a buyer. 8. Capitalization rates used in valuing veterinary practices are reflections of risk. The higher the risk that a buyer might perceive, the higher the capitalization rate, and the lower the practice value. Theoretically, should a specialty practice be viewed as more or less risky than a general practice? One could argue that the risk is lower since the fees are higher (and hopefully so are the profits), but the counterpoint is that the stakes are higher too and, therefore, so is the risk. It takes more capital up front to open a specialty practice, and specialty and ER practices are vulnerable to associates who leave or go to other practices opening nearby. WHA T ISSUES CA USE THE MOST PROBLEMS IN SPECIA LTY A ND EMERGENCY PRA CTICE VA LUA TIONS? 1. Poor record keeping. If the appraiser can't understand your historical financial statements because expenses move from one category to another from year to year, or unrelated expenses are combined into accounts with misleading titles, or you can't provide an accurate listing of equipment or inventory, then the valuator can't easily determine what adjusted earnings actually are. Similarly, if you take some "aggressive" perks out of the practice (such as having the practice pay the utilities and repairs on your home), then your practice is going to look less profitable www.vin.com/members/proceedings/proceedings.plx?cid=iveccs2010&category=&pid=56892&o=vin 3/5
on paper than one whose owner pays those expenses personally. That approach might have saved you taxes in the past (though likely only because your return didn't get examined by the IRS), but now you need to be able to identify those personal expenses and convince the appraiser and a potential buyer that those funds will be available to the buyer in the future. If you bury them deep enough in your financial records, even you won't be able to find them. 2. As discussed in previous sessions, there is no one model for how these practices are set up. Each practice structure is unique, even if there are some broad general categories. There may be several legal entities involved in the operations. Some of these structures are very complicated, requiring the appraiser to determine the relationship between the management company (if there is one) and the practice, how equipment acquisition and maintenance costs are shared among the various specialties, if at all, and how the specialists share common expenses, like rent and front desk staff costs. Valuing a specialty practice, therefore, takes more analysis. Otherwise, it is likely the appraiser will miss key elements that impact value. 3. Because there have been many new specialty and emergency practices created in the last few years, there may not be enough history in a particular practice to use traditional valuation methods. Most appraisers use 3 5 years of historical data, but what happens if the practice has only existed for 22 months? Less than two years of operations hardly sets a trend, so determining what annual profits or cash flow a buyer could expect is decidedly difficult. 4. Without much practice history, appraisers likely will use a different valuation method, such as discounted future earnings. In this method, the appraiser uses projections of operations in the next few years as the basis for determining the buyer's expected earnings, without being able to tie those to past history. This method works well for large businesses that have routinely been preparing budgets and can demonstrate how well their projections in the past have equated to what really happened. For veterinary practices, however, including specialty practices, the existence of such a budget, let alone historical comparisons of budgeted to actual results, is exceedingly rare. Therefore, an appraiser must get comfortable with the owner(s)' projections of future revenue and expenses; alternatively, the appraiser must develop those, or have the practice's CPA develop them, as part of the valuation. That makes everyone very uncomfortable since they are no better at reading a crystal ball than you are. 5. At least in our experience, specialty and emergency practices are not necessarily more profitable than general practices, even though their gross revenue is significantly higher, their production per doctor is generally higher, and their average transaction charge is almost always higher. (Fortunately, there are some notable examples of high quality, high profit practices out there - let's hope yours is one of those!) Since higher profits lead to higher practice values, specialty and emergency practices do not necessarily appraise as highly as their owners might expect. That leads some appraisers to explore various ways to improve profitability on paper, by adjusting associate compensation, reducing expected facility expenses, adjusting owner compensation, etc. to something that results in higher profits. Such adjustments may be appropriate and reasonable in a given situation, but the true test is whether or not those adjustments are likely to happen in real life. As a buyer, you may hope you can reduce facility costs or staff benefits, for example, but will those changes adversely impact the practice's ability to serve clients, retain staff, and produce revenue? 6. As suggested previously, the lack of reliable benchmarks among specialty practices continues to be a major issue. Practice appraisers must rely heavily on their personal experience and their judgment to determine what's reasonable in a specialty practice. That suggests that if either their experience is limited or their judgment relies too heavily on what's normal in a wellness practice, the results of the valuation may be flawed. 7. Valuation methods such as the excess earnings method, for example, which rely heavily on the value of equipment and other tangible assets may overvalue the practice by ascribing too much value to these assets. Unfortunately, some practices over-invest in expensive equipment, but have neither the staff nor the clientele to use that equipment productively. If you have looked at the cost of MRIs, for example, have you also projected the number of transactions needed to support the purchase and recover the cost? If practices buy equipment but then under-utilize it, its cost isn't adding to the bottom line profits. Purchasers of practices are buying the www.vin.com/members/proceedings/proceedings.plx?cid=iveccs2010&category=&pid=56892&o=vin 4/5
cash flow that these assets produce, not just the equipment itself. They are looking to see what return they can get on their investment. What return are you getting on your investment in equipment now? Would that be sufficient to attract a buyer? 8. Emergency practices located in specialty centers often handle overnight and weekend care for patients of other specialties within the hospital. How is revenue split between the department that took in the case and the emergency practice? Some emergency practices appear to have low revenue on paper because fees for some of the care they provide are allocated to the other practice, even though the emergency practice is doing the work. References References are available upon request. SPEA KER INFORMA TION (click the speaker's name to view other papers and abstracts submitted by this speaker) Lorraine Monheiser List, CPA, CVA Summit Veterinary Advisors Littleton, CO, USA URL: http://www.vin.com/doc/?id=4610412 www.vin.com/members/proceedings/proceedings.plx?cid=iveccs2010&category=&pid=56892&o=vin 5/5