Determining the worth of a practice depends on many factors. Every meaningful measurement of value must be considered. Every meaningful practice is unique. A practice, though legally defined as a business, is a personal service rendered by an individual. Since the owner is the key producer, absentee management does not work. The recent decline of retail dental chains is a prime example. This uniqueness is why many valuation methods do not accurately apply. The simple rule of thumb, where value equals a percentage of gross, just doesn’t work. To illustrate the pitfalls of this approach, let us consider two dental practices, both grossing $200,000 annually. As a rule of thumb, an example of 75 per cent of gross billings would place a value of $150,000 on each practice when, in actual fact, one could be worth $50,000 and the other $250,000, which is five times as much.
Practice “A” is located in a remote, underserviced area, with lower than average demographic statistics; low fees, poor location, a short premise lease, older equipment, minimum leasehold improvements and lower earnings. Practice “B” is located in a popular urban area, with a good location, a long-term premise lease, a first-class facility, attractive leasehold improvements, state-of-the-art equipment and good earnings. Common sense would indicate that Practice “B” will bring a much higher value.
The key to placing a professional opinion of value is through the comparisons to actual sales. Some of the factors that must be considered include fees charged, insurance coverage, assignment, competition, types of services rendered, net income, expenses, and personnel. For example, many dentists believe that a practice which is heavily booked, in an area which is underserviced, is worth more money. This is not so. In fact, it is the reverse. The value of a practice is actually reduced if the area is underserviced. Purchasers are not willing to pay for “goodwill” (patient flow), if they can open a new practice and become busy with the overflow of patients from the established dentists in the area.
The market, “supply and demand for dental practices”, has increased over the past 20 years that we have been appraising health care practices. We have seen a steady growth in value and number of sales, particularly through the eighties. Due to the recession in the early nineties this growth has stabilized; however, we are currently seeing signs of a resurgence.
In the sixties and seventies, whenever a practice became available, due to retirement, death, disability or relocation, the owner or the estate found it difficult to find buyers at any price. More often, the office was vacated or sublet, equipment and furniture stored in a basement (or sold if possible), staff were released and patients advised to find another dentist.
The value of dental practices has been increasing because of population ratios, i.e. shortage of patients and the higher cost of setting up a new office. The ratio of dentist to population now favours the patient and, to meet this demand, many offices now book evening and Saturday appointments. Morning appointment bookings can be scarce for the new practitioner today.
The capital required to build a new dental facility today is a significant sum, ranging from $150,000 to $200,000. Leasehold improvements, good equipment and fixtures add up to a substantial need for capital. Interest rates, office rents and the fear of not being busy are all deterrents to the noble efforts of young dentists to start new practices today.
The purchase of an established practice offers better assurance of “busyness” and good earnings. The disadvantage of second-hand assets becomes secondary to the immediate income opportunity of the prudent purchaser. The competition to buy a practice is further increased due to established dentists seeking to expand their existing practices and others delaying retirement due to lower rates of return when they invest the proceeds of their practice sale.
However, in spite of the foregoing, practice values and asking prices must be realistic. Buyers do have other alternatives, including associating, locums, taking salaried positions, opening a new office or buying another established practice. The price which is paid must be reasonable and at fair market value. The new owner must be in a viable position to pay for the practice and also earn a reasonable income. The principal and interest must be paid. Nearly every purchaser has to borrow the entire amount to pay for a practice.
Using an average sale price of $200,000 amortized over five years, at seven per cent interest, monthly payments would be $3,960 a month. The principal and interest annually for the five years would be $47,523 per year. Deduct that from a gross of $200,000, leaving $152,477 to pay for overhead, which runs from 50 to 60 per cent. After income tax, the new amount must be a viable amount for the buyer to financially survive and thrive or the opportunity may not compare well against the competition.
The market varies from location to location, from time to time, and is always changing. No wonder many dentists are at a loss when it comes to finding out the worth of their practice.
Many dentists assume that practice values are similar to real estate values. It is true that both are subject to the supply and demand of the market place, but the similarity stops there. Real estate has a passive value; it can appreciate without the active participation of the owner. The owner can be in Hawaii and the value of real estate could increase. However, a dental practice must be actively attended to and worked by the owner. Recent grosses and current production are relevant. Buyers usually do not pay for expectations of future income.
Practitioners working part-time should not assume that the buyer will consider the “potential” of the practice if it were fully developed. The practice market does not work that way. The practice must be appraised for what it actually produces and not for what it might produce depending on who buys it, what they do and how successful they might be.
Dentists sometimes compare their practice with other practices which have sold, based on information they have heard. However, many practitioners have no idea of the true net income of a colleague’s practice or even what is grossed, and they are not privy to the terms, allocation or conditions of the sale, which can have great bearing on price.
Medical practices sell for less than dental practices. There is a good reason for this. The profession is not as competitive and physicians offices are used mainly for consulting purposes; therefore, they require little investment in equipment. A dental practice is like a dental hospital. The owner must supply the location, premise lease, plans, construction, equipment, staff and financing of the entire project.
Finally, the practitioner’s used equipment can cause a misconception. Many clients point out that “it would cost $80,000 just to buy the dental equipment today.” Equipment 10 to 20 years old has a minimal functional value to the buyer and must be appraised realistically. However, the value of assets which are in profitable use are much higher than the value of assets which are not.
Besides the market place, specific information, which is particular to a practice, requires careful assessment. Generally, values are required to be allocated to four areas for tax purposes. Three classifications are:
These are all tangible assets.
The above three classifications are material items and can be readily obtained. The fourth classification is goodwill, a definite intangible asset and often, the most valuable component. Goodwill cannot be simply ordered and delivered. The purchaser is buying the tangible assets, but, without goodwill, a sale rarely takes place.
We believe that goodwill is the expectation of the buyer to enjoy the rights and privileges that the former owner has – to use the office and assets and to treat the patients to earn an income. The sale of goodwill in a practice should always contain an enforceable non-competition clause, which legally restricts the seller from competing with the purchaser for a certain (and reasonable) time and distance.
APPROACHES TO VALUE
The value of many commodities, such as gold, stocks, real estate and automobiles, can be established by the ever-present market place. However, businesses and practices, each being unique, require an opinion of worth, usually in advance of an anticipated sale. Studies in valuation methods clearly indicate that the market comparison is the best approach. However, many times, accurate information is difficult to obtain.
Some owners seek valuations from their accountant or dental supply salesperson. Obviously, it is important to obtain a qualified opinion. The wrong valuation method, or not knowing the market place, can confuse the owner and perhaps cause the loss of a good sale at market value. Qualified appraisers will usually be a member of a reputable organization like the Canadian Litigation Accounting and Valuation Institute (CLAVI).
CLAVI requires that members clearly state in the appraisal which approach has been adopted and shall be fairly described and explained in the report. The opinion of the value of the goodwill and the assets appraised should be determined by the Direct Market Sales Comparison approach. Other approaches to determine investment value, such as capitalization rates, multiple of earnings, discounted cash flow, and rule of thumb, are not as reliable for a personal service professional practice. The Direct Market Sales Comparison approach, which is based on the factual current market place of supply and demand for certain geographic areas and types of practices is the most accurate method. Sellers, buyers, financial institutions and the courts give the most weight and consideration to this approach.
The end result of a professional appraisal is:
Currently, one of the most timely benefits for having an appraisal is to maximize your lifetime capital gains exemption. Every established practitioner with a minimum of three years of profitable operation should consider an appraisal for this, among other reasons.
The cost of a professionally prepared appraisal will depend on many factors, including the purpose and scope of the assignment and the size and complexity of the practice to be appraised. In general, the fees for a complete appraisal by a qualified appraiser will range from $1,500 to $3,500 for a typical solo dental practice.
In today’s increasingly adverse, litigious and complex business world, there is an increasing need to have your practice professionally appraised.
Co-authored by Roy Brown
Ontario Dentist – 1995