Valuation of a Dental Practice & The Purchase Process
When evaluating the purchase of a dental practice, you’ll likely be interacting with the seller’s broker. It’s in your best interest to be familiar with the process: everything from the valuation and offer to the close of escrow. From my very biased point of view I’ll say, it’s those that hire their Dental CPA too late in the process that end up missing out.
First, let’s point out the obvious and note that there’s at least some degree of subjectivity with selling anything, and a dental practice is no different. During the valuation process, it’s critical to evaluate how far off the asking price is from the expected value.
When the selling owner decides to sell, they likely contacted a broker to list the property for sale. Keep in mind that the broker is paid a commission, and the standard rate is 10% of the gross sales price, and it’s paid by the seller. As such, as with any other broker, it’s in the best interest to sell the property for top dollar, which is why the asking price is almost always above their valuation. It’s important to remember that the seller’s broker, while probably a great person, is biased and looking out for their own client in order to maximize their profit from the deal.
Where to Start
The seller’s broker should have provided some sort of sales packet that contains information compiled by the broker. This is a good place to start, but keep in mind that the information in this packet isn’t always completely factual. There’s often a questionnaire that gets completed by the dentist from memory and includes questions like: “What percentage of your clients are insured?” Questions in this packet tend to be within 25-30% of actuality, so it’s helpful to remember to take this information with a grain of salt.
Financials & Tax Return
If not already provided with the sales packet, you’ll want to request the selling business’ financials and tax returns. It’s typical to provide the prior 3 years, plus the current year-to-date financials. Depending on your ability to read a balance sheet and profit & loss statement, and your familiarity with a corporate tax return, this is where having a Dental CPA on your team early can be a huge help.
In order to value the seller’s business, the starting place is always the 3 most recent tax returns. From that financial information, certain adjustments are made to account for earnings and expenses that are specific to the seller. These adjustment items include depreciation, amortization, interest paid, officer salaries, associate salaries, family wages, and auto expense. Additionally, the most recent financials are given a weight such that they count more towards the value of the current business. There are some proprietary ranges that are used to come up with a set of values, and ultimately an average value estimated for the business.
Monthly “Budget”: Cash Flow Projection
As a bit of a side note, what I do for my clients at this point is to evaluate the potential purchase. We prepare a monthly budget, which can maybe better be considered as a projection of future cash flows by month. For this specific practice that might be purchased, we want to know how much we can expect to earn each month, what expenses are involved, the tax implication, and how much cash can be expected in the new owner’s pocket each month. This involves understanding the potential loan, how equipment would be depreciated, and the timing of other large expenses. Assuming the cash flow makes sense, we continue to move forward with exploring the purchase.
Equipment: Valuation & Inspection
If you’re not familiar with inspecting equipment to determine the overall condition of machines, it would be helpful to hire an independent party not associated with the seller’s broker. Most of these “inspections” will only yield an informal value and non-warrantied condition, but it gives you either additional assurance of the deal, or potentially provides some negotiating power for any deficiencies.
The Chart Audit
Some time around now there may be a conditional offer sent by you and accepted by the seller. It’s conditional because you’ll want to inspect the practice, go through the charts, and see how everything compares to what you were told in the initial packet. The seller’s administrative staff should be able to help you pull statistics about current patient numbers and demographics, average billings, patient insurance rates, and all sorts of other information. Additionally, you’ll want to inspect the building, furniture, fixtures, equipment. Another intangible inspect will be the quality of both professional and administrative services and the patient care provided.
Equipment Split & Intangibles
Let’s say the practice is valued at $1 million. Of that, both parties agree that equipment and fixtures total to only $600,000. The remaining $400,000 is accounted for by giving a somewhat subjective value to supplies on hand, the patient list, and a covenant not-to-compete. And anything beyond that, in order to get to our $1 million total purchase price, is considered “goodwill”. Think of it as the amount you both agreed you paid more than the tangible and other intangible assets of the business. There’s a delicate dance that happens at this point between both the seller’s and buyer’s agents, which is another reason why it saves you money by having your Dental CPA involved in the process. The seller is motivated to keep the equipment valuation lower because they’ll be taxed on any appreciation recognized on these assets. The buyer is motivated for the opposite because a higher equipment valuation means that the assets can be depreciated (“written off”) at maybe 5 or 7 years instead of 15 years.
There’s a whole lot to be negotiated in a sale, and having both your attorney and CPA coordinating this process is helpful. After negotiating the selling price, equipment valuation, and finally the split of assets, you’ll move on to some of the smaller items that are often overlooked until it’s too late. For example, will the selling dentist be staying back to work for a certain period? If so, for how long, at what rate (flat/commission), as an employee or contractor, and can you pull the ripcord sooner if need be? Are you purchasing the building from the seller? If not and if you’re renting the building, has the lease been extended and terms negotiated to your benefit?
The fact is that you’re likely to overpay for the practice, as the selling broker tends to push the envelope and set the price above the true valuation. The most important thing is to consider the monthly projection of cash flows to determine if the deal works out for you. If it does, you have to ask yourself if it’s worth overpaying for the practice. Is it close to home and will it make the rest of your life easier? In the long-term, will an extra $50K make that big of a difference if there’s huge potential for revenue growth? Can the practice be physically moved to a more economical location, maybe one that you can purchase, without harming the patient list? Will the practice’s location allow for some additional room to sub-contract specialists for which you can increase billing?
Ready to Go?
Once the sale is closed, you’re going to need to have your accounting already ready and your payroll primed to pay the employees that now “belong” to you. There’s some lead time in getting your business connected with the IRS and CA EDD, but if your Dental CPA started the process a few weeks before the close of escrow, you’ll be ready to go!
Dave Sholer, CPA, MBA works exclusively with dentists in California, offering full-service accounting & tax solutions for dental practices of all sizes.
Want more info? Dave offers a no-cost, zero obligation consultation to answer whatever questions you have and/or to review your books, tax returns, and payroll situation. He will answer any specific questions you have regarding a potential practice purchase and can walk you through the entire process.