Building value as you build your practice (Proceedings)

The valuation of a veterinary practice reveals a telling story about the practice and its owners and staff. It is evidence of the practice's ability to pay bills, retain staff and clients, and invest in the future. It is also management's report card and a forewarning of the owners' future financial security.

Practice valuations are mandatory when planning for financial security, buying or selling a complete interest or a partial interest in a practice, writing buy/sell agreements, estate planning, bank financing, mergers, divorce, or for litigation for damages (for example, condemnation, breech of contract, lost profits, etc.).

With so much riding on the outcome, it's alarming to see how many owners have never had their practice valued. If these owners had a similar investment in, for example, AT&T or Microsoft, they would be checking the value of their investment every day! It's time to face the facts – a practice's value is not equal to one year's revenue; and, a practice's existence is, in itself, no assurance of value. So, let's look at how veterinary practices are valued in today's market and what you can do to control the final outcome.

Determining Value

The most common method used to value a veterinary practice is the excess earnings method. It has carried a variety of descriptive names over the years, but the basics of the formula are the same. The principal components of value are net assets and goodwill. Other methods are available, (for example, the discounted future returns and capitalization of earnings methods) but they are not often used because of disadvantages inherent with each.

Net Assets

Net assets include working capital assets such as cash, accounts receivable, and drugs, hospital, and retail supplies. Values for these assets are usually first obtained from the practice's Statement of Financial Position prepared on the accrual basis. Then, each asset is adjusted from its stated book value to its appraised fair market value. For example, accounts receivable are adjusted to reflect only the value of the collectible accounts. Working capital assets are reduced by working capital debt such as accounts payable, payroll taxes payable, sales tax payable, and retirement contributions payable.

Net assets also include the practice's tangible assets such as office supplies, office furniture, and medical and office equipment. The practice land and building is included only if the practice owns these assets. Tangible assets are valued at current market value, the price a buyer would pay given each item's age and condition. Market value can be determined in one of three ways:

• An independent appraisal by a qualified appraiser familiar with veterinary equipment.

• An agreement between the buyer and seller.

• A financial formula that considers original purchase price, age and replacement cost.

If real estate is to be valued, obtain an independent appraisal from a qualified appraiser experienced in valuing special use facilities. After all assets have been valued, all purchase debts such as notes, leases, and mortgages payable are listed and subtracted from the asset total to arrive at net asset value.

Goodwill

The intangible asset value, or goodwill, is the value placed on the practice's earnings from operations. To determine the goodwill value, the earnings generated from the normal, ongoing operations of the practice must first be calculated. This calculation begins with practice income as reported on practice tax returns for the prior three years. (Less than three years may be included if major changes have occurred such as the construction of a new facility, the addition of a second practice, severe weather damage, etc.)

Then, practice income is adjusted to reflect the normal operations of the practice. Adjustments are made for: 1) income and expenses that are on the tax return that are excluded from the calculation of value, such as interest expense and the gain on sale of equipment; 2) expenses that are not on the tax return that are included in the calculation of value such as nondeductible entertainment expense; 3) non-recurring expenses, such as those associated with flood damage, litigation, relocation, etc.; and, 4) an increase or decrease in rent expense to reflect the true rental value of the land and building.

An adjustment is always made to the amount paid to owners and associates for their veterinary and management services. This adjustment does not count the number of doctors employed; it considers the medical and management services provided and applies a standard compensation rate to the dollars generated from these services to determine the practice's true veterinary and management expense. For example, in a companion animal practice, veterinary compensation of 21% may be applied to the dollars of medical revenue generated. Management compensation of 3% may be applied to all revenue generated in the practice. The total, plus payroll taxes, represents the fair market value of veterinary and management services and replaces amounts actually paid.

The calculated fair market value will be higher than the actual dollars paid if doctors have been underpaid in the short term because of cash flow concerns. The calculated value will be lower than actual dollars paid if owners have been drawing their owner earnings throughout the year in addition to a fair salary for services, or if associates have shared in owner profits.

If the practice has developed its own standard for determining veterinary and management pay, consideration will be given to the existing formula.

With income and expense adjustments completed, the practice's expected earnings from operations can be determined for each year included in the valuation. Then, the earnings are averaged. Many owners worry that the value of their practice is hindered by their strategy of withdrawing all profits at year-end to avoid high corporate tax rates. They are concerned that $0 taxable income means $0 goodwill value. This is not the case. The goodwill value reflects the practice's ability to generate excess earnings (profit) regardless of whether that profit is left in the corporation or withdrawn. This means that once excess earnings are generated, they can be reinvested into the practice or paid out without reducing the practice's value. Many owners use these earnings to fund their savings: the excess earnings generated by the practice not only establish the practice's value, they also create investment value outside of the practice.

Because the average expected earnings represent the earnings generated by both the tangible and intangible assets, the earnings from the tangible assets must be identified and subtracted from the total to arrive at the average expected earnings attributed to the intangible assets. The remaining earnings are the practice's excess expected earnings.

Next, the excess expected earnings are capitalized. The capitalization rate reflects the rate of return available in the marketplace from investments expected to produce similar income with comparable risk. There are various methods for determining a capitalization rate. When the summation method is used, the appraiser starts with a low risk rate – U.S. Government notes or bonds are generally considered the benchmark for the risk-free rate. Next, the valuator adds a series of premiums that, in total, reflect the rate of return that an investor would expect to earn by taking the additional risks associated with owning a veterinary practice and finally the risk associated with owning the named veterinary practice. Historically, the capitalization rate for veterinary practices has ranged from 20% to 25%.

The capitalization rate is then converted to a capitalization multiplier (100% divided by the capitalization rate) and applied to the practice's excess expected earnings to arrive at goodwill value. For example, if a 20% capitalization rate is applied to excess earnings of $100,000 the resulting goodwill value is $500,000:

Looking at it from the buyer's viewpoint, if the buyer requires a 20% return on investment, he or she would want to receive $100,000 in annual earnings from an investment of $500,000.

Practice Value

Finally, the values of the net assets and goodwill are added together to arrive at the practice's fair market value.

Given the many decisions the valuator makes throughout the process, valuing a practice is not a job for the inexperienced. For example, in a practice sale, if an inexperienced valuator arrives at an inflated value, a knowledgeable buyer will reject the value and the sale will be lost. This may result in the seller eventually receiving less than the practice is worth; overvalued practices often remain on the market for long periods eventually being sold for less than they are worth. An inflated value can also alienate an associate—not only may the seller lose a buyer but a key employee as well. Conversely, an understated value can jeopardize the seller's future financial security.

The buyer and the seller do not need to obtain separate valuation reports, provided the original report prepared by the seller's valuator fully documents how the value was determined. In this case, the buyer's advisor should review the seller's valuation and comment on differences in opinion or methodology and how the differences impact the value.

Increasing Value

In many practices, goodwill is often the largest component of value. So, if the value of your practice today falls short of your expectations, increasing goodwill will be the most direct way to increase total value. This means increasing excess expected earnings, which can be accomplished by reducing operating expenses or increasing revenue.

Reduce Operating Expenses

Start with operating expenses. Is there room to reduce them without adversely affecting the quality of your medical care? Begin by comparing your expenses with industry benchmarks. Are your expenses higher? If so, why? Can they be brought in line? For every $1 that operating expenses are reduced, practice value will increase by as much as $5, assuming the cost cutting pares down excess spending and not quality of patient care or client service.

Variable expenses are averaging 14% to 18% of revenue in companion animal practices and 21% to 25% in equine practices and include drugs, hospital supplies, laboratory costs, and vehicle expense. If these costs are high, you could be paying too much for products, have too much inventory on the shelf, or have an overall low fee structure for value-based services.

Fixed expenses, which include advertising, office supplies, continuing education, equipment repairs and maintenance, telephone, and advisor fees, are currently averaging 8% of total revenue. Cost overruns in this category are usually due to a lack of budgeting, overall low fee structure and/or low client demand.

Staff compensation is averaging 22% to 25% of total revenue in companion animal practices. This target assumes a staff-to-doctor ratio of 3.8-4.4 to 1, a well-paid (versus minimum wage) staff and total revenue per doctor of approximately $565,000. Higher revenue per doctor justifies a higher expense target assuming that increasing the number or competency of staff allows doctors to be more productive. The problem here is often under spending rather than over spending with practices trying to manage with minimum wage, under qualified, and/or part-time people. In general equine practices (part ambulatory, part hospital), staff compensation is averaging 10% to 15%.

Facility costs are averaging 8% of revenue. This category includes rent, repairs and maintenance, utilities, property taxes, and insurance. High costs in this category can rarely be lowered by any significant amount, so reducing the expense percentage requires an increase in revenue from fee increases, expansion of services, or increased client activity.

Variable expenses increase as revenue increases, assuming the growth in revenue is due to increased client activity and/or expanded medical services rather than fee increases. In contrast, fixed expenses, staff compensation, and rent remain fairly constant over an extended range of revenue growth. When fixed, staff, and facility expenses increase, they jump dramatically, usually to a whole new spending level. Why would you decide to make the jump? Because, you've determined that the demand for veterinary services can take practice revenue from its current level to a substantially higher level, if the practice increases its capacity to see more people or offer more services.

Increasing Practice Revenue

An increase in practice revenue will also increase practice value. In Well-Managed PracticesSM total revenue per doctor averages $565,000. Comparing your revenue to the results from the 2007 Benchmarks - A Study of Well-Managed PracticesSM will provide a starting point in determining where to focus your efforts if your revenue doesn't match up. Growth in even one area will increase practice value, assuming expenses remain fairly constant. The comparison will also help you determine if your practice is accomplishing all that is reasonably attainable given your personal goals, practice philosophy, and community demographics.

For example, if your examination fee is $40, your average charge per doctor transaction should range from $128 to $136. If it is lower, is it because your pricing strategy is antiquated (your fees are too low) or is your practice providing a narrower range of medical services than what is common in a Well-Managed PracticeSM ? If the average doctor transaction in a two-doctor practice for example is even $5 below standard because of low fees, the practice may not only be losing $33,000 of profit each year, the owners may lose up to $165,000 in investment value when it comes time to sell. Dr. Karen Horne, the senior owner of a two-doctor practice in Minneapolis, has finally set aside the time to plan for her future financial security; her goal is to be financially independent in eight to twelve years. As part of the financial planning process, she's had her practice valued. Here's what she learned:

1. She will need a total of $1,750,000 of income producing assets to cover annual living expenses of $140,000 including taxes.

2. Her existing investments, other than her practice and practice real estate, should be worth about $300,000.

3. Her equity in the practice real estate will grow to $350,000.

This means that her practice must make up the balance. According to the valuation report, its current value is $600,000. Karen knows that she has a great deal of control over her practice's value and she begins to look at what changes she can make to build the value.

She discovers three changes she can make immediately. First, update her value-based fees using Benchmarks 2007 – A Study of Well-Managed PracticesSM and the Veterinary Fee Reference published by the American Animal Hospital Association. This will increase the practice's average doctor charge from $90 to $96 or by 7%. Practice revenue will increase by about $40,000.

Second, when recently attending a management conference, she learned that fees for hospitalization do not include inpatient examinations; she had assumed the fee covered both. Charging for inpatient exams will mean additional revenue of at least $30,000.

She reviewed her inventory purchases over the past twelve months and found that she could reduce her purchase costs by working closely with fewer suppliers and negotiating lower prices. Her annual costs would drop from 22% of medical revenue to 21% for an annual savings of $6,000.

As the increase in revenue and decrease in cost will be achieved with no additional spending, the revenue increase and expense reduction will go directly to earnings. If a capitalization multiple of 5 is maintained, these three changes alone will increase the practice's value by $380,000 in a very short time.

Dr. Chuck Donovan, the new part owner, is pleased with the increase as well. It increases the value of his 30% share and increases his share of owner profits – profits that he will use to reduce his purchase debt.

Like Karen and Chuck, you have considerable control over your practice's value. If your goals include building the investment value of your practice and offering the highest standard of medical care your practice can provide, managing your practice's value must be part of your plan.

*This information is intended to provide the reader with general guidance in practice succession matters. The materials do not constitute, and should not be treated as, appraisal, tax, or legal guidance or technique for use in any particular succession situation. Although every effort has been made to assure the accuracy of these materials, Wutchiett Tumblin and Associates does not assume any responsibility for any individual's reliance on the information presented. Each reader should independently verify all statements made in the material before applying them to a particular fact situation and should independently determine whether the succession technique is appropriate before recommending that technique to a client or implementing such a technique on behalf of a client or for the reader's own behalf.