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How Much is Rodney D. Johnston, MBA, CMA Omni Practice Group, WSCA Corporate Partner
If you ask any chiropractor what their practice is worth, they would probably quote a rule of thumb value of 70% to 75% of the last twelve months gross collections. But is that accurate? Do buyers, banks, or others use the rule of thumb valuation when buying or loaning on a practice? Determining the true value is more complex than you think and may have a large impact on your sales price when it’s time to transition.
To start, what is “value?” There are several definitions. One used by the Internal Revenue Service is “value is the price of an asset (practice in this case) that would bring as the result of a bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party.” In other words, value is what a buyer and seller would agree upon to purchase and sell a practice.
So, using the rule of thumb approach may work according to the definition of value. Let’s look at an example:
Practice #1 has annual production of $800,000 per year with overhead of $700,000 per year. The owner takes home $100,000 per year.
Practice #2 has annual production of $500,000 per year with overhead of $200,000 per year. The owner takes home $300,000 per year.
Using the rule of thumb approach of 70% of collections, the first practice would have a value of $560,000 and the second practice would have a value of $350,000. The first practice is valued higher, but the practice owner takes home almost two- thirds less than Practice #2. It doesn’t make sense.
According to the IRS Business Valuation Guidelines, there are three generally accepted valuation methods. Those methods are:
1. The Asset Based Approach 2. The Income Approach 3. The Market Approach
One or all of these
approaches can be used to value a practice accurately.
This is where the rule of thumb valuation is flawed. Practice #2 is worth more to a buyer than Practice #1. It is well run with overhead under control. The owner is taking home $300,000 and there is more than optimum cash flow in the practice to cover any debt service. The first practice, if they could find a buyer, would have a hard time getting financing.
So then, how the heck do you truly value a practice? According to the IRS Business Valuation Guidelines, there are three generally accepted valuation methods. Those methods are the asset based approach, the income approach and the market approach. One or all of these approaches can be used to value a practice accurately.
Before we get into the methodology, we have to first discuss a little clean-up of the financial statements. We start with five years tax returns and then we do what is called “spreading the financials.” It sounds a bit strange, but not to the accounting and finance nerds—they salivate when they get to massage the numbers. The tax returns are input into a spreadsheet and expenses are “added back” that are not necessarily part of the practice. You may hear the term add-back on occasion. These numbers can be auto expense, meals for the staff or clients, travel expense, and also the owner’s salary. The goal is to come up with a true “adjusted” net income that shows exactly how much cash flow the new buyer would have to pay him or herself after paying “true” expenses related to the practice.