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Enhancing Buyer Affordability

By Dr. David Edward Marcinko; MBA, CMP™

By Hope Rachel Hetico; RN, MHA, CMP™

All doctors realize that earnings drive the value of any medical practice, and more earnings equate to increased value. But, if a buyer cannot reproduce the earnings of the seller, the practice is worth less to the buyer. And, there are many variables that enter into this calculus.  

For example; will the patients return to see a new doctor, and will traditional referral sources refer to him or her? Does the new doctor have the necessary skills, training and experience to provide the same level of care, as the seller? Most importantly, consideration has to be given to the transferability of goodwill and/or assign ability of managed care contracts. 

For these and many other reasons, the following blended practice valuation approach may be considered for small and mid-sized medical practices, instead of the more traditional business techniques often used.

Introduction

Dr. Carl M. Caplan, MBA, a retired consultant from Baltimore, Maryland, believes that a medical practice will sell [or should sell] only when the buyer feels that s/he can generate a reasonable level of income while servicing the practice debt.

Therefore, the projected income level to the buyer is a critical factor, which he has termed “real” net income, as demonstrated below. 

[1] Sales Example 

Let’s say that the seller of an orthopedic surgical practice has an annual gross income of about $ 600,000. The practice is a professional corporation that pays its owner $ 250,000 per year in salary, with a corporate profit of $ 10,000. The office also provides a pension plan, life, annuity, disability, and health insurance, FICA taxes, seminar, traveling, continuing education expenses, and other fringe benefits, in the amount of $ 110,000 per year. 

Therefore, the “real” net income before taxes is $ 370,000. Since the doctor owns the office building, he pays no rent and his wife, a registered nurse, works as his medical assistant, receiving an annual salary from him of $ 12,000. 

First Math Steps

The first math steps in using the concept of “real” net income appraisal is to determine what income a buyer would receive under conditions that would likely exist in the office after the sale. 

Again, for example, suppose the buyer would have to pay $ 46,000 in rent, per year, to the seller, which is a reasonable rate for the geographic area. The buyer would also have to find a replacement for the seller’s wife, based on the going rate for RNs of other practices in the area; or about $ 36,000 per year. The office expenses are therefore increased by about $ 70,000 which must be subtracted from the seller’s real net income of $ 370,000, leaving a potential “real” net income of about $ 300,000. 

The Multiplier

Let’s further assume that the seller is asking for the equivalent of one year’s gross revenues (gross multiplier of 1), as the sale price of $ 600-K, and wants all cash up front. The local bank will currently provide a five year loan at about 9.25 percent, and the buyer will borrow the customary 20 percent down payment from another source on the same terms.

Crunching the above numbers produces a monthly cost to the new buyer of about $ 12,526 or about $ 150,000 per year. Using the Caplan method, “real” net income is only about $ 300,000 and there could still be a patient attrition rate of 10-30 percent, or more, depending on the transferability of some managed care contract and, of course, bedside manner and clinical acumen, of the purchasing doctor.

Now, at a 10 percent attrition rate, minus the variable costs to produce the $ 60,000, the resultant loss would now be about $ 54,000, further reducing the new buyer’s “real” income to a range of about $ 246,000.

Working Capital Needed

Moreover, the buyer still has to secure working capital to pay overhead costs until the accounts receivable can be converted into payments.

Assume the practice turns over its ARs every 4 months, or about every 120 days. Based on $540,000 in annual revenues after a 10 percent attrition rate, the amount required for ARs would be $ 180,000.

Considering the 9.25 percent interest charge, and the five year pay-back period, the annual payments would be about $ 45,000 and the new buyer now has a remaining “real” net income of only about $ 201,000 prior to any debt payments for the practice. 

Loan Basics

Now, recall that the principal portion of the loan is not deductible and once a sales price has been determined, it is divided into asset values. In this case, the practice may have tangible equipment (operating assets) appraised at $150,000, with the rest divided between goodwill and a non-compete covenant. 

Considering the difference between the asking price and the depreciation schedule of 15 years, as well as the fact that working capital is a loan paid with after-tax dollars, the buyer has cash flow considerably less than the calculated $ 201,000.

Therefore, with this method the practice appears to be over priced relative to the sellers original estimate using the 1X gross revenue “rule of thumb multiple” method. 

[2] Discount Sales Example 

Today, it is not uncommon for insurance contracts to be non-transferable, reducing practice sales price. Since earnings drive the value of any practice, if the new buyers cannot replicate prior earnings, the practice should sell at a discount.

Many variables enter into consideration however, and the Caplan method offers the following items for consideration:

· Will referring practitioners still send patients to the new doctor?

· Will patients see the new doctor?

· Can the new doctor provide the same medical services?

· Where will earnings be derived? 

Above all, due diligence in the form of the above inquiries must be performed before any sales transaction is consummated.

[3] Practice Merger Example 

Finally, when merging practices of unequal production, Caplan suggests the following guidelines.  

Let’s suppose Dr. Adams produces $ 500,000 and nets $ 200,000 per year. Dr. Baylor produces $ 250,000, and nets $ 100,000, for a combined net income of $ 300,000. After some preliminary estimates, they assume that by merging they will experience overhead cost reductions of $ 30,000, while revenues stay flat, but increasing the aggregate to $ 330,000 after their merger.

Since Dr. Adams is bringing in two-thirds of the revenue, he is credited with $ 330,000 x .667 or $ 220,000.  So, Dr. Baylor receives $ 330,000 x .333 or $ 110,000.

For an equal contribution of income, each doctor would have to contribute $ 165,000; therefore Dr. Baylor pays $ 55,000 as an adjustment to Dr. Adams. 

Conclusion 

These methods are buyer friendly and might best be used in cases where a dearth of buyers exists, in collegial mergers, to reward a current associate doctor or to ensure the continued survival of a medical practice business entity.  

And so, what valuation methods have you used or seen in your local medical community; what was the outcome and why?   

NOTE: For comprehensive institutional information on this topic, please subscribe to our premium, 1,200 pages, 2-volume quarterly print subscription guide: Healthcare Organizations [Financial Management Strategies] http://www.healthcarefinancials.com

Speaker: If you need a moderator or a speaker for an upcoming event, Dr. David Edward Marcinko; MBA is available for speaking engagements. Contact him at: MarcinkoAdvisors@msn.com

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