OBSERVATIONS ‘06

Q&A OF BLUNDERS, CAUTIONS AND STRATEGEMS IMPACTING THE PRACTICE SALE THROUGHOUT 2006 (PART 1)

 

by Sam Reader

Compliments of S.G. Reader & Associates, Inc.

 

 

Q:  My wife’s attorney says my practice is worth $1.5 million because I collect close to $1 million per year.  I struggle to take home $300,000.00 per year!  How can this be worth $1.5 million?

 

A:  The opposing side will usually inflate the value – for obvious reasons.  I’m sure your wife’s legal team found some formula stating the value of a practice worth 1-1/2 times its annual collections.  Some attorneys will average the collections over the last eight years, particularly if they can capture some of those Camelot years.  However, if the last eight years do not look attractive and most of the growth is shown to be over the last nine to ten months, the attorney will throw out the past eight-year average idea and value the practice based on projected collections!

 

Sound crazy?  This happens all too often, and the ideas from the opposing side become even more insane.

 

There are many theories floating around in the community, and to their credit, a few of those theories will nail a fairly accurate value.  Regardless of all the theories or formulas, it pretty much boils down to these three fundamentals:

 

1)      12 to l8 months’ net cash flow (take home pay including add-backs), plus tangible assets;

2)      Collections-to-asking price ratio (comp of the community);

3)      Net income-to-debt service ratio (funder’s comfort cushion).

 

 

 

 

 

Let’s use the example of the practice valued at $1.5 million.  The average collections for this clinic are $1,035,000.00.  The net cash flow is only $303,000.00.  The overhead is 70%.  The one-year net cash flow of $303,000, plus tangible assets, totaled $568,000.  The collections-to-asking price ratio is 1.82%.

 

Example:

$1,035,000.00 (collections) ÷ $568,000.00 (value) = 1.82% (collections-to-asking price ratio). Considering that most clinics sell between 1.22–1.38% (depending on the region), 1.82%, on the surface, looks like a pretty good buy!

 

Net income-to-debt service ratio will, in the end, let us know if this value of $568,000.00 is a good buy.  The average debt service to the funder, or $568,000.00, over a ten-year term @ 9-1/2% interest will be approximately $88,095.00.  The net cash flow to the (so-called) new owner once this debt service is subtracted is $214,950.00.

 

Example:

$303,000.00 (net) – $88,095.00 (debt service) = $214,950.00 (net to new owner).

 

The net income-to-debt service ratio is 2.43.  In other words, the new owner’s take home pay is almost 2-1/2 times its debt service to the funder.  Since this calculation does not  include the extra $400,000.00 (or so) in addition to the $568,000.00 to operate this clinic, the net income-to-debt service ratio of 2.43 is tight.  Excluding the calculation for operating cash flow, on the average the net income-to-debt service ratio on most practice sales will come in between 3-1/2 to 4-1/2 times its debt service to the funder.  This seems to be a “comfort cushion” to the funder in consummating the deal between seller and buyer.  The average net income-to debt service ratio history, based on clinics sold in high-end locations such as Scottsdale, Fort Worth, Del Mar, Solana Beach, and North Dallas, etc., is 4.42.

 

To place our example clinic under the “comfort cushion” of the funder, the net income-to-debt service ration of 3.60 would dictate that the value would be adjusted to a fair market price of $425,000.00.

 

Again, on the surface one might think a million dollar practice valued or selling at $425,000.00 is a steal.  This would place the collections-to-asking price ratio off the chart at 2.43%.  What a buy!

 

In the final analysis, net income-to-debt service ratio will trump collections-to-asking price ratio.  Why?  Because net cash flow is everything, and without the aid of a funder, there is no purchase.

 

Getting back to the opposing side’s value of $1.5 million, the annual debt service to the funder would be on or around $232,812.00.  This would leave a new net cash flow to the new owner of only $70,188.00 – a net income-to-debt service ratio of .30.  In other words, the new owner’s take home pay is one-third his debt service to the funder.  Unacceptable!  There is not a funder on the planet that would touch this project at that price.  Therefore, the clinic is not saleable because it is unfinanceable at this price.

 

In the end, the value of any practice is what the market will bear, and the market won’t bear much without the support of a funder.

Epilogue:

It was suggested to the opposing legal team to find a practice broker to list and sell the practice for the desired $1.5 million.  The response?  Suggestion denied!

 

Be Smart.   Be Strong.   Be Helpful.   Enjoy!