Is the Price Right?
An accurate analysis of a practice's worth ensures that both the buyer and seller have the right information.
BY BRAD RUDEN, M.B.A.

One of the services I offer is the valuation and appraisal of medical practices. I have been approached by doctors buying into partnership positions, and practices selling partnership shares. They're all seeking the same thing: the determination of a fair value for a practice.

No one approach can account for all of the factors and variables that go into appraising a medical practice. The key is to examine each of these factors and variables in order to determine the economic value of a practice. In general, economic value is defined as the value of an asset deriving from its ability to generate income.

When I appraise a practice, either for a buyer or seller, the first step is to determine exactly what is being bought or sold. This might sound simple but it's of paramount importance. It will eliminate any false assumptions or confusion. An accurate analysis ensures that both the buyer and seller have the right information on which to base their decisions.

Four categories need to be carefully examined during the appraisal process: tangible assets, intangible assets, liabilities, and equipment leases.

Tangible Assets

A good place to start is with tangible assets which are typically made up of office and medical equipment, furnishings, and other property owned by the practice. Cash, accounts receivable (AR) and retained earnings (RE) are also included in this category. Cash, AR, and RE are included in partnership buy-ins because a partnership buy-in is typically a stock transaction. However, they are excluded from a practice sale because most practice sales are asset transactions and not stock sales.

A balance sheet should indicate how much a practice has paid for tangible assets as well as how much cash or retained earnings are in a practice. On a balance sheet, along with the original purchase price of the equipment, is a separate line identifying the accumulated depreciation taken during the life of an asset -- this is also revealed on a depreciation schedule with tax returns. The difference between the purchase price and the accumulated depreciation is the asset's book value. Practice valuators must be careful to not confuse the book value of an asset with its actual economic or replacement value.

Depreciation is an expense created and allowed by the IRS to recognize that equipment wears out or has a limited useful life. This is done to encourage businesses to reinvest in equipment and up-to-date systems. The rules for depreciation typically allow a practice to expense a piece of equipment at a rate faster than its useful life, meaning an asset may be depreciated to zero book value in 5 years but have an actual useful life of 7 years, 10 years, or more. The result of this is that the book value indicated on a balance sheet is very often less than the actual value of those assets. Armed with this knowledge, the practice appraiser, buyer and seller must usually recast the book value of assets by straight-line depreciating them over their useful life in order to get a better grasp of their value.

Intangible Assets

The traditional definition of the intangible assets of a medical practice includes:

► established office procedures

► practice reputation and name recognition

► staff training and experience

► likelihood of patient retention

► office location

► patient demographics

► financial condition of the practice

► departing physician's noncompete clause

A transition assistance for the new owner.

These elements are intangible because they have contributed to the success and worth of a medical practice, but their values are not recorded in a practice's financial statements. The question is -- because the elements that make up intangible value are not recorded in financial statements -- how do doctors know they have actual value and how is that value derived?

Several methodologies are used by experienced appraisers for determining the intangible value of a practice. Each of these methodologies contain inherent strengths and weaknesses. Some are "backward looking" (basing value on historical practice performance). Some are "forward looking" (basing value on anticipated future performance). The basic flaw in both is that backward-looking methodologies may not be reflective of future practice performance, and forward-looking techniques rely on a certain amount of projection and speculation, which may or may not prove
to be accurate.

As such, it is my opinion that using just one methodology may not result in a true value of a practice's intangible assets. I tend to use three or more appraisal techniques to identify practice value. Their strengths and weaknesses balance each other out, resulting in a well-rounded and justifiable figure. I do believe that any methodology used must be based, in whole or part, on income accruing to the owner(s) of a practice. After all, what value can an intangible asset truly have if it cannot be converted into financial benefit for the owner?

Liabilities

Liabilities are debts owed by a practice. When analyzing the liabilities of a practice, an evaluator must first determine which people will be paid off from the transaction, thereby not accruing to the new owner, and which debts will stay in place and be assumed by the new owner, making him/her ultimately responsible for payment.

When buying into a practice, the new partner automatically becomes liable -- with the other owners -- for any debt of the practice. As such, those liabilities must be then deducted from the value of the practice so as not to be paid for twice.

As for a practice sale, most banks will not finance a purchase if there are substantial liabilities to be assumed by the buyer. When financing a practice purchase, the bank holding the note wants "first position," meaning if there is a default for any reason, the bank is first in line to lay claim to any assets to cover the default. However, pre-existing liabilities in the form of loans or equipment leases typically have first position over a practice purchase note. Therefore, a bank will want these items paid off before funding the transaction.

In some cases, the transaction is attractive enough that lending is possible without all notes being paid off -- usually these unpaid notes are minor equipment leases. In these cases, the value of the practice is increased by the value of the leased equipment; then the remaining balance of the leased equipment is deducted from the practice value to reflect the new owner making those payments.

Leases

Leases are a form of a liability; therefore, an evaluator must be careful in appraising a practice that has leased equipment. First, leases are a tax-deductible overhead expense. This means the expense shows up in historical finances. However, it may not be there as a future expense (being retired at term or being paid off prior to a practice sale). An evaluator must be careful to account for this when calculating cash flows and compensation accruing to an owner.

Second, an evaluator must be aware that there are two basic types of leases: an operating lease and a capital lease.

Operating lease. With an operating lease, such as a lease with a fair market value purchase option, the term is shorter than the expected useful life of the equipment. The lease payments do not cover the equipment cost during the initial lease term. This type of lease is popular when the possibility of near-term equipment obsolescence is likely. From an accounting standpoint, an operating lease is the simplest type of lease because the lease payments may be deducted as a business expense and there is no requirement to include the asset on the balance sheet, as long as the footnotes to the financial statements indicate the amount of your firm's lease rental obligations.

Capital lease. With a capital lease (generally done when the lease term spans 75% or more of the leased property's useful life), accounting requirements typically dictate that the lessee record the equipment as an asset and a liability on the balance sheet.

The net result is that, because an operating lease does not appear as a liability on the balance sheet while a capital lease does, an operating lease has the effect of improving a practice's debt-to-equity ratio and making it appear healthier than it may actually be.

Furthermore, by not appearing as either an asset or liability on a balance sheet, equipment under an operating lease tends to get overlooked in some appraisal methodologies. Because of this, an evaluator must be careful to account for this equipment when appraising a practice.

The Big Picture

Many factors internal and external to a practice must be taken into account when ascertaining its value. An experienced practice appraiser can help walk you through the minefield of commonly made mistakes to ensure that a justifiable and defendable value is derived.

Brad Ruden, owner of MedPro Consulting & Marketing Services in Phoenix, Ariz., is a frequent author and lecturer on ophthalmology practice management topics. You can reach him at (602) 274-1668, by e-mail at medpro@uswest.net, or via his Web site at www.medprocms.com.