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‘It Depends:’ Calculating the Value of a Practice for Business Transactions

Wednesday, May 23, 2018 9:00 AM

BSM Products and Services, Expert Advice, Financial Management

Written by: Dixon Davis

Dixon Davis
Senior consultant

A physician approached me the other day and asked what value I would give his practice. As a consultant who works with many practices around the country, I understand that this is not an uncommon — or unreasonable — question. However, my response is usually quite unfulfilling: “It depends.” I know it’s a response we all hate because it’s not a definitive answer, but it’s true in this case.

Calculating a practice’s value depends on several factors. It’s impacted by the various scenarios that would require a valuation, the different factors that should be considered, and how values could be calculated. All these factors went into my “it depends” answer that I gave my client.

To understand the complexity inherent to a valuation, let’s start at the beginning. What types of events generally require a valuation? Here are a few common scenarios:

  • Acquiring a practice
  • Merging with another practice
  • Selling to private equity or another corporate entity
  • An associate buying shares to become a partner
  • Buying out an existing partner
  • Buying or selling ASC shares

Each of these situations differ in the way a valuation is calculated: Corporate entities will typically pay different values than a physician; a merger may include current liabilities whereas an asset purchase may not; buying out an existing partner is different than acquiring a neighboring practice in the community. So, this may lead you to ask: What are the different components that make up a valuation?

  • Tangible assets: Those items you own in your practice such as equipment, furniture, and improvements.
  • Shareholders’ equity: The adjusted value of practice assets, less practice liabilities.
  • Accounts receivable (AR): The amount of current AR in a practice that is collectable.
  • Intangible assets (goodwill): A value that represents a practice’s continuing income stream. In other words, the worth of buying into a current income stream with an established brand versus building it on your own.
  • Current earnings: Often referred to as EBITDA, this figure represents the cash value of earnings that would be available to the purchasing entity if acquired.

Depending on the situation, a valuation may include anywhere from one to all five of the above elements in the final valuation. Again, it depends on the nature of the valuation as to what elements may be included.

Beyond the elements used to create the valuation, there are additional factors that may need to be considered for a valuation. They include:

  • Goals and objectives of the seller
  • Nature and history of the practice
  • Operational and financial efficiency
  • Market share and dominance
  • Competitive assessment

For example, if I was conducting a valuation for an established practice with strong market share in a competitive market, the value of goodwill for that practice may be higher than another practice with similar financial performance, but with lower market share and minimal competition in its market. Or, a practice may receive a higher valuation if its operational efficiency is strong, resulting in a larger profit margin than a comparable practice that has similar net collections but a less efficient office, resulting in a lower profit margin.

The Bottom Line

The bottom line is that determining the value of a practice does depend on different factors. Understanding the intent of the sale, current business operations, and the market all need to be considered. A valuation can be helpful in identifying the value of a transaction; however, the final value always comes down to what a willing buyer and willing seller can agree on. If the numbers and operational considerations are agreeable, then you have a deal.

WE CAN HELP: BSM provides independent, unbiased assessment of practice value to help clients make informed decisions. Click here or reach out to us to learn more.

3 Comments

  • Jack Muckleroy said Reply

    Good intro to a complicated question. Any tips on how to change a buyout scenario so it accurately reflects what a departing member has contributed in financial and effort?

    • BSMAdmin said Reply

      Believe it or not, it's another “it depends” answer. I see many buy out structures depending on intent, but a calculation to determine what they have contributed to the group is rare.

      A common approach may be a valuation of the practice multiplied by the percentage of ownership. Most common is a deferred comp that targets a year's salary (average of previous three years) or the provider's collectable AR when he or she leaves. Both of these have a tie to his or her recent production.

      Many try to have a similar buy in and buy out that can offset. Lots of variation depends on what the intent is of the group. Just be careful of having buy outs too large — it can create a serious financial strain on the ongoing partners.

      Regards,
      Dixon Davis,
      BSM senior consultant

  • Jay Collins said Reply

    Jack, it was not easy, but we have made changes to our partner buy-out terms. For most practices, they may not realize that their buy-out terms are confusing, overly vague, unsustainable, etc. until many years down the road (when the first one leaves). As you might well expect, the closer a partner is to retirement, the less likely they are to accept reduced terms. In our case, special exceptions were made for late career partners (i.e., new rules were phased in).

    For practices that have not had their first buy-out, I would recommend running a pro forma model based on the partner agreement. They might be surprised.

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