Solving the valuation puzzle

Valuating a dental practice is like solving a crossword puzzle - it requires knowledge in many areas. The purpose for the valuation should be clearly identified, and it usually falls in one of two categories:

1) An ongoing-basis type of valuation, commonly used for the purpose of division of assets for a divorce, or

2) Market-value approach, used to identify the value of the practice prior to its sale.

In this article, we will discuss valuation for the purpose of a sale. In this scenario, the underlying motivation of the buyer is to “purchase a stream of income.”

An accurate valuation is equally important to the seller. If the practice is overpriced, the purchaser will not be able to acquire financing for the purchase. The practice also will remain on the market for an extended period of time if it is overpriced, losing value the longer it is on the market.

A purchaser can only afford to pay a price for a practice that will allow him or her to earn an income equal to or better than what he or she could expect to earn as an associate working in another practice, without making a capital investment to purchase a practice.

“The Acid Test” is one method of valuation to arrive at a maximum fair price for a practice. This test takes into consideration the income of the practice as shown on documents considered to be accurate, such as federal income tax returns and current operating statements.

Working from a federal income tax return, first take the profit shown on the return and make adjustments, adding back noncash expenses such as depreciation and expenses which are elective expenses benefitting the doctor. These include such items as interest, travel, entertainment, and auto or pension expenses

After adding back these expenses, subtract the profit expenses which may not have been shown on the income tax return, and will have to be paid by the purchaser. The two most common expenses not shown are rent (because the dentist owns the building) and a salary for a spouse who works in the office on a full-time basis, but is not paid for her work. Now deduct a salary requirement for the new owner. We suggest using 30 percent of gross receipts.

Using this formula, if a purchaser buys a practice for $275,000 and finances the entire purchase price, he or she should be able to pay all expenses and monthly debt service toward the practice purchase and still have $12,500 per month or $150,000 per year in pretax income.

After this analysis, other adjustments to consider are:

Makeup of income coming into the practice.In the best-case scenario, all of the income would be fee-for-service. However, if part of that income is from orthodontic services the purchaser would not be able to provide or from payments from capitation and other discount dentistry programs (including Medicaid), these are negative factors and may require additional adjustments to the purchase price.

 The quality of the staff. An experienced staff with a long tenure may be considered a plus compared to a new staff which lacks experience.

 Associate on staff. If an associate generates part of the practice income, will that associate continue with the practice or will the position be eliminated to ensure more income and patients for the new owner? Does the current owner of the practice have a noncompete covenant with the associate and will that agreement apply if the practice changes ownership? If not, the associate could leave the practice (taking his or her patients) and become a competitor.

 Growth trend of the practice. If a practice is not growing, then it is dying.

 Quality and quantity of equipment and furnishings. Is the equipment in good working condition and are the furnishings modern? Additional debt service may be incurred by the prospective buyer to bring the practice into compliance with the minimal current professional standards.

 Visibility in the community and the geographic location within the state. Most purchasers want to be located in larger cities and/or medium-sized college towns with a lot of activity and good school systems. The least desirable, of course, are remote towns or areas with unstable economies.

With this information, you should know, within reason, what the practice value is and be able to determine a price which is reasonable for a seller to accept and a purchaser to pay.

Roy Berry has more than 40 years of experience in the dental profession, and is owner of Roy Berry Consultants & Practice Brokers in Indianapolis, Ind. The firm engages in consulting, appraisals, evaluations, and brokering for dental practices. Berry is a member of American Dental Sales, Professional Valuation Study Group, and is listed in the American Dental Association’s book on Dental Practice Appraisers and Valuators. He can be reached by phone at (800) 659-6117 or by email at royb@in.net. Visit his Web site at www.royberry.com.