Penalizing Prosperity

How to avoid losing out on your investment when it comes time to sell your practice.

BY BRAD RUDEN, M.B.A.

When starting a business, the typical goal is to grow the business and make it "sellable" — to cash out and profit from your monetary investment and sweat equity. Clearly, the larger and more profitable your business is, the more value it will have and the more you will receive on a sale.

Interestingly enough, medicine does not follow that logic. In my 16-plus years in this business, I have consistently seen larger practices routinely sell for less than the commonly accepted appraisal methodologies would indicate. There are several reasons for this, which I will outline in this article.

Perceived Limitations to Large Practices

The primary factor affecting a large practice's sale price is that there is simply a small pool of qualified buyers. Anyone can own a bowling alley, a restaurant or a hardware store, but it is rare — and in some states, illegal — for a non-physician to own a medical practice. The educational and training requirements for being an ophthalmologist create a substantial barrier and limit the pool of potential buyers. This smaller pool of qualified buyers means there is less competition in bidding for the practice or, inversely, the same pool of large practices are competing for the same qualified buyers.

A second factor limiting potential buyers is that large practices demand a combination of management ability, medical skill set and work ethic. A potential buyer needs to be qualified in all three of these areas in order to succeed. Many physicians possess one or two of these qualifications, but it is difficult to find a candidate who possesses all three to the degree necessary to succeed as an entrepreneur in a large practice.

Another limiting factor is that large practices are often intimidating to a single buyer. A typical buyer wants a practice that performs well but has room to grow. Most large practices are operating at or near peak capacity. Because a large, busy practice may be operating at its maximum ability, there is little room for error. This peak performance must be maintained, as any decrease in volume or revenue will likely result in a decrease in profitability.

Lastly, large practices carry large price tags. There are two reasons the pool of potential buyers decreases substantially when the purchase price is seven figures. First, many simply cannot qualify for the necessary financing to complete the purchase. Second, many physicians who already have debt in their lives may be very reluctant to take on substantial debt for a seemingly risky venture. A large practice combined with a substantial loan for purchase can be quite intimidating.

Internal Sale Offers Benefits

What can one do to overcome this seeming penalization of prosperity? Many owners of larger practices will discount their asking price below what may be indicated by typical valuation methodologies in order to attract potential buyers. However, if one plans ahead and time is not a constraint, my suggestion is to forgo an external sale (i.e., sale to an outside party) and instead pursue an internal sale. That is, an owner should consider recruiting one or more associates and sell the practice via a partnership buy-in. There are several reasons that an internal sale should result in maximizing the sale price of a practice. These are:

■ Knowledge of the value. The associate gets to know the practice, staff and patients from the inside. This helps to create a comfort level leading to his buy-in. The more comfortable a buyer is with the practice, the more likely a seller can get the full amount of the appraised value.

■ Knowledge of patients and staff. The ownership transition is easier when the buyer has been able to work in the practice for 1 to 2 years prior to becoming an owner. This aids in staff and patient retention when the ownership transfer occurs.

■ Knowledge of the business. Lenders look more favorably upon someone buying into a practice in which he has been employed because it is assumed he has more knowledge of the business and has developed a patient following versus an outsider making a purchase.

The phasing in of an associate allows for the timely and orderly phasing out of the owner.

In addition to the above, there are two substantial benefits of an internal sale to the selling physician. One benefit is that the purchase can take place over a period of time (typically 3 to 5 years). This allows the seller to spread income from the sale over several years rather than realizing the full amount — and the resulting tax obligation — in a single year. The second benefit of an internal sale has to do with minimizing the seller's tax obligation. When one buys a practice outright, prior to working in it, it is typically done as an asset sale. However, a partnership buy-in (internal sale) is usually handled as a stock transaction. The benefit for the seller is that a stock transaction has lower tax obligations than does an asset sale.

Considerations for an Internal Sale

One must keep in mind that a certain "cannibalization" affect will occur in both income and surgical volume when bringing on an associate. Typically, the first $100,000 or more that is generated by a new associate are simply dollars the senior doctor has forgone and transferred to the associate. An owner must be prepared to accept the decrease in volume and subsequent decrease in income when bringing on an associate. If an owner tries to retain the volume, the associate will have less incentive to complete the transaction and, in some cases, he or she may leave the practice outright.

I have had some owners of large practices express concern that an internal sale may be more time consuming. My experience tells me otherwise. Many large practices can stay on the market for years due to a lack of qualified potential buyers. Even if one is identified, they typically want the seller to stick around for 6 months or longer to assist with the transition of ownership of such a large entity. By selling via the partnership route, one reduces the uncertainty of selling and replaces it with a timeline so the ownership transfer can be conducted in an orderly manner over a predetermined time frame.

Selling a large, prosperous practice is a difficult and time-consuming task. The small pool of qualified buyers typically results in sellers getting less than anticipated for the practice. However, with forethought and planning, if one chooses to sell via the partnership route, I believe the seller can receive more for the practice, have a lower tax obligation and transition into retirement in a more orderly manner. OM

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