By Adam Cmejla, CFP®
Dec. 8, 2021
One of the most important things to know when selling your practice is how the practice is being valued and what variables are being used to calculate that variable.
Most practice owners we talk to who are in various stages of planning an exit strategy ask us, “What can I do to get a higher multiple?” This is the wrong question. The question behind the question (and what you should be asking yourself) is: “How can I reduce the perceived business risk of my practice to a potential buyer?”
Recall from one of our previous articles that (a) the discount rate used in the valuation of your practice is the expected rate of return that a buyer desires on your practice and (b) that discount rate increases with perceived or real business risk.
The discount rate influences the multiplier used in an inverse way: the higher the discount rate, the lower the multiple. This is demonstrated using the following formula:
100 ÷ Discount Rate = Multiple of Your Practice
For example, a practice buyer that is expecting an 18 percent return on their investment would offer approximately a 5 multiple on your practice (100/18%=5.5). The buyer is more confident in the predictability of future cash flow and is therefore willing to pay you a higher multiple of your current cash flows. On the other hand, the buyer of a perceived high risk practice might ask for a 30 percent return on their investment. In this case, you’d only command about a 3 multiple on your practice (100/30%=3.33).
If you’ve done proper planning and listened to our advice and recommendations over previous articles, then you’ll have a solid understanding of what your number needs to be for your exit. What I mean by “your number” is the amount of money you need to walk away with post-sale after taxes and broker/transaction fees that, in combination with your other retirement assets and income streams, will provide you the quality of life you desire in retirement. If you know that number then you’ll be able to solve the equation that determines whether the valuation you’re receiving is not only fair but also satisfies your personal wealth-planning goals.
If you’ve received a valuation on your practice that is less than the number you need to satisfy your personal goals, then you’re left with two options: adjust your post-sale lifestyle such that your current valuation is sufficient or increase the valuation to meet the number you desire.
One of the ways that you can accomplish the latter aforementioned decision is by increasing the financial health of your practice through a higher EBIDTA (earnings before interest, depreciation, taxes and amortization). If you find yourself in the situation of having or wanting to increase your EBIDTA, here are four factors to consider to increase the pre-sale value of your practice.
Maintain or Grow Revenue
While this may seem like a “Captain Obvious” strategy, it’s easy for a want-to-be-retired practice owner to find themselves spending more time out of the practice. Maybe they reduce their clinic day by half or even a full day or take an extra week or two of vacation per year because of the desire to spend time with grandchildren or other family.
Regardless of the reason, any buyer is going to ask for at least two, usually three, years’ of practice tax returns. Declining revenues are going to spark questions that can translate into perceived challenges and business risk to a potential buyer. With increased risk comes an increase in expected return on their investment. An increase expected return on a buyer’s investment translates into a reduced multiple for you as the seller.
Reduce Your Accounts Receivable Balance and Timeline
Seeing a high accounts receivable number on a balance sheet can be a yellow or even red flag for a buyer. This demonstrates weaknesses in the practice’s business model. Lack of process or procedure for collecting revenue from patients, inconsistent billing reconciliation processes for insurance plans, and a lack of attention to practice financials, are just a few of the concerns that a buyer will have.
It’s important to tighten your collections process in your practice. Consider outsourcing your billing to a third party. Follow-up with patients to collect on unpaid balances (“Hi <<patient name>>, according to our office records we’re showing an outstanding balance on your account of $XXX from your recent purchase of <<contacts, glasses, etc.>> Are you in need of additional supplies? If so, we’d be happy to place an order to restock you with payment in full for the outstanding balance and new supply”). If that doesn’t work, consider sending past-due accounts to collections. A step further from this is to institute an office policy that glasses and contacts will not be dispensed unless the patient’s account is paid in full.
Clarify & Categorize Your Add-Backs
How to reduce a practice owner’s tax bill is one of the most common questions we get from clients, and for good reason: everyone should pay the amount of tax they’re legally obligated to pay, but no one should leave the IRS a tip. To that extent, we advocate that practice owners use their practice to capture as many tax reduction strategies as possible. One of the common strategies is to run “fringe benefits” through the practice. These take the form of continuing education trips, other travel expenses, automobile expenses, spouses and/or kids on payroll, etc. While these are all successful in reducing net operating income to the practice, it also has the ripple effect of reducing the net cash flow that a buyer would expect to earn from the practice.
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An experienced buyer like a private equity fund/group will usually ask you to detail any add-backs on your financial statements, but an OD buyer may “not know what they don’t know” and will look at the financial statements at face value. In this situation, the net cash flow to a future buyer will be higher than what’s reflected on the financial statements, but in the absence of having clarity about how much, they’re left to assume that the only expense that will be added back into the cash flow is owner salary/compensation for working in the practice.
Be sure you’re able to confidently show and prove the value of add-backs that are being run through the practice.
Admittedly, this is a recommendation that doesn’t have a clear strategy to execute. In my years of consulting and advising ODs, I’ve seen strong positive correlations between healthy financial statements and a tenured office team. Highly profitable, highly successful practices often have a tenured, seasoned team serving and supporting the practice. The inverse is also true.
There’s no silver bullet for improving this metric. My best high-level recommendations are to ensure that your practice financial metrics are within range of acceptable practice management metrics: non-OD staff expense should ideally be no more than about 25 percent of gross collected revenue and each team member should account for approximately $150,000 – $175,000 of practice revenue.
These two numbers are related. A practice with non-OD expenses greater than 25 percent has a fat payroll, and revenue per team member will typically be below $150,000. This demonstrates excess human capital in the practice, and thus, reduced earnings to the owner. A practice with non-OD staff expense less than 20 percent indicates that the staff may be overworked, underpaid, stressed and unhappy. This can lead to staff turnover and cause additional stress for the practice owner (and thus future buyer).
Spending part of your life building your practice culminates with the eventual sale of your practice. If I’ve said it to practice owners once, I’ve said it 1,000 times: you WILL exit your practice at some point. The question is whether it will be on your terms or someone else’s terms. In the absence of proactive, intentional planning, it’ll be on someone else’s terms…and unfortunately those terms are rarely in your best interest nor do they give you the most negotiating power. Focus on what you can control, plan early and plan often.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ebooks/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.