By Erik Ferjentsik, MBA
Dec. 12, 2018
How do you determine the value of anything? For cars, we have Kelley Blue Book, Carfax and other resources. For stocks, we have company financials, public data, advisors and online tools. For real estate, we have sites like Zillow, building inspectors, publicly available data and realtors to perform a comparable property analysis.
But for privately held service businesses, like optometry practices, there is no directory or one-stop shop to obtain such information.
As a service business, much of the value of a practice is connected to intangibles, such as its history, patient records, production, online presence, brand reputation, cash flows and staff experience. It’s much easier to determine what a set of snow tires, or a remodeled kitchen with granite countertops, is worth than it is to value an office with 10,000 patient records, 20 percent of which are Medicaid, and located in a medical building that was last remodeled 12 years ago.
As an experienced practice appraiser, and co-owner of an optometric practice with my optometrist wife, I cringe when an OD calls my office and says, “I already know what my practice is worth…I read an article that says they typically sell for 65 percent of gross sales. So, I don’t need an appraisal, I just need your help selling it.”
Would you price your three-bedroom house at $150,000 if you read an article that said all houses sell for number of bedrooms x $50,000? Of course not. There are many variables tied to the value of an asset, all of which need to be reviewed.
Let’s take two examples.
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Practice 1: Pretty Practice
Pretty practice was remodeled last year, has old and new equipment, and $100,000 wholesale inventory. The 4,000 square foot mega-facility boasts four exam lanes, spacious optical, finishing lab and EHR. Four ODs work at the practice, along with six support-staff employees. The practice shows gross revenues as of the last tax year at $1.6 million.
Practice 2: Ugly Practice
Ugly practice has pink-shag carpeting, dated equipment and no retail inventory. The 1,500 square foot office has two exam lanes and still uses paper records. Only one owner OD works at the practice with two employees. The practice gross revenues as of the last tax year were at $500,000.
Can you tell me which practice is better, or what each practice is worth? Not a chance! You don’t even have 0.1 percent of the info you need to properly asses each opportunity. But according to that trusty article you read, you do have enough info. The Pretty Practice would be worth $975,000 and the Ugly Practice $325,000. So, let’s just skip over the appraisal and start negotiating, right? WRONG!
What if I told you that the Pretty Practice was worth less than the Ugly practice? It is! Why? Well, when looking at the other 99.99 percent info needed, your practice appraiser points out that the margins of the Pretty Practice are substantially lower than the norm.
The appraiser notes that rents are $135,000 triple net with high common area charges. The lab is not profitable. Each OD is only generating about $400,000 in revenues, which isn’t enough to cover expenses for each OD and support staff. Upon reviewing the lease, it is uncovered that the gross sales are tied to rent increases, which automatically increase 5 percent every year at minimum regardless. There are no options to renew after one more year of rent.
Cost of Goods Expenses (COGS) are too high at 45 percent, signifying employee or patient theft and poor pricing and discounting policies. This practice spends $200,000 per year on marketing to fill all the ODs appointments (the appraiser who is also a consultant determines that $150,000 is wasted on Google AdWords that does not reach the target market).
It is determined that 60 percent of the inventory is unsellable. The practice sees 30 percent Medicaid, 20 percent Spectara and 30 percent other low-reimbursement insurances.
The appraiser calculates Owner’s Discretionary Income (a.k.a True Net, EBITDA, Restate Net Income, Owner Cash Flow, and several other possible variations) to be $180,000 before any salary is taken out for the owner OD who works full time seeing 25 patients per day. Most staff, including associates, have only worked for the practice less than three years. Now on to the Ugly Practice.
The Ugly Practice has extremely strong margins because many expenses are lower than usual in rural area practices. Rents are only $15,000 fixed per year gross with three years left on the original lease and two five-year options to renew. The landlord only charges 3 percent escalators every renewal term. There are no COGS for this practice because they don’t sell frames.
With no optical, less space to rent and lower volume of patients = less staff = less payroll expense, the practice has lower expenses, and less managerial requirements. This practice spends virtually nothing on marketing because it is the only practice for 30 miles and has an outstanding reputation. The practice accepts a handful of insurances, no Medicaid and a strong amount of cash paying patients for specialized clinical services.
The owner OD only sees about 12 patients per day and all staff have been there for over seven years. The appraiser calculates owner’s discretionary income to be $250,000.
Now, to answer the question, which is a better opportunity? That will depend on whether each practice is properly appraised and priced as well as the prospective buyer. A qualified practice broker can help you determine which is better based on your desires, capabilities and experience.
The appraiser, in this sense, can put on a consultancy hat and help the buyer turn the problems uncovered in the appraisal into improvements and growth opportunities. But to make some obvious conclusions – the owner of the Ugly Practice sees half the patient load of the Pretty Practice, while generating $70,000 more per year.
The Ugly practice will require more capital improvements sooner, but it’s not too difficult to replace carpet, remodel and convert to EHR. It’s certainly not as difficult as resolving a culture of employee theft, renegotiating a lease with an unreasonable landlord, or moving to a better location. The risks faced by the owner/buyer of the Pretty Practice would arguably be greater than that of the Ugly Practice. All such variables, and more, should be factored into a valuation and/or the buyer’s perception of value.
It turns out, that using the 65 percent of gross formula would have overstated the value of the Pretty Practice by hundreds of thousands of dollars, whereas the Ugly Practice value would have been significantly undervalued.
So, yes, when buying, selling, or partnering with an optometric practice, one should obtain a practice valuation from a qualified optometric appraiser. An appraisal takes 30+ hours by an expert to complete. So, it doesn’t make sense for an OD to try and become an expert overnight by Googling valuation methodologies. Much the same, I won’t Google “how to give myself an eye exam,” and try to cut out the optometrist!
It’s customary for a practice seller to get the practice appraised first. The act of ordering an appraisal (and hiring a broker) shows the buyer’s market that you are ready to sell and that your practice can provide enough data to complete an appraisal and justify the asking price. Your broker will review the appraisal with the buyer, who then has the option of ordering a second opinion appraisal.
The ensuing negotiations can then be based on data and fact versus arbitrary buyer/seller opinion. This will help keep negotiations non-emotional and preserve the relationship between buyer and seller, which is important to ensure a smooth transition. Additionally, banks will use the appraisal to underwrite the loan, which helps the buyer get approved for financing.
One more thing…many think the purpose of an appraisal is to arrive at a selling price. While this is certainly an important output, the real value of an appraisal is having an expert third-party develop a deep understanding of your financials, which can then be applied to the many phases of the practice purchase and sale process thereafter. You will need an experienced party to mediate interactions with buyers, banks, landlord, lawyers and accountants and guide all parties through the many complex phases of a practice transaction.
Having an appraisal in hand without a broker to facilitate the rest is like giving a patient their keratometry results and wishing them luck in figuring out their prescription and eyewear. Selling/buying a practice is a complex and arduous process with many variables that differ over time and for each unique transaction.
Ultimately, the value of an asset is worth what someone is willing to pay. Since there is no publicly available info showing what practices are selling for, you must rely on a firm that specializes in practice sales, and can apply internal data and direct experiences to the process of placing a fair market value on the practice and facilitating the transaction process thereafter.
Erik Ferjentsik, MBA, is President and Principal Consultant of Visionary Practice Group, an optometric consulting and brokerage firm “specializing in providing practice appraisals, brokerage, and consulting services for optometrists in transition.” Erik also owns a successful optometry practice with his wife, Kelly McGlynn, OD. To contact: (877) 268 – 8881, or firstname.lastname@example.org .