Strategies for Buying Your First Practice
Sometimes it’s better if you color outside of the lines.
If you are looking to buy a practice that will be your home, not an investment practice but the practice that you work at growing and building yourself, get ready to do things a little differently than you expect.
A properly appraised dental office is a function of real profitability, sometimes called EBITDA and Return on Investment. If you take real (normalized) profitability (EBITDA) and divide it by your desired Return on Investment (ROI) you will get a number that reasonably represents the value of the practice.
This is the basic formula used by Chartered Business Valuators or their equivalents everywhere. So, what secret strategy can I bring to the table? Let me explain.
The earnings statement or statement of profit and loss as prepared by your accountant is normalized during the appraisal process. Normalization is the process whereby anything that is not an essential expense is added back into the profit or in some cases removed from the profit. This is in the attempt to create an earnings statement or EBITDA that contains only but all of those revenues and expenses that relate directly to the operation of the practice. One of the major adjustments is to calculate and include as an expense a “Professional Compensation” amount equal to what an owner would have been paid as an associate.
Let’s assume that you find the practice of your dreams and includes everything that you wanted.
You get very excited and start looking at the numbers. The Normalized Earnings Statement looks something like the following:
In this example, the true profit is $420,000 and with a current ROI of 19% (which is a multiple of about 5.25) the value would be estimated at about $2,205,000. The true profit of $420,000 is about 19% of the appraised value of $2,205,000. A few more calculations would show that by the time you pay the bank and CRA most of your $420,000 is gone but you would still be left with about $60,000 of profit – not bad – you think.
It’s about at this time however that your advisors point out that we are likely heading into a second COVID wave and buying a practice now would be way too risky. “What if some patients decide to wait until COVID is totally gone before they come back to the dentist? What if the transition doesn’t go so well and you lose some patients? You could be underwater!!” From a profit perspective, this is actually correct. If your gross falls off by only 5% your profit would drop to $339,000 and after you pay the bank and CRA you would be $8,000 in the hole. This is not good and you realize that your advisors are right: you can’t buy this practice, the practice of your dreams, if it could take you into the hole, so you pass.
Unfortunately, you missed one important consideration. In determining the real net profit, the appraiser assumed that you paid yourself as if you were an associate. Even in the worst-case scenario above your professional compensation would have been $456,000 so assume that you cover your $8,000 shortfall out of your professional compensation, you still have $448,000 to live on. Of course, there will be some income tax in there somewhere and that will depend on how your accountant sets you up – either way, you will likely have lots of cash flow.
The takeaway here is that your disposable cash flow is not just the profit from the practice but also the professional compensation that is factored into the valuation formula. Right now, there are some very good opportunities in the marketplace however there is potentially also a lot of COVID-related risk. Before you pass on what could become your perfect practice make sure you color a little outside the box and don’t succumb to advisors who don’t see the whole picture.
If you are considering a purchase and you are uncertain about the cash flow or if an advisor is telling you that there is too much risk give us a call at 866-853-5344.
We have almost 40 years of experience both as brokers and as practice enhancement coaches and we will help you look at the situation from inside and outside the box. As always, I can be reached at:
Derek Hill (firstname.lastname@example.org)