Understanding Practice Valuation
The subject of business—and more specifically, dental practice valuation—consumes many textbooks and is the focus of both undergraduate and postgraduate programs. We cannot within the confines of a single chapter expect to cover this entire subject but hope instead to provide the reader with enough information about the terminology and techniques to allow entry to more detailed study on the topic. We have no doubt that at some time during the course of your career you will need to have some idea how a dental practice is evaluated.
It would be convenient if the Internal Revenue Service’s definition of fair market value—what a willing buyer will pay and what a willing seller will accept when neither is under any compulsion to act and both have been advised of all information needed to make a decision—would allow parties to always arrive at some mutually agreeable price. However, the market does not always work that way, and consequently, an appraiser should be retained to determine the starting point for negotiation between the parties.
Before we get too far down the road concerning the process and techniques, let’s clarify a common misunderstanding. The terms “appraisal” and “evaluation” (or perhaps more precisely, “valuation”) are frequently used interchangeably when in fact they have significantly different meanings. A valuation is used primarily to determine an appropriate asking price for a practice placed on the open market. After collecting and reviewing practice and financial data, the valuator may recommend a narrow range of value (sometimes based on the perceived urgency of the sale), but the ultimate decision regarding the asking price lies with the seller. In the case of a true appraisal, the valuator will present a document to the client specifying a dollar value, and as a result of his or her experience and credentials, would be prepared to defend that number. That defense might be given to a potential buyer with counsel, a financial institution, or in litigation. As you might expect, this appraisal document involves considerable time and expense. In our office, we do market valuations at about a 20:1 ratio to true appraisals.
There are four distinct steps leading up to the revealing of a specific or range of valuation numbers depending on the nature of the assignment. Each step is vitally important to the credibility and accuracy of the project and demands considerable effort on the part of both the valuator and the client.
First, the purpose and scope of the assignment must be determined. Is the work being done to place the practice for sale on the open market, or is it being done because of litigation between two partners? What is the effective date, and to whom will this information be revealed? Does the client understand the fee for these services, and what are the time constraints for the completion of the project?
The second step involves the collection of all necessary financial and demographic data regarding the practice. The client is asked to complete a questionnaire about the practice and to provide statistical and cultural information about the area in which the subject practice is located. In addition, we will need a current profit and loss statement, as well as business federal tax returns for the last 3–5 years, along with all supporting schedules. We normally schedule a complete physical inventory at this time and guide the client through a hands-on count of instruments, handpieces, and patient records.
In the third step, we spend a considerable number of hours processing the data in order to use it in subsequent valuation computations. We determine the in-place, functional, and productive value for all equipment based on our experience and familiarity with the market. Be advised that this number will not be the same as the retail, wholesale, “book,” or liquidation price and in most cases will amount to less than 35% of the total value of an ongoing dental practice.
Another significant step in the processing phase is referred to as the “normalization” of the tax returns. While doctors and their tax preparers may have taken great pains to find as many legitimate deductions from gross income as possible, our job is to separate necessary operating expenses from the perks of business ownership in order to determine the true cash flow and profitability. In addition, certain noncash items and expenses that would disappear at closing must be filtered out.
Let’s divide these expenses subject to normalization into three categories: doctor’s personal expenses, judgment calls, and disappearing items.
There are probably as many variations in tax returns as there are accountants preparing them. Careful analysis of the return is necessary in order to give an accurate picture of the funds available to pay overhead, taxes, living expenses, and debt service. You will benefit in understanding these valuation issues by studying chapter 3 on dentistry by the numbers.
Now the process of applying the various methods of valuation begins. These methods, which we will discuss in great detail shortly, range from purely mathematical computations to very subjective techniques based on the experience of the appraiser. Some, all, or perhaps even a weighted combination of several methods may be used to arrive at a conclusion. While a strict, by-the-numbers technique would probably be most appreciated by our dentist clients, the fact remains that most appraisers are going to use some combination of art, science, and mathematics to come to their conclusions.
The fourth step in the process involves the writing of a report either as specified by the requirements of a true appraisal or to advise a prospective seller/client about placing the practice on the market. Whereas a report to a prospective seller may be in letter format, the appraisal document is generally printed in multiple copies and bound.
The letter of opinion will review the comparisons made by the valuator of the target practice to other similar practices. Based on his or her experience in the market, a market price will be recommended to the client. The urgency of a sale may have considerable effect on the final decision regarding the listing price.
In the case of a true appraisal, the final report will be presented in several bound copies and will go into considerable detail about the qualifications of the appraiser, the methods of valuation used, the “weight” of those methods, and finally, a specific number that represents the valuator’s professional opinion as to the value of the practice.
As mentioned earlier, the methods of appraisal range from pure mathematics to the valuator’s instincts. We also discuss a frequently used term in business valuation and how it may or may not apply in dentistry. The most common methods used to determine the value of a dental practice include summation of assets, comparable sales, capitalization of earnings, and its first cousin, the excess earnings to retire debt calculation. Let’s discuss them individually after laying down a few ground rules. For the course of this matter we will confine our discussion to the valuation of single-owner practices selling assets and not stock and expecting to get cash at closing. Variations on that theme will be discussed later in the chapter.
Summation of Assets
Being familiar with the market and having previously determined the value of the tangible assets, the valuator performs a build-up of values based on the comparison of the subject practice to a model practice. This scoring includes items such as location, staff experience, equipment, hygiene efficiency, patient counts and demographics, cash flow, and profitability as they relate to a statistical norm.
All qualified appraisers will have access to a variety of databases that will suggest what similar practices with similar revenues have sold for in similar markets. While accepting the fact that all dentists are unique, and consequently their practices are unique, five or more data points in two or three different databases can be very convincing in determining a practice’s place in the market. We frequently use the real estate analogy: if you knew what fifty homes with 1,500 square feet of living space, three bedrooms, and two bathrooms on one half of an acre in a suburban neighborhood of a city sold for, you could probably come very close to knowing the market value for the fifty-first such home.
Capitalization of Earnings
This method utilizes a computation based on a calculated rate of return on the practice’s profits. This rate of return is referred to as the cap rate and involves a variety of factors outside the scope of this chapter including present dollar values, risk of the market, fixed securities return, and so forth. For now, let’s think of the cap rate as the rate of return on the “excess earnings” of the practice. Excess earnings are defined as cash available after overhead is paid, after the owner receives a fair compensation for producing dentistry, and after a fair return is made on any cash invested in the practice and some allowance is made for capital improvements. If those earnings are known as a result of the work done to normalize the tax return, an appraiser can use that derived cap rate to work backward into the value of the practice.
Let’s simplify this by using the example of />