When a practice owner plans on selling a practice, there may be a bit a shock. Practice owners are often surprised at how accountants and potential purchasers determine a monetary value of a practice. Potential purchasers have a different way of thinking about the practice.
Potential purchasers are looking at the business as an entity that generates a certain amount of money each year. The purchaser’s greatest concern is about how difficult it will be to maintain the business’s profit. After all, any purchaser could chose to invest in any number of opportunities. Why choose this business over others?
In contrast, the current owner is usually more focused on the daily details of running the business. They are often more focused on the organization’s core values, i.e., the mission of the organization, and how to accomplish those values. And the current owner often sees the business as a set of tasks that consume one’s daily attention. (See the Boss’s boss or the unreleenting business demands in mental health practice.
Accountants have some rules of thumb for determining the economic value of a business based on several years of profit and loss statements (i.e. the P & L or the income statement), the company balance sheets, the salary that the owner has been taking home, and how much it will cost the company to replace what the owner has been doing. There are companies that do company valuations. They can be a helpful resource when the time is right.
Let’s consider two businesses that look similar on paper. Business A has two partners who are very active in the daily activity of the business. Income comes to the practice largely by those owners’ direct activities. These partners have the relationships that generate the referrals and they provide most of the therapy.
Business B has two owners who are largely uninvolved in the day-to-day running of the business. They each see clients a couple days per week and rarely interact with referrers.
Now if these two organizations have roughly equivalent financials, which will be worth more? If you said Business B you would be correct. Why is this so?
Central principle for establishing value
The central business principle is this: A business has greater financial value if it is able to generate profit without the direct involvement of the owner. The more dependent on the owner a business is, the less its value. From a purchaser’s viewpoint, the less a business requires the purchaser’s attention the better. Potential purchasers want a business that “runs itself” with only occasional oversight. A business requiring less attention is harder to mess up and in short is more resilient.
Many business owners find this counterintuitive. Their own emotional attachment skews the perception of their business’s financial value. After all, no one but the owners know every detail of what it took to build the organization. And they hope compensation follows the effort. To the owners, each step had a personal cost. Sadly they may mistakenly believe that effort has monetary value.
To a purchaser it is the business as a whole and its ability to generate profit that has value. It is not the effort required to build it to its current state. Another way of saying this is to say that if something doesn’t directly contribute to the profit showing on the P & L and balance sheets, the potential purchaser doesn’t know how to place a monetary value to it, even though it may have great value to the owner.
But what about the intangibles?
There are always intangibles that an owner brings to an organization. But that is exactly the point—they are intangible. They cannot be easily quantified. Potential purchasers prefer to be able to count something and to place a monetary value on it. So again in our examples, Business B is a better value for the potential purchaser because new owners need only do a minimal amount of work to keep the business going. No doubt with increased attention they likely will see increased profit.
And what about valuing partnerships?
With partnerships the issue of valuation is much more complicated, as the variety of partnerships is very diverse. Nevertheless, value is best determined at the time of forming the partnership.
It is a great challenge to figure out exactly what the value of a partnership will be years from now when it may be time to sell. There are so many contingencies affecting its particular value for each partner. A quick example will make the point.
Suppose there are three partners and the business has been in existence for twenty-five years. They are selling the partnership to a hospital for $300,000. The first partner is a founding member of the practice and has been very active in the management of the practice and intends on retiring once the practice is sold. The second has been twenty years in the practice but is currently doing little for the whole group and has only been working for three days per week for the last five years. Partner 3 has five years in the practice and intends on staying on once the hospital takes over.
So does each get $100,000? Is it prorated by longevity with the practice? by percentage of all the sessions each partner provided since its founding? How do we credit Partner 1 for providing the managerial efforts over the years? How do we set a price on what Partner 3 is providing by staying on and adding value to the hospital?
Even with this simple example you can begin to see the complications that can arise. What if the partners who joined after the founding paid into the partnership in order to join, as some partnerships require? How is that weighted?
Obviously partnerships involve many issues that need to be worked through. An attorney will be glad to help you sort through the larger ones in order to develop a contract that will outline the plans for many scenarios that may come up. No system will be perfect, but there is enormous benefit to getting good legal counsel when setting up a partnership.
Other assets associated with practice
Rather than expecting much money out of the practice itself, many view the purchase of the commercial real estate that is leased to the practice as a more sound investment than the practice itself. Rather than paying rent to someone else for your counseling center space, the goal is to pay the rent to yourself, as you are purchasing the space.
I know of a couple of practices that set up a limited liability corporation (LLC) for purchasing the real estate the practice was leasing. The LLC then purchased a space to house the practice, and employees could buy shares in the LLC. In the end the participants in the LLC were both business partners in the real estate company and working with each other in the practice. Again, this sort of arrangement requires planning for the contingencies of disability, death, leaving the practice, retirement, and sale of the property, all ways that people may leave these arrangements.
Learning to think like a purchaser
So there are discernible reasons why accountants and purchasers of a practice will place a monetary value on a practice in the way that they do. If we understand how they value a practice, there is no reason that a practice cannot become a saleable asset and carry on into the future once it has been sold to the next owner.