practice made perfect
Some Assembly Required
BY MARILEE BLACKWELL, M.B.A., C.P.A., A.I.B.A., AND DONNA SUTER

Ever found yourself trying to read a sche-matic describing how to put together a gift late into the night? And, of course, you find you have one or two left over pieces. Transition planning, just like a tricycle, is best put together before the last minute.

Many O.D.s wait until they are ready to retire to start thinking about an exit strategy. With a last-minute approach, O.D.s do not know the value of their practices until they are ready to sell. And at that point they don't have time to make improvements that would enhance the value of their practices. Lack of planning, for some, means just closing shop.

Even if you can fix anything, glancing at an instruction manual confirms that you have all the pieces you'll need. Just having a transition plan makes the seller's life less stressful because you've already identified potential difficulties. This reduces the probability of unsettling surprises at the time of implementation. A favorite family story of Donna Suter's was the Friday night she decided to fix the garbage disposal in the kitchen sink on her own. Try as hard as she could, one section of pipe wouldn't stop leaking. The plumber with his training, on the other hand, only took 15 minutes to assess the situation and fix the problem.

Be prepared

In a perfect world, transition planning and implementation would include the following steps:

►Make sure all the pieces are there. This is done with an evaluation of the practice to estimate value and build on its strengths, while working on weaknesses. Depending on the situation, you might perform the evaluation five to seven years before retirement.

►Confirm you have the proper tools. The tax tools to transition and sell your practice vary with your accountant's choice of entity (sole-proprietorship, S Corporation, C Corporation, LLC, etc.) The right tools create a smooth path for transition and reduce your ultimate tax burden.

►Look at the instruction manual. Get an appraisal six to nine months prior to sale. This timeframe gives you a cushion in which to negotiate price and finish the legal documentation. The sale or purchase of a practice is a large transaction. Your consulting team should include your appraiser, CPA and attorney.

►Avoid unnecessary delays. If forming a partnership, work with your consultant to develop a financing plan that will allow both partners to meet their income goals and for the new partner to pay off the acquisition debt in a reasonable time.

Selling the family business

Three generations of Haydens had owned Hayden Family Eye — grandfather, father and daughter (Dr. Abby Hayden). The family was well-known, respected and active in community events.

The practice was grossing $760,000 and netting $220,000, or 29%, and Dr. Abby Hayden was 10 years from retirement. As part of her transition plan, Dr. Hayden wanted her part-time associate, Dr. Rachel Herrera, to become a partner. Dr. Hayden wanted Dr. Herrera to buy 50% now and the other 50% of the practice in five years.

At the time Dr. Hayden contacted us, she was working five days per week and Dr. Herrera was working two and a half. Dr. Herrera was also working at a commercial practice outside Dr. Hayden's drawing area two days per week.

With the exception of office overhead, all expenses were within the normal ranges. One and a half full-time equivalent O.D.s. produced the gross revenues.

Assembly required ...

Sounds good so far, right? Well ... there were complicating factors. The practice was located in what had once been a thriving community. It was now low-income. The population was declining due to changes in roads and local businesses closing. Those remaining showed a high unemployment rate and a low median household income. Revenues had steadily declined over the last five years.

According to the American Optometric Association in "Caring for the Eyes of America 2004," "the frequency of eye examinations in 2003 did not appear to vary by annual house- hold income, suggesting that the scope of insurance coverage (if any) may be a significant factor in determining the examination interval." In Dr. Hayden's case, the high unemployment in the area had reduced the frequency of exams, and low household income exacerbated the problem. The practice's revenue per patient was low at $125.

Not a good, safe bet

From an appraisal point of view, the economy and demographics significantly increased the risk of purchasing the practice. Based on history, there was a good chance that the population would continue to decrease and unemployment would increase, resulting in prolonged erosion of practice revenues. Declining revenues would reduce the income available to the doctors and for Dr. Herrera to pay back her acquisition debt. Higher risk means lower value. Given current demographics, historical revenue and expense trends, the practice appraised for 50% of collected gross revenues —- $380,000.

Dr. Herrera's family had also lived in the community for several generations. Even though the future demographic and economic outlook was not good, she wanted to stay in the area. Dr. Herrera decided to buy in to the practice even though the risk was high. She wanted to work full-time and eliminate the long commute to the commercial practice.

Consider the options

The three primary ways to finance the sale of a practice are:

1) Outside financing
2) Seller financing
3) An earn-in.

It's possible to get outside/ bank financing for the purchase of 100% interest, but difficult to get it for the purchase of a partial interest. This often means that the seller has to finance the deal or agree to an earn-in.

With seller financing, the seller acts as the bank. The buyer becomes an immediate 50% owner and pays the seller principal and interest. The drawback to seller financing is that it puts the seller in the position of both partner and creditor, which can lead to big problems later. Another drawback: The buyer is compensated as a full partner prior to paying off the acquisition debt. We usually don't recommend seller financing.

With an earn-in, the buyer reduces her compensation each year to "earn in" to her percentage of ownership. For example, let's say that Dr. Herrera wanted to earn in to 50% of the practice over five years. She would "earn" 10% of the value of the practice each year and reduce her compensation by 10% of the sales price. Dr. Hayden's compensation would increase by 10% of the sales price each year for five years. With an earn-in, the buyer is not compensated as a full partner before she pays off her acquisition debt. In a partnership transaction, an earn-in is preferable to seller financing.

Where there's a will ...

Under the current arrangement, Dr. Hayden was earning $180,000 per year and Dr. Herrera $40,000. Dr. Hayden had children in college and could not take a huge decrease in her income in order to make the partnership work.

The sales price of 50% of the practice was $190,000, with Dr. Herrera making a $10,000 down-payment. Dr. Herrera's parents were able to loan her the remaining $180,000. The terms were $10,000 down and 5% interest over five years. Dr. Herrera's payments would be $40,000 per year. In order to generate an additional $40,000 net to pay off the acquisition debt, the practice would have to produce additional revenue of $140,000 per year. In a growing community, $140,000 wouldn't be that difficult. But in this community and given the practice's history of declining revenues, $140,000 would be a stretch.

We decided that the most effective way to increase revenues was to emphasize the health portion of the exam in the clinic and affordable prices in the optical. In our initial on-site consultation, we noticed the staff had poor phone skills and non-existent computer skills. In the optical, there were poor quality frames with little variety and little or no patient education.

In the clinic, we introduced dilation and blood pressure measurement as the standard of care, and scripted staff to explain the medical reasons behind each test. We added retinal photography and corneal mapping, and had the doctor explain how lifestyle choices like smoking contribute to eye disease.

In order to take advantage of reimbursement from managed care plans, we stratified our fee structure and changed the way comprehensive exams were billed and coded. We added specialized testing on a fee-for-service basis for diabetic patients. Then we trained the technician to collect more information for the doctors and educate the patients about the importance of the tests. We also trained the para-optometric assistant to make lens technology recommendations based on a patient's lifestyle.

Because the building had the room, we added a lens fabrication unit that only charged the doctor for materials. This allowed the practice to offer a no-questions-asked replacement warranty. We evaluated frame lines and stocked only those that offered a two-year warranty.

The finished product ...

Dr. Hayden was very pleased with how the recommendations "fit together" in the end. After studying the situation, turning this piece another way and re-aligning others, this "midnight project" emerged with higher revenues and profitability. The numbers speak for themselves (see chart on page 83). By following our recommendations, the practice increased revenues in the first year, with more increases projected for the next four years. The rise in revenues came from an increase in practice net from 29% before we started, to a projected 35% by the fifth year.

Dr. Hayden was able to piece together her exit strategy by moving her practice into the 21st century. The conversion wasn't any easier than restoring an antique car. But we all agree that the results were worth the sweat, equity and following the instruction plan to the letter.

Ms. Blackwell, president, Blackwell Consulting, (800) 588-9636, and Ms. Suter, president, Suter Consulting Group, (423) 236-5465, team up to offer financial guidance and on-site consulting services designed to increase your gross revenue and improve your net income percentage.