27: Valuing Practices

Chapter 27

Valuing Practices

Price is what you pay. Value is what you get.

Warren Buffett


Objectives
At the completion of this chapter, the student will be able to:
1. Describe the basic approaches to practice valuations
    Summation of assets
    Capitalization of income
    Cash flow feasibility
    Comparable sales
2. Discuss the advantages and disadvantages of the various methods of asset valuation.
3. Describe factors that contribute to the valuation of a practice’s “goodwill.”
4. Describe two common methods for valuing accounts receivable in practice transfers.
5. Briefly discuss the tax implications of practice assets for the buyer and seller.
6. Describe the method of valuing corporate practices.
7. Describe the three classes of assets purchased in practice sales.


Key Terms
book value
corporate ownership
fair market value
goodwill
intangible assets
minority interest discounts
practice price
practice value
replacement value
value and price


Goal
This chapter will provide guidelines for the dentist to use when evaluating a practice for purchase options. Factors that affect the practice’s price will be discussed.

Dental practices have a value for dentists who want to begin a practice. They can avoid start-up problems and gain an ongoing business, complete with patients and cash flow. The problem is to decide how much they will pay to buy an ongoing practice as compared to other professional options. In this sense, the actual price is irrelevant. So the wrong question to ask is “How much does the practice cost?” The right question is “How much will I make while I pay off the practice compared to other options?” If a practice is fairly valued, then a dentist can live comfortably while ­paying off the ­practice loan.

Why Value Practices?

There are several common reasons that dentists might want (or need) to set a value for a dental practice. Unfortunately, the most common is to figure out the value of common assets in a divorce settlement. As a rule, all assets gained in a marriage are common assets and spouses must divide the value in a divorce. (Some states consider them personal assets.) The dental practice is often an important and contentious marital asset to divide. A dentist may also want a value attached for buying (or selling) the entire practice or buying into a practice as an owning partner. The third common reason for valuing practices is for general financial and estate planning purposes. If, for example, a dentist wants to know how much retirement income to expect from the sale of a practice, he or she needs an accurate estimate of the value of the practice.

A dentist will probably use someone who is an expert in the field of practice valuation to help with setting a price and the practice transition. He or she will do this once or twice in a career. The experts do it many times a year. They know how to set reasonable values and how to find buyers and set up financing plans and tax compliance. The dentist should concentrate on his or her area of expertise, doing clinical dentistry, and hiring a consultant to use his or her expertise for the dentist.

General Rules of Practice Valuation

There are several general rules to remember when valuing practices.

Value Does Not Equal Price

The value of the practice is an estimate of the financial worth of a practice. The value, then, depends on the formulas used to determine the value. The price for the practice is determined by how badly the seller wants to sell and how badly the buyer wants to buy the practice. If a practice is in an isolated rural area, few people may be willing to move to and live in the area. The seller, in this case, would be much more willing to sell the ­practice for less than the financially determined value.

The Buyer Is Buying the Income Producing Capacity of the Practice

The buyer does not really buy dental chairs, handpieces, X-ray processors, or patient charts. What the dentist buys has the proven ability of the practice to make money. All of the assets are incidental to (though supportive of) that purpose. A practice that makes no profit has a value of zero (0). A buyer might purchase the physical assets, but there is no value placed for the ongoing concern of the practice. Gross production, then, is not a good determinant of the value of a practice. Net income as shown on tax returns is a much more useful determining factor. A common pitfall is the departing dentist who claims that the practice is really much more profitable because they have consistently taken a certain amount of cash per year out of the practice in unreported cash. The seller claims that the price should be much higher than the numbers warrant. The purchaser has no way of verifying these illegal activities, and so he or she has to disregard them in the valuation estimate.

The Practice Value Is the “Fair Market Value”

The IRS definition of fair market value (FMV) of any transaction is the “price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts” (IRS Pub 561). This says, essentially, the value is whatever the seller can get for it. The price paid becomes the value. The FMV is related to the motivation of both the buyer and the seller.

A Dentist Does Not Buy the Practice’s “Potential”

A buyer purchases the expectation that the present, or historical, profits will be transferred to them. Future profits are uncertain and depend, largely, on the abilities of the buyer to improve the practice. Many new practitioners end up overpaying for practices based on the misguided belief that they should pay for the practice’s potential. If a new dentist doubles the profit in a ­practice, he or she should reap the rewards of that increase, not the departing dentist. So a purchaser only buys the profits proved from the practice.

Methods of Valuing Assets

Several different methods help to determine the value of the various components of a practice. Each has strengths and weaknesses. The fairest method is the FMV. The FMV is an estimate of the willing buyer and willing seller method described previously. Another way of thinking of FMV is to think of an estimated price that someone would give at an auction, with interested, informed ­people participating in the auction. There are no “blue book” values. There are rules of thumb for determining FMV, some useful, some less so. Until the asset trades hands, the purchaser does not really know its value. Replacement value is the cost of replacing the equipment with a new, similar asset. This method overstates the value because the asset being sold generally is not new. Used assets need more repair and maintenance than new ones. A problem with this method is that there may not be a new similar asset to learn the value. Accountants often use the “book value” to calculate value of assets. Book value is the purchase price reduced by any depreciation or amortization charges taken against the asset. For example, a dentist has a dental chair that he or she bought new for $20,000. After 3 years, the dentist has taken $13,000 in depreciation expense. The value “on the books” (book value) is $7,000 ($20,000 – $13,000). The problem with this method is that it is determined, largely, by the method of depreciation used. This is determined by the IRS estimate of a “useful lifetime,” which may bear only passing similarity to the actual useful lifetime of the asset. Some methods speed up the depreciation deduction for tax purposes. To solve these problems, some accountants use an “economic depreciation” figure, which tries to account for actual useful lifetimes and depreciation methods. Although better than a straight book value method, it is still subjective, although accountants claim that it is less so than appraisal methods. In the preceding example, the dental chair may have an actual useful lifetime (economic lifetime) of 15 years, although the IRS lets the owner depreciate it (for tax purposes) over 7 years. The “economic depreciation,” based on a useful economic lifetime of 15 years, is 3/15 × $20,000 or $4,000. The “adjusted book value” of this asset, based on this economic depreciation then, is $16,000 ($20,000 – $4,000). If the adjusted book values of all the assets in the office is added up, an estimate of the value of the tangible practice assets can be derived. Similar calculations for financial assets, such as accounts receivable, can also be derived.

Four Asset Classes

In valuing practices, a value on each of four classes of assets may need to be placed (Box 27.1).

Physical (Tangible) Assets

These assets include in-place physical assets such as ­equipment (dental operatory and office), leasehold improvements, and furniture and fixtures. (This is usually a small part of the value of a practice.) Any of the methods can be used to value these assets, but the best is to have a reputable equipment dealer give an estimate of the FMV of the assets. Consumable supplies (inventories) can be valued by taking the purchase cost less useless supplies (taking into account shelf life). This is easy but time consuming. Another estimate of FMV of supplies is $5,000 per dentist. This is also a small part of the purchase price, so the dentist should not worry about it (i.e., do not count matrix bands). Placing a value on the leasehold improvements of the office is a disagreement in many practice purchases. Some advisors claim that leasehold improvements are a separate tangible asset and should be valued, either by appraisal or estimated through a useful lifetime of 20 (or 30) years. Most valuation experts claim that leasehold improvements are part of the ongoing concern value of a business and are, therefore, included in the value of the goodwill of the business.

Intangibles

These assets generally make up the largest part of the total value of a dental practice. Because they are intangible, they become difficult to value (Box 27.2). These assets are called “Section 197 Assets” because that section of the IRS code defines them and how they are treated from a/>

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Jan 4, 2015 | Posted by in General Dentistry | Comments Off on 27: Valuing Practices
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