Practice sale or practice acquisition choices: when is the timing right so I can retire? (Proceedings)

The time for a practice sale depends on the following items: timing, personal health, interest in work, motivation for work, age, stress, funds, alternative investments and alternative activities. Some say you need 15-20 times your current earnings in investment funds for retirement. That means if spendable income is $100,000, then you need $2 million investment. You must know the value of the veterinary practice to hopefully get your retirement investment ($2 million in our example).

The purchase of a veterinary practice is likely to be the biggest financial commitment a veterinarian will ever make in his or her life. Therefore it must be very much analyzed, not only for financial reasons but for the personal issues involved. The buyer must decide if there is a match between the buyer and the clients and the style of medicine. There is also a need to match the buyer and the geography or location of the practice.

If those major philosophical issues can be resolved, then for the buyer the rest of the work has to do with the due diligence and feasibility studies, and getting buyer and sellers to agree on the details of the purchase.

Due diligence requires the buyer to study the style of medicine and the medical records as a minimum beginning review. Due diligence will include review of the factors needed for a feasibility study and financing and budget estimations. This includes review of several years of management financial history, quality medicine statistics, equipment quality, the fee schedule and review of invoices.

The review of the medical records to ascertain the compliance with medical standards should at least include reviewing for the depth and frequency of diagnostics, the methodologies of treatment, and frequency of client rechecks.

The minimum medical review should include the number of injections per patient on a sampling of the records, the number of diagnostic tests, the number of x-rays, and the number of prescriptions. This basic data is important to ascertain some quality of medicine.

Lastly, the minimum due diligence would include a fee schedule review. This may not be meaningful, if the buyer has not been working in a geographical area. If not, these figures must be compared to one of several sources of industry price surveys. Those include the American Animal Hospital Association, the AVMA, NCVEI, or National Commission on Veterinarian Economic Issues' baseline data. Another very good comparison of analysis of the pricing as compared to the bottom line would be to review the Well-Managed Practice Studies by Wutchiett and Associates and Veterinarian Economics Magazine.

After the above data has been reviewed, to see if there is room for improvement, the buyer can justify changing management and pricing to provide the cash flow, the next step is to review the practice from a fair market value (FMV) basis. This most likely will require a third party valuator to be involved. The cost of this practice valuation will vary from $6,000 to $10,000 depending on the state of the books and records provided to the valuator. It sounds simple, but it is very complicated to analyze the Profit and Loss Statements, the Balance Sheets, and make them coordinate with the Internal Revenue tax returns as a validation of real revenue and expenses.

A seller and a buyer can determine from a Valuator analyzing the data as related to the tax return, if a seller has been keeping some of the revenue off the books to save taxes or has been doing a large amount of bartering for services. The seller's action here would lower revenue and lower cash flow to decrease the value of the practice.

For sellers and buyers to understand areas of negotiability, they must understand the basic theories of practice valuation. Simply, a practice valuation requires a fair market value for the tangible assets plus the intangible assets including goodwill. The largest variable for seller's retirement or buyer's availability is the goodwill value, which is commonly based on excess earnings, times some capitalization rate. When this goodwill value is found and is added back to the assets and after the liabilities are deducted, a net fair market value for the practice can be determined.

Some valuation complications are in assessing the subjective issues to arrive at the capitalization rate. One early step is to determine the excess earnings. This is found after review of the Profit and Loss Statements and the IRS tax returns to develop an adjusted or normalized Profit and loss Statement, to remove nonrecurring expense and personal expenses.

The major issues that need adjusting on most Profit and Loss Statements are as follows:

Officer wages need to be removed, because they may have been used instead of an adequate veterinarian salary to save taxes, or it has been used as a compensation for ownership, which we want to be reflected in the bottom line.

Staff salaries and wages are studied to clarify that veterinarian compensation or taxes have not been mixed with this category.

Veterinary salaries (in small animal medicine) are adjusted to make DVM costs be based on the production earnings of approximately 22% of gross production revenue.

Auto and truck expenses are deleted from a small animal practice, unless they are justified for sending staff with mail or on errands.

Continuing education may have to be adjusted depending on the reasonableness of that number, whereas some veterinarians that are owners take an excess amount of continuing education.

Non-cash expenses are removed, such as depreciation or IRS Section 179 write-offs.

Interest expense is removed because the presumption is the practice is purchased by a cash buyer and therefore there should be no interest expense or because a new interest expense will be unique to buyer.

Clinic or hospital rent may have to be adjusted. This requires a third party opinion as to market value for rent, so it can be adjusted to the actual market value.

Payroll taxes and benefits may have to be adjusted, if the DVM labor had to be adjusted. The appropriate adjustments to taxes and benefits would have to be made.

Because the depreciation and IRS Section 179 non-cash expenses are removed, there remains no allowance for equipment replacement. Therefore, a sinking fund of 1.5% to 3.0% of gross is inserted to allow an expense to provide money for equipment replacement, with obsolescence.

A management fee would be imputed if there was not adequate staff management or compensation to the owner for that expense. That is usually 3.0% to 5.0% of gross. Once these adjustments are made, we have what we call a normalized expense list that then allows us to calculate an estimated cash flow, as adjusted. This estimated cash flow or excess earnings help with the estimation or prediction of future earnings of this hospital. These calculations presume no changes were made in management, pricing or fee schedule.

In calculating the discount rate to come up with the capitalization factor, the valuator considers many subjective issues of each individual practice. Many of the following factors and more, may be evaluated by observation and information provided to the valuator.

These factors include location, components of gross, the growth factor in the gross revenue, new clients, the total clients, the staff and their longevity, the net gross productive/staff, the gross in general, the physical plant or building, competition, quality of equipment, management, internal marketing and industry comparisons.

These factors can be scored by the owners to arrive at some numerical score that can be used to assist in arriving at the capitalization rate. These subjective issue reviews are major issues for sellers to study to determine if the timing is right.

After the fair market value of the practice has been calculated by the valuator, there needs to be a separate analysis of these financial statements from a buyer's perspective for a feasibility production for future profit, if the buyer and the valuator or consultant are aware of management things that could be changed to improve these numbers they can factor those in. If a predicted change can be made, the buyer may be able to come up with an alternative purchase price number, which may be greater than the fair market value. This value could allow negotiation to please the seller and be acceptable to the buyer at the same time. The deal then has to be made with the offer, the acceptance, and the consideration.

This sale or purchase offer can be made with a Letter of Intent or with a Purchase and Sale Agreement, whether for a stock company or for a LLC or Proprietorship. These are basically similar in content with different terms referring to the ownership units. The Letter of Intent is the easiest, if there is no concern about other buyers moving in front of the first prospective buyer, in that the Letter of Intent is non-binding. If the buyer provides a Letter of Intent, it puts the burden on the seller to respond with terms that are not acceptable and to confirm whether or not the real estate will be included. It must also cover that the seller will provide a Non-Compete Agreement whether or not the seller continues to work.

The Purchase and Sale Agreement is more binding than a Letter of Intent. It includes representations and warranties of both parties explaining the extent of holding the other party accountable for information provided.

All of these documents allow for negotiation. If we are considering a partial buy-in, the first factor is to figure out how to get out. Therefore, there needs to be a buy and sell agreement for either party to get out upon the following major life circumstances. Those would include death, disability, divorce, marriage, retirement, want out or bankruptcy. These issues must be discussed to provide how either party will get out and/or pay off the other when one of these events arises.

In summary, practice acquisition is a tedious, negotiable process that may take many months, but hopefully concludes in a win-win situation. Selling is a tedious process that should begin three to five years before the sale or retirement. Knowing when to sell for retirement requires the seller to know the future needs for income and activity and to know the value of the practice being sold. For this preparation a practice valuation should be done every three years to allow sellers to make management changes to maximize the selling price.