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Valuing your Practice

By Dr Phillip Palmer BDS

In my 34 years as a dentist, I would regularly calculate in my mind what I felt my practice was worth. I used simplistic rules of thumb to work out what I felt was my practice's fair market value. There were always numerous anecdotes doing the rounds about different practices that had been sold and why this dentist had gotten more for his practice and that dentist had gotten less. However, when it came time to sell my practice, much of what seemed to be common knowledge about market value had changed, if it ever was valid in the first place. Definition of fair market value Fair market value is the price, in cash or equivalent, that a buyer could reasonably expect to accept, for those assets of a practice placed for sale on the open market for a reasonable period of time, with buyer and seller each being in possession of the pertinent facts and neither being under compulsion to act. Various methods of appraisal have been used over the years. Some of the methods used have fallen out of favour and more sophisticated appraisals have evolved. To establish the most accurate value possible, a combination of valuation methods is recommended. A discussion of four approaches is summarized below: Rules of thumb A practitioner who asks what percentage of gross his practice is worth is really asking for a rule of thumb valuation. Many practitioners and their advisors use this method to place value on one of their largest personal assets with no knowledge of the method's validity and often with a misapplication of the numbers that should be used in the formula.

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In Australia the most common rule of thumb I hear touted is that a practice is worth 30-50% of gross for goodwill, as well as the value of the equipment. The same is true in the United States. But when they added in the value of equipment, fixtures and fittings, etc, the average price usually comes to approximately 60% of gross. In the U.S., a study of more than 1,500 dental practice transactions throughout the United States concluded that the average practice sales price-to-grossrevenues ratio amounted to 60.4%. One statistical standard deviation (two-thirds of the 1,500 plus practice sales) had a price-to-gross-revenues figure in the range of 42% and 79%. Because the standard deviation value is so high there is a need for a custom evaluation to determine the price of any particular practice. Whatever the rule of thumb, would you be willing to use it to buy a practice that grosses $100,000 but has equipment value of $500,000? In our example above, you would end up paying $530,000-$550,000 for a practice with a gross of $100,000 and at best a take home pay of probably $20,000. Rules of thumb can work ­ but only for a narrow range of `average' practices. Is your practice really average? More often than not it is the same as a patient asking for a diagnosis by telephone. You are better off having your practice professionally appraised, rather than assuming that some rule of thumb formula would apply to your practice. Income approach. The capitalization of earnings, or income approach method is probably the most common means of valuing a dental practice by accountants, who don't truly understand all the issues in running a practice. It is one way to determine a value (how much your practice is worth) from your earnings. Securing a stream of earnings is one reason a dentist would purchase a dental practice. That is why this method of practice valuation derives some relationship

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of your earnings to the value of your practice. It has at its conceptual basis the price-to-earnings (P/E) ratios that one finds when analysing the worth of common stock of corporations. The first step is to differentiate between what the current owner/dentist earns for tax and personal reasons as opposed to what another dentist (buyer) would actually earn from the practice. One needs to carefully examine the past three years income and expenses. Revenues and expenses are normalized to exclude unusual items or items not necessary to operate a dental practice (i.e, depreciation, interest, personal insurance, automobile expenses, superannuation, etc.). After making all the necessary adjustments, we arrive at a revised net profit for each of the three previous years. The second step is to determine the investment earnings of the subject practice. That is the extra income that the practice owner makes over and above what he/she would make working in the practice as an employee dentist. We must compensate the practitioners of a practice a fair salary for service provided to the patients. A figure of 35 to 40% of collections by all of the dentists employed by the practice is typically a fair and comparable salary for a general dentist. From the normalized net profit determined in the first step, we should subtract the compensation for the services rendered by the dentists in the practice to determine the investment income to the owners of the practice. A purchasing dentist is typically willing to give some price for this amount. This amount is above and beyond what a dentist can obtain in a comparable associate position. The final step is to capitalize those investment earnings. To do this, one must arrive at an appropriate capitalization rate. Think of the capitalization rate as the minimum rate of return necessary to induce an investor to buy or hold the dental practice. The proper capitalization rate will equal the rate of return a buyer would expect by investing in the dental practice as opposed to some other investment with less risk, more liquidity and fewer administrative concerns. The riskier the investment, the higher the capitalization rate.

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Determining the proper capitalization rate is one of the most difficult procedures in this method of valuation. In dentistry, variables include speciality, practice size, location, and experience and number of staff. No standard table of capitalization rates applies to different types of dental practices. The capitalisation rate for dental practice varies between 18 to 30%, the more positive attributes the practice processes, the lower the capitalisation rate we give it, and in turn the higher its appraised value. A capitalisation rate of 25% means the purchaser could recoup his or her investment in four years. A capitalization rate of 20% means the purchaser could recoup his or her investment in five years. The appropriate capitalisation rate is applied to the weighted average of the previous three years investment income to determine the appraised value of the practice. If we were to use the capitalisation of income as our sole approach to appraising the value of a practice, the obvious problem is that it makes no allowance for the value of equipment, nor for the size of patient base (among other factors), nor for expected upgrades that would be necessary to bring the practice into line with accepted 21st century norms Thus we could have two practices side by side, with identical profits,-say $200,000 per year, but one could be state-of the art, with new equipment, and facility (and thus no need to invest anything for many years into the facility), and the other dilapidated and with 1970s equipment and they would have an identical valuation. Worse still, the modern one could have a huge patient base to grow from; the other could have a relatively small base. There would be no allowance made for these factors in a capitalisation of income valuation.

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The other problem is that we could have a practice grossing, say $800,000, with a take home of $270,000 (ie 35%). It would have a capitalisation of income value of zero (0), as there is no excess over what would be earned there as an employee. But is it really worth nothing? Market Approach Another method used to appraise the value of your practice is the comparable Sales Method or Market Analysis. A comparable study determines the value by examining and comparing other similar practices that have recently sold in the subject practice's area. While the comparable sales method may be the most valid and preferred method of appraising dental practices, a difficulty often arises in obtaining information about recent sales in the immediate market area. There are very few organisations in Australia (with the probable exception of Dentist Job Search P/L) that have the database that would enable them to maintain sufficient records of practice sales. Tangible assets This involves valuing each major category of tangible (hard) assets and intangible assets (goodwill). The total value of the practice is then obtained by adding the value of each separate asset category. Tangible assets are often referred to as the operation assets or hard assets. These assets consist of those items that have been assembled in a dental practice in order to generate income. The following is a list of hard assets: · · · · · Dental equipment Furnishings Instruments Dental supplies Office supplies

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Intangible assets Goodwill refers to the intangible assets of a practice and can be defined as those elements of a practice that cause patients to return to the practice. It also refers to the availability and existence of trained employees within the practice as well as the existence of systems, controls and methods that are part of the operations of the dental practice. The existence of a patient base, the reputation of the professional practitioner, the existence of a patient referral base, and the advantages of a location are additional components of the goodwill value. Most personal goodwill can be transferred to a new owner because most of the patients have trust and confidence in the selling dentist. Thus, the selling dentist's recommendation is likely to carry substantial weight in the patient's decision to stay with the new dentist. Most general dental practices will have a goodwill value equal to 35-45% of their three-year average gross revenues. Conclusion It is understandable why business owners, including dentists, desire a simplistic formula to determine the value of their business. However, every dental practice is distinct and different and no one formula or method is universally applicable. Just as every patient requires a thorough examination; treatment plan and diagnosis, it is imperative to assess the current condition of the practice and the numerous factors that will influence the market value of that practice in order to determine its value. I truly believe that most dentists are honourable, and despite wanting the best price for their practice, also want it to be fair to the incoming dentist. Similarly most purchasing dentists want to do the right thing by the outgoing dentist and

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give him a fair price for his practice. An opinion as to the value of a practice should be made keeping this in mind, and the obvious truth of the matter is that each practice should have a number of valuation techniques used. The average of the methods should become the agreed value. [To be published in Australasian Dental Practice Magazine September/October 2005]

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Microsoft Word - ValuingYourPractice.doc