How Much is Too Much?
In a market that at times seems to have gone crazy, how do you know what to actually pay for a dental practice? There is no question that today’s (2017/18) dental practice purchase and sale market is often very irrational with practices selling for as much as 200% of gross revenue. In this kind of market, can you really know what is enough and what is too much? Let’s look at how to come up with the simple answer.
In today’s market almost any decent practice, depending on how it has been appraised, is going to attract multiple offers. Even practices that have been appraised on the high side are likely to attract more than one offer. Before we explore how much to offer, let’s consider today’s appraisals. It is important to know that all appraisals are not created equal; different appraisers use different methodologies. With only a very few exceptions, “Business Valuation 101” suggests that the value of any private (i.e. non-stock market) actively operating business should be a function of its profitability. In other words, practice values should be based on the practice’s net profits. Practice values are almost never correctly represented by comparative sales or percentages of gross production methods. No two practices are exactly the same and the factors that would need to be measured to compare them are too complex to be measured by most brokers; professional practice management consultants suggest that any practice will have in excess of 25 specific operational characteristics that would need to be measured and “compared”. Similarly, two practices with exactly the same gross production will almost never have the same net profit. As an owner, what is yours to keep and spend as you choose is only the net profit after tax and after your acquisition loan payments. Appraisals that do not equate value to net profit are misleading and are often a poor indicator of how much you should pay.
Fortunately, almost every appraisal will provide you with the owner’s most recent financial statements as prepared by their public accountant, further adjusted for non-practice related expenses and for a professional compensation factor. The net result of these items should be the actual net profit (sometimes called “Normalized Net Profit” or “EBITDA”) that a purchaser should expect from the practice before tax and loan payments. This is the point where a little help from an accountant or similar professional could be useful. Depending on how much the purchaser spends on the practice, a good accountant should be able to calculate the taxes and loan payment amounts that would also be payable. Both of these expenditures will be somewhat dependent on how much you have to borrow to buy the practice. Assuming that all of the purchase amount is going to be borrowed, obviously the tax and loan payments need to be less than the net profit. If the purchaser is going to be an owner occupant, then there is actually a little more cash flow that could be available. Remember, the net profit includes a “Professional Compensation” amount equal to what an associate would normally get paid. A purchaser would actually have the Net Profit plus the “Professional Compensation” which could be used for taxes and to service debt.
The question remains as to how much is enough, and how much is too much? To begin with, anything that requires more cash for taxes and loan payments than the Net Profit before Professional Compensation, is absolutely too much. Chances are anything that requires more cash than the Net Profit alone is also probably too much. That sounds simple, but what do you do when you want the practice and you know there will be competing bids? What you should do in this case is offer the most that you can afford but not so much that your taxes and loan payments are more than the net profit. This is where you need to sit down with your accountant and have them do some “what if” calculations for you so that you can pay enough to get the practice but not so much that you go broke doing it.