Practice Valuation Basics

Practice Valuation Basics

The most important thing you should remember about your practice’s value is that while it may be outlined by the opinion of a lending institution, an experienced broker, or the mathematics of valuating future earnings, it is ultimately determined by the amount of money someone is willing to pay you for it. Your goal as a practice owner shouldn’t be to hold out for the valuator who’ll give you the answer you want to hear , but be able to demonstrate as best as you can, through your client service protocols, employee pay scales, associate workload, growth and client retention that past performance IS indicative of future earnings. That said, let’s get down to the business of outlining some top and bottom numbers for your practice. In very basic terms, business valuators and prospective buyers may want to know any of the following facts about your business:

  • What is your gross revenue
  • What is your adjusted net return or EBITDA
  • What is the likelihood that past performance is indicative of future earnings
  • What is the value of the tangible assets
  • What is today’s value of tomorrow’s expected earnings
  • Will the revenue stream support the debt service and still provide the investor with a return on any cash put into the business?
  • What are the strategic or tangential benefits of ownership that aren’t necessary apparent in the business’s financial statement?

 

Gross Revenue: Why It Matters

Some practices may be wildly profitable, but 18% profit on 500K is nothing like 10% profit on 2.5M. Practices with higher gross revenues are more attractive to prospective buyers because they can earn more money or they have the promise of earning more money if they can reign in expenses. Something that many consolidated groups can do because of their buying power.

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The Value Of Tangible Assets

When valuators are reviewing assets, they’re not looking at the balance sheet value, but the market value. They are relying upon industry experts, their own experience, and reference materials that help determine a fair asking or street price of all of the tangible assets of a business. Additionally, they are looking at the company’s debt and agreeing on how or if it will be transferred at the time of the sale. It’s important to note that many corporations and buying groups don’t trifle with valuating assets. Their ‘rule of thumb’ offer based on your adjusted EBITDA net profit, is like one big bid for everything that’s in the yard sale box.

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Past Performance is Indicative Of Future Earnings

Why a multiple of 5 or 7 or 12 times EBITDA? The answer couldn’t be more straightforward. Higher multiples reflect the buyer’s confidence that future earnings will be consistent with your business’s past performance, including trajectories of growth. The multiple of EBITDA that a buyer pays you is the amount of money that they believe your future earnings are worth in today’s money. As a buyer or seller, you may also hear the term market capitalization rate. This refers to the ratio of net earnings divided by the amount of money paid for the investment that earned the revenue. For example, if a business has a net return of 10K and the buyer paid 100K for the business, the market capitalization rate (referred to as the ‘cap rate’) would be 10/100 or 10%. Keep in mind that the capitalization rate provides no guarantees to either the seller or the buyer. It merely reflects what other people have paid for business earnings. In our industry, the general cap rate is 21% which is in perfect agreement with our ‘rule of thumb’ multiple rate of 4.5-5.5 times EBITDA. Click here to look more closely at valuation equations.

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The Value Of Tomorrow’s Earnings

For the buyer, predicting the future revenue of the practice after the transition to new ownership is the most terrifying part of a business purchase. And for good reason. Though the revenue stream comes with some question marks, the future loan payments do not. On both sides of the negotiating table, valuators will look at historical earnings (or in some cases gross revenues) and take a stab at what the business will generate in the future. By calculating an expected revenue stream, each side can take a look at their investment goals and debt service, then work backwards to determine how much to pay today for what they believe they’ll earn tomorrow. This kind of valuation is called discounted cash flow. For both sides, there are a few harbors in this maelstrom of ‘what ifs’. For instance, if the practice has a history of solid management practices, consistency of team members, and most importantly a consistent level of financial performance, then predicting future revenues is a less roiling proposition. Still there is the bigger question of what is happening in the industry as a whole. An axiom that all managers need to remember is that risk is a value killer. Any opportunity for a manager to demonstrate that historical earnings and growth can be relied upon to reoccur in the future is of real value today. Another comfort to both sides of the negotiating table is that the top price range for the practice is roughly outlined by the answers to two important questions:

  1. Does the return on investment from this business exceed the likely return one can get elsewhere?
  2. What is the maximum amount of debt that the predicted revenue stream will support?

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Does ROI from this business exceed what I can get elsewhere?

Most agree that the United States government is here to stay. The US provides investors with an opportunity to purchase a bit of that permanence in the form of Treasury Notes at a current interest rate of around 2.5%. In the financial world, barring a global catastrophe, this return is considered guaranteed. If a buyer has money to invest, the return on that investment has to at least exceed the interest on the guaranteed T-note otherwise the risk wouldn’t be worthwhile. But one doesn’t have to stop at the T-note. There are lots of other investments that may be more secure than your veterinary practice, namely other veterinary practices. Previous sales of veterinary practices establish a reference point for how much people can expect to pay for a certain amount of gross revenue or net operating income. The top end of the asking price can also be framed by the size of the loan that the net capital from the business can support. In very basic terms, your payment on the amount of money you borrow can’t exceed the amount of money you net. 

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Strategic or Tangential Benefits of Ownership

In some cases, there may be additional buyer benefits of ownership that are not immediately apparent to the seller. Imagine if you are playing gin and you discard the four of clubs. From your perspective, the card has little value, but to your opponent who holds the four of diamonds, the card is worth much more. As a seller, you don’t know all the reasons why the buyer is looking to purchase the practice, but were you privy to the gains they stood to make from ownership, you could, in theory, ask for a higher price than perhaps your earnings history merited. Fortunately for the seller, some buyers are willing to show a few of the cards that they are holding. And why shouldn’t they? Opening up a dialogue with a would-be seller gives them more opportunity to learn about the business, secure an opportunity to put a bid on the table, and partner with the seller for a smooth transition, typically a critical juncture in any ownership swap. Owners interested in selling their businesses, even years away, have nothing to lose by reaching out to would-be buyers now and talking about how each can dovetail their efforts for maximum profit on both sides of the negotiating table. But beyond the esoteric, the looming advantage that all consolidated veterinary businesses enjoy from owning your practice is buying power and expense savings. By centralizing management and marketing, tens of thousands of dollars are not only shaved off of your expense sheet (and subsequently added to EBITDA), but the money that is spent, is spent more wisely and is more effective at achieving its goals. By owning many practices, instead of one, consolidation-model companies benefit from as much as a 10% savings on their cost of goods, an amount of money that can exceed 100K per practice, depending on the practice’s size.

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Conclusion

As the above material demonstrates, the basic concepts of practice valuation are not an issue, but what business factors to consider and how much weight to give to each can be hotly contested. The recurring bugaboo in nearly all negotiations is the question of whether earnings/revenue will persist into the future (risk) and the amount of the earnings/revenue themselves. Though all practice value is ultimately decided by the buyer, it doesn’t hurt if the seller is armed with some strong talking points when negotiating for a higher sale price. Professional valuators can help. They have the experience of putting a price tag on a practice and the experience of going back to those practices after 1,3,5 and 10 years to see if they were right! This kind of first hand trial and error work is really essential in taking what is a highly subjective process and honing it to turn out reliable, accurate valuations. But as stated before, what buyers want is to be assured of continued performance and growth. Any practice that can open up its accounting ledger, its management files, and its software reportage and unambiguously demonstrate solid leadership, solid client retention and compliance, steady growth, and accurate revenues and expenses only increases the buyer’s confidence in what they are purchasing. When managing for practice value, hospital leaders should pay attention to these major value drivers.

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Growing Practice Value