Multiple factors affect practice valuation process

April 20, 2012

Sam Quintero, O.D., Practice Advancement Committee

There is no single commonly accepted method for valuing an optometric practice. No two practices are exactly alike. There are relative and extremely variable economic conditions within a community and the amount and type of local competition that affect the value of a practice. The location, decor, tenure, quality of operation, equipment, management systems in place, and financial health will also significantly determine whether or not a practice should even be considered for purchase.

There are two aspects to practice valuation: one is the process of appraising the value of the enterprise, and the other is assessing the economics of the enterprise, considered to be the process of “due diligence” by a prospective buyer.

The first to be considered is appraised value of the enterprise. The basis for valuing a business can be found in Revenue Ruling 59 – 60, issued by the Internal Revenue Service (IRS) and accepted by the American Society of Appraisers, as “the price, in cash or equivalent, that a buyer could reasonably be expected to pay and a seller could reasonably be expected to accept if the property, business or professional practice were exposed for sale on the open market for a reasonable period of time, both buyer and seller being in possession of the pertinent facts, and neither being under compulsion to act.”

These very important factors should be kept in mind: the length of time a seller is able to remain to provide a smooth transition affects the purchase significantly; all assets of the optometric practice are valued, including, but not limited to, the ophthalmic equipment, instruments, furnishings, decorator items (only personal items are excluded); all real property, building and land are excluded from an appraisal and intangibles are valued only if the practice is sold.

The fair market value may be determined by averaging the following three accepted methods of appraisal, weighted to reflect changing and unpredictable trends in managed care and industry economics as they currently exist:

  • Capitalization of Earnings: Method or Excess Earnings Method – which values goodwill as a multiple of what the practice earned in excess of an economic salary to the owner(s) and of earnings on tangible assets. It attempts to determine the attractiveness of a practice as an investment based upon the owner’s effective net earnings, otherwise known as the adjusted earnings of the business enterprise. The final value of the business is based upon the adjusted earnings divided by the “cap rate,” which is a percentage basis that evaluates different risk factors involved in investing in an optometric practice versus other investments. 
  • Asset Method – this method values the two primary components that contribute to practice value: tangible and intangible assets. Tangible assets are the physical items of the practice. Intangible assets include goodwill, practice reputation in the community and any other factors that should minimize patient attrition and maximize patient growth during and after the transition.
  • Comparable Sales Method – this method is most applicable when there are numerous comparable sales, similar to the housing industry. This method takes into account the significant benchmark variables of the practice, for example, the net-to-gross income ratio, percent of income for staff salaries, cost of goods sold, and practice overhead expenses, and then compares these numbers to previous sales of similar practices.

It is important to note the appraised value determined is not necessarily the selling price. There are other factors one should consider.  Below are some considerations that may affect a selling price and should be considered.

A. Favorable lease terms and agreement.
 B. Seller financing all or part of the sale, with a reasonable down payment.
 C. Whether or not some or all of the staff plan to remain through, at least, the transition.
 D. The supply and demand of the anticipated time of sale.
 E. The “Doing Business As” name and phone numbers remain with the practice.

The second consideration is the economics of the practice which may be equally if not more important in the decision to purchase a practice.

This is the process that will include the gathering of data relevant to the financial stability of the business. 

The financial statements provided for the appraisal process contain the necessary information for the economic analysis of the financial integrity of the practice. Important to this analysis is the balance sheet and the income statement. 

This process in practice valuation is often referred to as “due diligence.”

Projections of income, expenses, potential profit and financing requirements are fundamental considerations in practice acquisitions. 

The three primary financial statements, income statement (profit and loss statement), balance sheet and cash flow statement, are all tools with different purposes that may be used to help assess the financial health of the business side of an optometric practice.

The income statement shows how profitable a practice is and is represented in its simplest form by the following formula: Net profit = Revenue – Expenses.

The income statement is perhaps the most informative financial statement. 

In this statement, a summary of all revenues and expenses are depicted that occur in a business that will either yield a profit or loss. 

This statement is generally divided into the following sections: income, operating expenses, profit or loss and break-even analysis.

The balance sheet provides a glimpse of a practice’s financial health at any given point by reporting the cumulative results of all previous decisions that influenced the finances and operations to that time. 

The balance sheet shows the assets owed by the practice, the debt obligations owed, and the equity (net worth) the owner has invested in the practice. 

The balance sheet is represented by the following formula: Assets = Liabilities (debt) + Owner’s equity (net worth).

No other factor affects purchase feasibility more than cash flow after expenses – the net operating income.

The cash-flow statement reveals the sources and uses of practice income for any given period.

It is the definitive account of cash-flow status because it is generated using the cash basis method of accounting. 

In this method, income is reported when received and expenses are reported when paid. 

In its simplest form, the cash flow (net cash flow) of a business may be calculated by adding the revenue generated from professional fees and optical dispensary sales minus expenses generated from fixed costs (occupancy, general overhead, marketing, payroll, etc.) and variable costs (cost of goods).

The net cash flow of the practice reflects the practice’s vitality; a positive cash flow provides for continued growth, whereas a negative cash flow may serve as a precursor to signaling the death of a practice and one that is not attractive for acquisition.

The purchaser of a business is interested acquiring an opportunity for the purpose of securing a positive return on investment, through a recurring stream of positive cash flow. 

The return on investment from a positive stream of cash flow should provide the income to support the lifestyle and financial needs of the new owner.

Therefore, the net cash flow should easily account for the fixed and variable costs of the practice and must also generate sufficient revenue to offset the additional expenses arising from the debt load associated with the terms of the loan, the salary (if stipulated in the purchase agreement) for the seller to remain in the practice during the transition period and a salary income for the new owner as well as revenue for long-term financial and estate planning considerations as deemed appropriate by the new owner.

In the final analysis, a practice is only worth what someone is willing to pay for it and is able to afford.

Therefore, both the buyer and seller must weigh practice value relative to lifestyle considerations and how much income is required to satisfy the debt to be retired and the importance of net cash flow of the business in the transaction decision.

One comment

  1. I notice that a rule of thumb is to average the last three years gross sales and then apply a range of 55%-65% to that result and add the inventory to come up with a starting point with the purchase price . This was advocated on http://www.optometryceo.com

    Thank you for your comments

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