OBSERVATIONS ‘06
Q&A OF BLUNDERS, CAUTIONS AND STRATEGEMS IMPACTING THE PRACTICE SALE THROUGHOUT 2006 (PART II)
by Sam Reader
Compliments of S.G. Reader & Associates, Inc.
Q: What advantage is there to buying a clinic versus setting one up from scratch?
A: The primary advantage is financing. Most of the funders I work with will no longer lend money for a startup. Several of these funders have mentioned that the 50% default rate among startups over the past 15 years or so have all but killed the startup program. There are exceptions for startup capital, but the requirements are difficult and not practical. For example, most funders will require a co-signer if the doctor is a graduate of less than three years. The funder will also want the co-signer to put up collateral equal to the loan. This usually translates into an equity loan from mom and dad’s house and/or retirement account. If the doctor is seasoned, he will still be required to put up collateral equal to the loan. Unlike the process in borrowing money for an established practice with no less than three years of tax returns on the clinic, financing is much easier. In many situations, the doctor will qualify for 100% financing and a worse case scenario of 10% down. This will depend on the doctor’s credit and work history, as well as the net cash flow strength of the clinic.
Most funders will not accept an application from a doctor having under three years of work related experience. A few funders will accept an application with no less than two years. This inevitably opens a Pandora’s Box of potential problems or opportunities for the new doctor fresh out of school. With
thousands of doctors graduating each year and having no credit opportunity for startup
and/or established clinic loans, something has to give. And it does – big time. More than 50% of the new graduates find their way (like lambs to the slaughter) into an unhealthy professional relationship with eager wolves waiting to employ with a promise and hope for a prosperous future. Following a typical grueling three years of service, the employer has all but sucked the mental reserves and physical stamina from the young associate. The young associate walks out the door empty handed, except for great experiences.
For most young doctors, this associate program seems to recycle three times before the young DC says, “Enough!” To the credit of some great employers, a good many associates have created financial hardships on the clinic by simply “hanging out” (putting in time) and not pulling their own. In either event, casualties are common.
The demand for professional survival and/or finding one’s own way has created some fascinating documentary in getting to the top. For example: Doctor A from the East Coast found himself working for three years in a clinic collecting $500,000 per year. The employer offered to sell him the clinic for $600,000 – no money down – just sign the promissory note. Doctor A felt it was a good deal because he thought he had no other options, nor family to turn to for down payment.
Several years into paying the promissory note, Doctor A started feeling resentful about the price tag on the clinic. Did he pay too much? Did he have options at the time he signed the promissory note? Doctor A learned later that with his credit score in the mid-700’s, he could have qualified for 100% financing. He also learned about net income to debt service ratio.
The formula is simple:
$500,000 (collections) x 41% (overhead) = $295,000 (net cash flow)
$295,000 (net cash flow) ÷ $58,127 (annual debt service) = $236,873 (take home pay before taxes)
$236,873 (take home pay before taxes) ÷ $58,127 (annual debt service) = 4.07
In other words, the doctor’s take home pay should be around four times its debt service to the bank. The net income to debt service ratio of 4.07 is based on a 10-year note @ 9-1/2% interest. The net income to debt service ratio average in the North Central to East Coast region is between 4.62 to 6.15, not including (additional) operational cash flow in the loan. In some of the high-end communities in the Southwest, such as Scottsdale, AZ, the average is 4.42.
Doctor A would later learn that the clinic he purchased should have sold at or around $375,000, not including accounts receivable. He over paid by $225,000. At a price tag of $600,000, his net income to debt service ratio was 2.16. In other words, his take home pay was only a little over two times his debt service to the previous owner – the banker. Doctor A could feel the physical and mental wear in keeping this big clinic afloat for only $93,000 in take home pay.
When confronted by Doctor A three years into the loan, the previous owner responded that the price tag of $600,000 was justified because he taught Doctor A how to be a great doctor, and he took a risk in letting Doctor A take over. The previous owner felt this training and risk factor were well worth the extra $225,000.
Doctor B from the West Coast, on the other hand, spent 15 years working for four different employers. Promises of future ownership were dished out, but to no avail. Contracts were written; however, the contracts were vague and unclear.
It would have served both Doctors A and B well to have had contracts spelling out a practice sale formula – a formula consistent with the practice prices of the community or region. The net income to debt service ratio is the safest formula of measurement. The contract should also have timetable triggers.
It is not uncommon for some employers to provide (in addition to a salary) annual equity accrual. I’ve seen this as high as 5% per year – capped at 30%. This means that 30% is deducted from the sales price of the clinic at the time of purchase. It also means the young associate may forfeit equity points if he/she quits and/or is terminated for due cause.
Doctor C from the South Coast borrowed money from his mom and dad’s retirement account to be paid back with interest. Doctor C had many anxiety attacks during the first six years of his startup practice. The thought of losing all of his parent’s retirement monies would put him in depression, particularly when he had slow months. But somehow he found the inner strength to fight the good fight and build his clinic. Although Doctor C’s parents have been paid in full with interest, he felt it was too risky for them and would not advise other doctors to do the same. In other words, mom and dad should not loan out more than what they can afford to lose. Too many parents have lost it all.
Q: Do I have what it takes to succeed with a startup practice?
A: Next issue!
Be Smart. Be Strong. Be Helpful. Enjoy!
