by Barry F. Levin, Esq. and Philip M. Bogart, Esq.
Performing a valuation for a dental practice is a daunting task with many complexities. A dentist can easily pay thousands of dollars to a professional valuation company to determine the fair market value of a practice. Before spending that money, it is vital to choose an appropriate valuation expert, and to properly understand the benefits and limitations of the valuation report.
Unfortunately, there is no standardized universally accepted formula that a valuation company may use to establish the value of a dental practice. There are many objective factors that should be considered to determine the value, and there are just as many non-quantifiable subjective factors unique to the dental industry (and to each specialty within the dental industry) that are just as important as the objective factors. Contrary to many individuals holding themselves out as experts in dental valuations, there is no handy rule-of-thumb that enables someone to determine the value of a practice by looking at a few facts and figures.
Ultimately, although it may be an overused cliché, performing a valuation of a dental practice is more of an art than a science. That is why it is imperative to work with a trusted advisor with ample experience in the dental industry to develop a reasonable and useful dental practice valuation. (In truth, in order for a dentist to make a fully informed decision, it is advisable for all members of a dentist’s team, including his/her lawyer, accountant, and financial advisor, to understand the dental industry, and the value, earning potential and challenges of a dental practice.)
The ideal valuation expert should be able to do more than merely analyze the numbers of the dental practice. Rather, the expert should understand the key drivers of profitability and growth that are unique to the dental practice being evaluated. Each dental specialty has its own peculiarities that must be taken into account. Clearly, certain characteristics relevant to a general practice owned by a 60-year-old dentist in a growing area in rural Kentucky may not be as important to a 30-something oral and maxillofacial surgeon in downtown Chicago. (Better yet, does the valuation “expert” understand what a maxillofacial surgeon is and how to grow a maxillofacial surgery practice? Can he/she even spell maxillofacial?)
Although there are many methods that may be used to value a dental practice, most approaches tend to fall into one of these three methods:
1. Asset-based valuation
The asset-based valuation method calculates the value of the dental assets of the practice that may be sold. These assets may be valued based on the original cost, the book value (reduced by depreciation), or the replacement value or appraised value.
The shortcoming of valuing a practice based solely on its assets is that the practice’s earnings and cash flow are not considered. Additionally, it is very difficult to accurately appraise the value of the goodwill of a practice. Any valuation of a business in the services industry should include an analysis of the profitability of the venture. As a result, this asset-based method is rarely used without also consulting one of the following two methods.
2. Market comparison valuation
The market comparison valuation method identifies similar practices that have been sold and applies certain ratios of those recent practice sales to the subject practice. There are several different valuation ratios that may be used by a valuation company, including the ratio of the sales price to 1) discretionary cash flow, 2) annual net profits, or 3) annual revenues of the practice. Intuitively, looking at recent sales would seem to be an effective method for valuing a dental practice. Many times, however, the unique features of a given practice are ignored; no two practices are the same.
3. Income-based valuation
The income-based valuation method identifies the projected future cash flow of a practice. The amount of cash flow is then capitalized, discounted, or multiplied based on one of the following methods: 1) the present value of future earnings (also known as the discounted cash flow method), 2) a capitalization of excess earnings valuation, and 3) a multiple of discretionary earnings valuation.
Many valuation experts favor this income-based approach, as it recognizes those critical components of a practice’s ultimate success. The income-based valuation method enables the valuation company to determine a reasonable price that a prospective buyer may pay for a practice, based on the realities of the practice, including the practice’s revenues, expenses, and an appropriate income for the buyer.
In addition, the income-based valuation takes into account the purpose of purchasing an existing practice: the expected revenue stream of the practice. Thus, one of the most important factors to quantify is the owner’s actual compensation, which includes the salary listed on the owner’s tax return, the value of all of the owner’s other benefits (i.e., health insurance, etc.), and the value of all of the owner’s other perks (e.g., company car, trips, and client entertainment). Keep in mind the IRS may deem these so-called perks to be taxable income! The point is that the income listed on a tax return or a profit and loss statement is not necessarily the same amount of revenue (or value) that was really earned by the seller or could be earned by the buyer. All relevant factors should be considered to determine the owner’s actual compensation.
Relevant data to review
Regardless of the valuation method, the outcome is merely a preliminary value. The following is a partial list of significant items that should be reviewed and considered by the valuation company:
- Recent income statements and income tax returns
- Percentage of collections used to cover overhead
- Equipment valuation — this should typically be performed by an independent dealer. The present value of all usable clinical supplies and hand instruments should be assessed, as well. In addition, does the practice own or lease the equipment?
- Cost of all leasehold improvements and date each improvement was made
- A production and collections report and a breakdown by each dentist and hygienist
- An accounts receivable and aging report. In addition, what percentage of the accounts receivable is actually collected?
- A description of any contractual relationships of the patients, employers, or insurance companies including HMOs, PPOs, DMOs, and capitation plans and when the contracts expire.
- A breakdown of practice expenses for insurance, retirement benefits, employee benefits, payroll taxes, medical reimbursement, telephone expenses, and continuing education.
- Total number of active patients. If this is the valuation of a specialty practice, a list of referring dentists would be extremely helpful. Also, number of new patients per month.
- A detailed physical description of the office, including, by way of example, the number of operatories
- A copy of the lease (including any options to renew or purchase). Does the dentist own the property, or does he/she have an option to buy the premises from the landlord?
- To the extent the owner/seller has other dentists employed, are there strong and enforceable non-competition and non-solicitation agreements in place?
Now what? How to use the valuation
Remember, the value of the dental practice determined by the valuation company may not be even remotely close to the actual agreed-upon purchase price. Quite often, the purchase price may not accurately represent what the seller (or the valuation expert) believes the dental practice is truly worth. Like swallowing a dental crown or an amalgam filling, this reality will be a bitter pill for the selling dentist to swallow. Of course, a seller typically believes that his/her practice is worth more than it really is. Moreover, in many situations, the valuation company represents the seller, so that valuation company will have no problem inflating the price for its client.
In fact, as a result of the country’s recent recession, many dentists are postponing retirement. Many dentists who do retire feel compelled to demand an inflated price as a result of the reduction in their retirement accounts. Conversely, the downturn in the economy has caused many dental practices to diminish in value. This is particularly the case because buyers care about the expected future earnings, not the past earnings of a practice.
It is essential to keep in mind that the “fair market value” of a practice is typically defined as “the actual selling price at which a practice will change hands between a willing, knowledgeable buyer and a willing, knowledgeable seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, and both parties have reasonable knowledge of all relevant facts.”
In other words, a dental practice is only worth as much as someone is willing to pay for it! Arguably, even the most customized valuation report may serve only as a springboard or a rough blueprint to commence negotiating the purchase price of a practice. That said, a comprehensive valuation conducted by a well-regarded expert establishes a rationale for the purchase price, which may be very helpful in marketing and negotiating the sale of a dental practice.
Barry F. Levin is a partner and vice chair of Saul Ewing LLP’s Business Department.
Philip M. Bogart is an associate in the business department in Saul Ewing LLP’s Baltimore office. They represent dentists and the business entities in which clinicians practice in all aspects of the dental practice structure through and including the structuring, negotiation, documentation, and implementation of associateships or employee arrangements, partnership arrangements, acquisitions, sales, and mergers of mature practices.