Debugging the Myths of Practice Transitions/Selling Your Practice - Part 3: Valuation Myth

The past two articles have walked you through what your timeline and exit strategy desires are, the second article walked you through putting your team together to achieve and facilitate your goals. Now let's discuss the nuts and bolts of a valuation. This process will either add or detract from a successful purchase.

Who Does Valuations? Understanding "Opinion of Valuation"

Unlike a piece of real estate, Dental Valuators are generally not licensed. Brokers or transition consultants do not generally have a license to valuate practices.

In common parlance, we refer to fair market value as "willing buyer, willing seller." This is very important because until we have a willing buyer and a willing seller, we don't have a deal. As important as willing buyer and willing seller are, the other very important elements are that "neither party is under any compulsion and that both parties have reasonable knowledge of the relevant facts." The compulsion issue stands alone.

There are rare situations where death, disability, or some other event can cause the seller to be under pressure to sell, but pressure is not compulsion. On the other hand, having knowledge of the relevant facts is another issue entirely. This is where a valid appraisal performed by a qualified appraiser using legitimate and accepted appraisal methods is critical.

Facts vs. Feelings: The Foundation of Accurate Valuation

There is a big difference between facts and feelings. I have cared for so many buyers who feel the practice is too expensive and have taken care of many sellers who feel that their practice is worth a lot more.

Both feelings and facts are important in the decision-making process, and neither should be less valuable when establishing a selling price for a seller or analyzing a practice to buy by a purchaser.

If the data is not there or suggests a deficiency in the practice, that fact must be reflected in the value. If the feeling is not there, it may not be reflected in the offer by the buyer. One buyer may feel warm and fuzzy whereas another may not. Feelings are subjective, so we will leave the feelings out of the analysis process.

The Components of Value: Net Income and Risk

Since facts and data are objective, we can look at the numbers and analyze, compare, and project to help us to arrive at a value. But the numbers are only one component of value. The other component is risk. Value is a function of net income and risk.

Risk is the subjective component to the process of appraising in contrast to the numbers, which are objective. What is important to understand is that without the objective component, there can be no knowledge of the relevant facts, and without the subjective component, there is limited reasonable knowledge.

Debunking the "Rule of Thumb" Myth

Without getting into the complexities of the different processes used in valuing professional practices, it is possible to review, in a generalized manner, the methods used, and the information required to perform an appraisal. The terms appraisal, valuation, and opinion of value may be interchanged.

To show that this is not a valid opinion of value, let's look at two practices, each grossing receipts of $800,000. Using the rule of thumb, both practices would be worth $560,000. However, if one practice has an overhead of 50% with the dentist taking home $400,000 and the other practice has an overhead of 70% with the doctor taking home $240,000, are they equal in value? Of course not.

Another example is using the same practices with $800,000 in gross production and both having an equal 50% overhead, but one has all new, state-of-the-art equipment and the other has old, outdated equipment. Again, these two practices are certainly worth different amounts, even though they provide the same amount of income to the dentists.

The Two Universally Accepted Valuation Methods

1. The Market Approach

The market approach to value uses comparable previous sales of like practices to determine value, much the same as real estate appraisals use comparable sales of real estate to establish value. This approach is the most accurate and most defendable method of valuation. It is hard to argue that like practices do not have reasonably like values.

It is information such as this that provides us with the ability to compare a proposed value to that of other transactions in order to confirm that the value arrived at using other methods of valuation falls within the reasonable parameters of the marketplace.

2. The Capitalization of Earnings Approach

The capitalization of earnings approach uses the concept that a multiple of earnings or the capitalization of earnings represents a legitimate return on investment and therefore a legitimate value. Capitalization converts earnings or excess income to value.

The problem that must be solved is, what are earnings? In a dental practice, the earnings are always distributed to the owner(s). Therefore, no earnings are identified, and with no earnings, there is no value. To address this, it is necessary to analyze and adjust the income and expense statement to determine:

• The actual required expenses that are necessary to operate the practice
• The usual and customary salary that would be paid to a dentist if he or she were to be hired to perform the dentistry in the practice

In most cases, this will result in some income left over that can be capitalized. This process requires someone with knowledge of dental practice management, industry standard expense norms, and acceptable salary ranges to do the analysis.

Risk Factors That Impact Practice Value

Once a true net income has been arrived at by analyzing and adjusting the income and expense statement to reflect real practice income and expenses, we have to apply the risk factors that impact value. Risk factors include many things, such as:

The Size Factor: Too Small or Too Large?

The size of a practice can also be a risk factor. If the practice is grossing less than $300,000 per year, it is likely that there will be little, if anything, left for a buyer after the operating expenses and the debt service have been paid. Not many buyers are willing to buy a practice if they cannot take home a reasonable salary.

On the other hand, a practice grossing $1,200,000 or more requires an experienced clinician and administrator. This experience is not readily available in most new buyers, thus once again creating greater risk in selling the practice.

Specialty Risk Factors

Specialties within a general practice also create risk. For example, if a practice has a significant portion of the production generated by a specialty such as TMJ, CAD CAM, Holistic, or orthodontics, it is hard to find a buyer who is qualified and has the same philosophical approach to the specialty as the seller.

If, in fact, there is significant specialty practiced within a general practice, the portion of revenue generated by the specialty may have to be carved out of the gross production, thus reducing the gross production and concurrently net income to the practice, thereby lowering the value.

The Build-Up Method and Cap Rates

All of the above factors need to be evaluated in order to develop a capitalization rate (cap rate). This number is properly arrived at by what is called the build-up method. The build-up method takes into consideration all of the risk factors and builds them up to a percentage number that is used as a denominator which is divided into the adjusted net income (the numerator) with the resulting number as the value.

The liquidity of money is usually determined by the prime interest rate, the cost of borrowing money (lending fees), treasury notes and bonds, and T-bill rates. The reason these are used in the appraisal analysis when considering risk is to provide a comparison to the risk of investing money in something other than a risk-free instrument.

The True Test of Value

In summary, it is very possible to legitimately determine the value of a dental practice. To do this, there are two accepted and legitimate methods: the market approach, and the capitalization of earnings approach, which, when determined, represent the value of the whole practice.

If these methods are used correctly by skilled appraisers, the value of the practice arrived at in the appraisal will cash flow. One thing that should be mentioned is that when interest rates are very high or very low, or net income in a practice is very high or very low, the impact on the build-up method to arrive at a cap rate will force the practice value out of the market range.

That question brings us full circle to: "Will a buyer buy, and will a seller sell if both have reasonable knowledge of the relevant facts?"