Everything You Need to Know, In One Post
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Before Getting Started
Before we get too mired in the details of practice valuation, I want you to do something, real quick.
If you're considering selling your practice:
Off the top of your head, what do you feel your practice is worth? What do you think you deserve?
If you’re considering buying a practice:
Knowing what you know, what does you gut say the practice is worth? Not “how much can I afford,” but how much do you believe it is worth?
Keep those numbers handy as you read through this article.
In the process of researching medical practice valuation, you are likely to find that there are a number of “experts” out there who will tell you that they have a formula they use related to your income and expenses, and they may try to make the process opaque.
They’ll tell you that they have special certifications and patented methods that they would be happy to reveal and print up and put in a binder with your picture on it after you pay them a retainer.
But let’s get right to the truth of the matter.:
The true value of a practice is not the amount you think it is worth, nor the amount someone tells you it’s worth based on gross, net, multipliers and the like. Rather, it's how much someone is willing to pay.
Practice Valuation Methods
There are many methods to consider in fleshing out the value of your practice. Some of the most common include:
Using a Multiplier, or the "Rule of Thumb" Method
Years ago, I ran and later sold one of the first medical billing and practice management software companies. At the time of the sale, there was this idea that one could value a company at anywhere from 1.5 to 3x the gross annual revenue of the business. And that’s what we did. The "1.5-3x" is the multiplier.
The rule of thumb method of practice valuation is a simplified approach used to estimate the value of a professional practice or business. It involves applying a predetermined multiple to a financial metric, typically the practice's annual revenue or earnings. The specific multiple used depends on the industry, location, and other factors. For example, in the medical field, the rule of thumb might suggest using a multiple of 0.5 to 1.5 times the annual gross revenue. In other industries, such as accounting or legal practices, the multiple might range from 0.8 to 1.2 times the annual gross revenue or net earnings.
It's important to note that the rule of thumb method is a rough estimate and should be used cautiously. It does not take into account the unique characteristics, profitability, or growth potential of a specific practice. Therefore, it's generally considered a less accurate valuation method compared to more comprehensive approaches like the income approach, market approach, or asset-based approach. Ten or fifteen years ago, the “rule of thumb” was that the value of a practice was 1.5-2 x revenues. But, given large-scale changes in healthcare, medical billing, back-office costs, more physicians working in groups rather than solo practices, and a host of other causes, most practices tend to be sold for a price at or below their average annual revenues.
The Market Approach
The market approach involves comparing the practice being valued to similar practices that have recently been sold in the marketplace. By analyzing comparable transactions, the market approach provides insight into the fair market value of the practice.
This is a lot like the way a house is sold: You compare your practice to what other similar practices in your area and of a similar size have sold for. You find “comparables” (comps). The thing is, there is no generally recognized source of medical practice comps. The exception to this is where selling a building is concerned.
It's important to note that the market approach relies on the availability and reliability of relevant comparable transactions. If there are limited recent sales or the comparables are not truly similar to the subject practice, the accuracy of the valuation may be compromised. Additionally, the market approach should be used in conjunction with other valuation methods to ensure a comprehensive analysis of the practice's value.
When selling a practice along with (or without) ownership of the office itself, we have very specific ways of valuing each, together and separately, and we’d be happy to discuss these methods with you.
The Income Approach
The income approach focuses on the future income or cash flow potential of the practice to determine its value. This approach estimates the present value of the expected future earnings or cash flows generated by the practice.
Here's how the income approach generally works:
1. Determine the appropriate income stream: Identify the income stream that best represents the practice's earning potential. This could be net income, cash flow from operations, or owner's discretionary cash flow, depending on the nature of the practice and industry norms.
2. Project future income or cash flows: Forecast the expected future income or cash flows generated by the practice over a specific period. This typically involves analyzing historical financial data, market trends, industry outlook, and other relevant factors. The projection period is usually 3 to 5 years, although it can vary depending on the circumstances.
3. Consider the risk and growth factors: Assess the risk associated with the projected income or cash flows. Factors such as market conditions, competition, regulatory environment, and practice-specific risks are taken into account. Additionally, consider the growth potential of the practice and any expected changes in revenue or profitability over time.
4. Determine the discount rate: Apply a discount rate to the projected income or cash flows to account for the time value of money and risk. The discount rate reflects the expected rate of return an investor would require for investing in the practice, considering the level of risk involved. The discount rate is typically based on industry benchmarks, market rates of return, and the specific risk profile of the practice.
5. Calculate the present value: Apply the discount rate to each projected income or cash flow figure and sum up the present values to arrive at the present value of the expected future earnings or cash flows.
6. Consider terminal value: In addition to the projected income or cash flows, the income approach often incorporates a terminal value, which estimates the value of the practice at the end of the projection period. This is typically determined using a multiple or a perpetuity formula based on a sustainable growth rate.
By combining the present value of the projected income or cash flows with the terminal value, the income approach provides an estimate of the practice's overall value.
It's important to note that the income approach requires a comprehensive analysis of financial projections, industry dynamics, and risk factors.
Using a house as an example, if you owned a house worth $100,000, but it rented at $5,000/mo, the asset (the house) is worth more than its base value of $100,000 because it also generates $5,000 per month. The higher the income stream, the more valuable the house becomes, and future earning potential (which really is goodwill) becomes part of the equation for valuing it.
While this seems an obvious, positive approach, in reality, it usually doesn’t pencil out for medical practices, as the income from a practice is produced only at the time the practitioner performs the service, and is usually taken home as “profit” as soon as it’s paid. There is no additional, residual, passive income generation from most medical practices.
The Asset Approach
This is the tact we most often prefer to take. It allows asset classes (tangible, intangible, goodwill) to be clearly separated out and assessed, and it also helps in the final accounting come tax time, as buyer and seller can divide up what assets are taxed in the manner they choose.
More formally, this breaks down into the following subjects to consider in an evaluation of the practice’s selling price. How much are the following worth?
Tangible Assets
This is the stuff in the office. The furniture, fixtures, medical equipment. Even the decorations, books, chairs in the waiting room. Whatever objects and equipment the seller intends to let go as part of the sale. As a seller, you would quite literally go through the whole office(s) and itemize everything.
When I sold my practice, I was advised by my accountant to price each asset as if I would be selling it in a garage sale, not so much based on “what I thought it was worth.”)
The itemization of assets has a significant tax implications. See our post on the tax implications of the sale of a medical practice, and definitely talk to your CPA for more advice.
Revenue
How much does the practice bring in before expenses? For this number, most buyers will want to see consistency of both revenue and accounts receivable.
Revenue is the amount of money that a company actually receives during a specific period, including discounts and deductions for returned merchandise. It is the "top line" or "gross income" figure from which costs are subtracted to determine net income.
Investopedia.com Net Income
This is basically the business’s profit, the amount left over when you subtract expenses and operating costs from revenue.
Add-Backs
Of course, you will try to write off as much as possible to reduce your tax burden, so when we do a valuation, we look at your tax returns and profit and loss statements and "add back" items such as the owner's salary to him/herself, healthcare, travel, meals, auto expenses, etc., to come to a more accurate (and usually higher) valuation for the practice. In the end, we wind up with what we call an "adjusted profit and loss," which we use to determine a practice's net profit and goodwill. See more on this below, "How to Present Expenses."
How to Present Expenses
How you show expenses is a subject that gets a lot of attention. Assuming you are using some kind of finance software such as Quickbooks or somesuch, you should be able to generate a profit and loss / income vs. expense report. Better still if you can do this for the past several years. This way, a potential buyer can see the consistency of expenses and income.
The thing is, many of us have expenses that a buyer may not be inheriting, such as certain staff, equipment expenses, and stuff like continuing education that is put against the revenue for the purpose of reducing one’s tax burden.
What’s more, the numbers on one’s tax return may not match up with the profit and loss statement. And, while we expressly do not advocate this, there are some businesses that do not report cash payments from patients. This presents complications as, in the end...
A seller will want to show maximum net income (profit after expenses) and minimum expenses.
Thus, you may need to set up an Adjusted Profit and Loss statement for a potential buyer that shows expenses they would be inheriting, leaving out the expenses they would not need to keep in order to keep the business humming along.
Dealing with these kinds of complications is what our consulting arm specializes in. If you’re wondering how to rectify differences between your tax returns and profit and loss statements, give us a free call.
How To Calculate Goodwill
As one popular finance website puts it,
The value of a company’s brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary technology represent goodwill.
Investopedia.com To further clarify, I’d add to this definition:
The value of your website, phone number, and any other intellectual property such as parked web domains your practice owns. It also includes your business’s history, online reputation, and even its location.
Think about the goodwill of Nike. It’s been around for decades, has a reputation for its technology and functionality where athletic clothing is concerned, a huge number of trained employees around the world, and a logo that most people recognize without needing to even see the word “Nike.” This is all goodwill.
Now imagine that someone wants to create a new brand of athletic clothing to compete with Nike. They won’t just be competing on the quality of their clothing; the hardest part may be going up against the goodwill of Nike. And if they wanted to buy Nike, the whole company, the value of Nike’s goodwill would represent much more than their tangible assets—it would have to include the company’s goodwill.
Just as a lot of goodwill is a barrier to entry for competition, and an asset for a buyer to inherit, it can also be an impediment to a sale if valued too highly.
When Facebook first started getting popular, Yahoo, Viacom and others offered well over $1 billion for it long before it started to be a profitable company.
As we now know, those offers were turned down. At the time of this writing, Facebook is said to be worth half a trillion dollars. Too high a valuation for anyone to afford!
So while you may not be selling a practice that equates with the goodwill of a Nike or Facebook, you will need to be careful that you don’t price your goodwill (and practice) higher than the market could possibly bear.
Understanding Goodwill Is Tough
Given that goodwill is intangible (not a real thing you can objectively see or touch), it is often the part of the valuation equation that is most difficult to calculate. That said, with the sale of a medical practice, in the final analysis, it often accounts for the largest amount of the value of the business.
Goodwill only exists and is determined when a business and/or its stock is being considered for sale. Otherwise, it doesn’t really exist.
These days, our experience is that buyers are paying less for goodwill and basing most of the value of the practice on past numbers and the perception of being able to continue or increase profit.
We have also found that, the way to give a buyer the greatest confidence that they will be able to replicate the seller’s success (and retain its goodwill) is to put incentives in place to minimize attrition, as well as show that the practice can make even more through a few simple tweaks.
The “how to” of reducing attrition and maximizing and increasing potential future earnings for the buyer are subjects we love talking about, and we’d be happy to share some of our ideas with you.
You may also want to check out our articles on transitioning a medical practice from one owner to another for some examples of how to do it.
Other Factors In Your Valuation
The Economy
Regardless of how or how much you calculate your business to be worth, the state of the economy will impact your final price and how easy it is to sell. I don’t think I need to go into too much detail about why—quite obvious, this one.
Terms of the Deal
The terms of payment you are willing to agree to as a buyer or seller will certainly have an impact on the final price. While the dream is to have your asking price paid in cash upfront, the reality in most cases is that it will be partially or wholly financed.
The terms of the financing may help determine the price, as a motivated seller may agree to a discount in exchange for more cash at the time the sales contract is signed, or for a year or two of monthly payments instead of four or five years.
In the end, there are no rules, only agreements.
As a seller, paying in installments may also benefit you from a tax perspective. And as a buyer, interest on a loan may also be a write-off. More on taxes below...
Tax Considerations
The way you justify your price will usually break down into the asset classes listed above, and the IRS has different ways of handling each. The amounts allocated to tangible assets, goodwill, and even a non-compete can all significantly impact the amount left in your pocket when all is said and done.
(For more on the tax considerations of your sale, see our post on that here.)
For instance, in an asset sale, a buyer will usually want to max out on tangible assets they are buying as a percentage of the total value of a practice for tax reasons, whereas a seller will want to put more weight into goodwill. We talk more about this in a special post weighing the benefits of an asset sale versus an entity sale, here.
I won’t go into great detail on the reasons why here, as I am not a tax professional. So when you get serious, find a good one. (If you need help, let us know.)
Timing
The way a sale is timed can have a major impact on its valuation and final sale price.
We recently helped a woman sell her acupuncture practice for about 1/10 of our assessment of its value due to her personal situation. While the business had been doing well for several years, her husband had just been informed that he was being transferred to another location in 6 weeks. She and her family had to relocate in that time span, and thus needed to sell as quickly as possible for whatever she could get. She was thankful to find a buyer at all, given the circumstances.
In another case, a large and very profitable complementary medical practice in the Bay Area suddenly had to shudder its doors when its owner and lead practitioner took ill and died three weeks after his diagnosis. His wife has been left to pick up the pieces, selling off each part of the practice as she was able.
While the above stories are extremes, the bottom line is that, the longer you have to prepare your practice for sale without a hard deadline, the more likely you are to get close to your ideal asking price.
We are aware of many unique ways of preparing a practice for sale, and would be happy to help! You can also check out a post or two on it here.
The Dangers of Overpricing
Think about selling something simple, like a bike. I recently had one on Craigslist. I had bought it for about $800, and a year later, after not having ridden it much, I tried to sell it for $599. And then $450...
The Craigslist ad for my bike.
Craigslist shoppers can be a haughty bunch, and I was immediately assuaged by people telling me it was overpriced. So I had to keep lowering the price until someone would take if off my hands ($300, if you’re curious. Ouch.).
Of course, selling a medical practice is a much more complicated proposition, and there’s a lot more at stake.
There are many reasons why you want to be sure to figure out a value for your practice that will drive demand rather than sit there and stale out on the market.
Unlike an object on Craigslist, if a practice is overpriced, a seller will not necessarily be able to keep lowering the price until it sells.
Many professional appraisers like to compare themselves to appraisers of houses, so let’s use that as a more a propos example.
Much like a house, once you set your desired price, the marketing begins. Someone looking for a house like yours will see it when it gets listed, and their curiosity will extend only as far as their ability to afford it, and perhaps even more importantly, their feeling that it is worth the amount being asked for it.
Anyone who has bought a home knows that, when you see a home advertised that appears to be what you’re looking for, but has been on the market a long time and the price keeps going down… you’ll think something must be wrong with it.
It’s shopworn.
As a buyer, you’ll either stay away from it, or lowball the hell out of it on the assumption that, by now, the seller must be desperate to sell.
Don't let your practice become shopworn! Price it right the first time.
In Summary
At the beginning of this post, I asked that you pick a number quickly off the top of your head for what you feel the practice you are considering buying or selling is worth. Return to that number now that you have read this far.
How does that number look and feel now? Still seem reasonable? Has it changed at all in light of the information you have taken in?
In the end, there are many ways to determine the value of a medical practice, and however complicated the analyses may appear, they usually boil down to the most important things that any buyer will be considering:
A buyer wants to be sure that a practice has a steady income, is profitable, and has a great reputation.
Even more fundamentally: That in purchasing the practice, they will make money, and have the opportunity to continue to do so.
Price your practice in a way that it will lead to a sale, based on defensible assumptions. After all the work you’ve put into preparing your practice for sale, all the stress of talking to the relevant stakeholders, and planning your post-practice life, it could all be for naught if you stumble on this first, critical step.
Summary Outline
- There is no magic formula for practice valuation.
- The true value of a practice is the amount someone is willing to pay.
- We believe the Asset Valuation Method to be most appropriate for valuing a medical practice.
- Have a trusted accountant check your asset allocations before you sign a sales contract.
- The terms of your deal are a major negotiating point and can have a big impact on the final sales price of a practice.
- Be careful not to overprice your practice so it does not become shopworn.
Action Items for Sellers
- List and value your tangible and intangible assets.
- See if there have been any recent sales in your area with which you can compare prices.
- Figure out ways that a buyer could increase their revenue if they wished.
- Consider whether the sales price and terms would allow a buyer to make a living from the outset of the purchase.
- Find a trusted accountant to go over final terms and their tax consequences for you.
If you have questions about how to do this or want some assistance figuring out what a practice is worth, we’re here to help. Reach out and let us know where you’re at, and we’ll be happy to share our knowledge with you.
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