Many optometrists at some point will be involved in a practice sale or acquisition. Some may even be involved in both, as either a buyer or a seller.
Having been personally involved in multiple practice sales and acquisitions, we have observed certain pitfalls.
Here, we discuss these pitfalls, so ODs can increase the likelihood of a smooth process with their practice sale or acquisition.
Underestimating the simplicity of practice value
The basic concept of business valuation is cash flow. The larger the entity participating in the transaction, the more basic this concept is. This is because their primary interest is taking the cash flow, growing it, and repackaging and selling the practice for a profit. A common expression used especially by large-size buyers is earnings before interest, taxes, depreciation and amortization (EBITDA). That’s cash flow and, that’s what they want to purchase. If, however, another doctor wants to buy the practice and establish their own professional career, then intangible items, such as updated equipment and goodwill, are of value. The bottom line: Know what matters to the buyer, so you can provide the practice data they value.
Underestimating the complexity of practice value
Many complexities can play significant roles in calculating a practice valuation. Just as the OD seller may not grasp the simplicity of practice value, they can also overlook:
• Time value of money. Dollar value today is not dollar value tomorrow because of inflation, rates of return, and risk.
• Opportunity cost and discount rate. When deciding to purchase a practice, what business opportunities are you giving up and should a discount rate be applied?
• Inflation rate and employee salaries and benefits. Rising costs influence
future return rates on cash flows.
• Growth rates. What are current market trends? What is the future potential for growth? Does it support optimism for future revenue accretion?
• Capital expenses. What is required to bring the practice up to standards?
• Depreciation. This is a non-cash expense, which is important because it reduces taxable income.
• Number of years to analyze cash flows. How many years is the buyer willing to risk their money on the investment? Big companies are generally looking to flip an investment in a competitive time window. A small individual buyer, however, may be investing their entire career and, thus, looking at a less rigid return window that could last a lifetime.
• Working capital. What are the short-term cash-draining assets required to properly run the acquired practice?
• Buyers in the market. Multiple buyers in a market can drive up values and vice versa.
• Buying spree. Companies desiring a particular area tend to pay more for a practice. Once they have saturated the area, they tend to pay less.
• The interest rate effect. As the cost of borrowing increases, buyers tend to offer less. Some buyers may be well capitalized and, thus, able to pay higher multipliers.
• The add-back effect. Buyers often allow sellers to add some expenses, such as a vehicle, back to the EBITDA to help increase the value of the sale.
Unawareness of real estate variables
Real estate can bring many variables to a practice sales transaction. As an example, let’s assume the optometrist seller owns their building. Now, let’s assume the practice buyer desires to occupy the building and include a property lease as part of the purchase transaction. A 10-year lease is a 10-year lease. However, a five-year lease with a five-year option to renew the lease is not a 10-year lease. It is only a five-year lease. The value of an option is heavily weighted in favor of a tenant, not a landlord. When the optometrist seller retains ownership of the building, they become the landlord to the buyer. At the five-year lease’s end, the tenant (practice buyer) can either renew the lease at a preordained price or renegotiate the price, always lower, or even vacate the property, which leaves the optometrist seller landlord with an empty less-valuable piece of real estate with the potential of reduced or even no cash flow. An ironclad non-compete may even prevent the optometrist seller from practicing in their own building. That is a truly ironic situation.
Mismanagement of payment terms
Practice purchases often produce a variation in terms of payment. Is the practice purchase paid to the OD seller in one lump sum, or is it stretched out over time? Keep in mind that the buyer who stretches payments out over time can ruin a practice and then not pay the installment obligations. It happens. Thus, always remember that the seller who gets the money up front has the money. They can reinvest that money and start earning dividends, interest, or pay off debt obligations.
PRESENT VALUE FORMULA AND CALCULATION PRESENT VALUE = FV / (1+R)N
where:FV=Future Value
R=Rate of return N=Number of periods
Stretching Out Payments of a $2 million sale over three years with 40% down, plus three 20% annual payments
|
|
% |
|
Rate of |
Number of |
|
|
|
Payout |
Future Value |
return |
periods |
Present Value |
|
Year 0 |
40% |
$800,000 |
|
|
$800,000 |
|
Year 1 |
20% |
$400,000 |
8% |
1 |
$370,370 |
|
Year 2 |
20% |
$400,000 |
8% |
2 |
$342,936 |
|
Year 3 |
20% |
$400,000 |
8% |
3 |
$317,533 |
|
Total |
100% |
$2,000,000 |
|
|
$1,830,839 |
Sample Calculation Using the present value formula, let’s look at year three in this hypothetical example:
FV = $400,000 R = .08 (8%) N = 3 (year 1,2 and 3)
Present Value = $400,000/ (1.08)(1.08)(1.08) = $400,000/1.259712 = $317,533
Failure to scrutinize the employment contract
Generally, most potential buyers want the optometrist to remain as an employee to initiate a smooth transition. Typically, the buyer will want to run the practice their way, which may be an issue for the OD seller. Examples can run from an employed associate optometrist acquiring the practice and possibly not wanting the selling OD remaining forever, to a large company purchasing the practice and wanting the selling optometrist present at least until they have the time to integrate a new employed doctor into the practice. Let’s assume, for example, that one potential buyer wants the selling optometrist to remain in their employ for three years at a salary of 18% of the OD’s production. Let’s assume another potential buyer
wants the selling optometrist to remain but at a 15% compensation rate of production. All other factors, such as vacation time, office hours, IRA contributions etc., will be equal. At first glance, a 3% difference in production compensation may not seem like much, but let’s say the OD seller who remains employed produces $1,000,000 annually in collected patient revenues. Each year, that would amount to a 3% variation in remuneration adding up to $30,000 per year or $90,000 over the three years. A total of $90,000 in compensation would presumably be something to carefully consider for the selling optometrist.
Benefit variables can and should also be scrutinized by the selling OD. As an example, the buyer may require the practice be opened on holidays it was closed under the optometrist seller’s (now employee’s) management.
Ignoring the age factor
From a financial standpoint, selling when the optometrist is too young can cost real dollars over time. At some point beyond the sale date, the difference between what the OD seller previously made when they were in control of the practice and what they now receive for the same work post sale adds up. Eventually, the optometrist seller (now employee) will hit a point where the amount received for the practice minus what they have given up in lost income will become zero. After a certain number of years, the young doctor actually loses money on the deal to sell their practice if they continue to practice and produce the identical revenue. This scenario is theoretical, but it also makes sense when evaluating what age one evaluates a practice sale.
Unrealistic arbitration expectations
Not all practice acquisitions are perfect. There can be disappointments. Buyers can default on payments. Sellers can have liabilities never imagined. Malpractice claims can surface that are uncovered by tail policies. Escrow payments can get held up by legal technicalities. Anything is possible. Most sale agreements have arbitration clauses whereby disputes are subject to binding arbitration, generally in the buyer’s geographic place of business. It all seems fair and reasonable at first glance. That said, the optometrist seller should be aware, especially if they’re selling to a party that has “deep pockets,” that the outcome of an arbitration may not be in their favor. According to Forbes, arbitration eliminates broad discovery and the right to appeal. As with any legal dispute, deep pockets can often apply weight to the scales of justice. Arbitration is no different in that respect.1
Not expecting change
Optometrists selling their practice and being disappointed by changes initiated by the new owner can be a real concern. Sometimes, the changes are for the better but not always. Practice sale transactions can be a catalyst for the departure of long-time loyal staff. This may include the resignation of employed ODs who did not participate in the sale and, thus, did not receive any of the funds from the acquisition. New owners, new computer systems, new bonus criteria, new examination software, changes in retirement plan matches, changes in laboratories, changes in other suppliers and overall changes in the way business is transacted may result in issues. Sellers can put stipulations in a sales contract, but it may not worth pursuing this with a well-financed buyer.
Lack of representation
Don’t come to a negotiation or any “clash” unprepared. At the end of the day, the optometrist seller or buyer must not forget that they are in a potential life-changing transaction. The deal is often critical to their future well-being, so they can’t afford to make that one deal a bad deal.
Lots to consider
An important takeaway from this article is that a higher monetary offer may not always be the best offer. Such items as property value, employment contracts, deal terms, present value of money, lost opportunity costs, and potential tax ramifications all can play a part in a practice’s true value. What’s more, the seller’s age, compensation as an employee of the buyer and more, as illustrated above, all have an impact. Money invested on proper professional assistance prior to a transaction, along with realistic expectations can save both buyers and sellers a lot of money and headaches post-sale. OM
Reference:
1. Is Arbitration Really In Your Best Interests? https://www.forbes.com/sites/jayadkisson/2022/09/26/is-arbitration-really-in-your-best-interests/# (Accessed Sept. 30, 2024).
