Practice valuation nomenclature has changed over the years. Practice values used to be referred to as a percentage of collections, but today’s most common reference point is a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). Traditionally, a solo practitioner thought of earnings as the total remuneration from the business in a given year. The reality, however, was that a portion of those earnings was compensation for the dermatologist providing clinical care and a portion represented profit generated from the business.
Historically, valuations were largely considered the total earnings of the owner. However, investors focus on the profits of the business as a basis for valuation. Further, investors consider the actual cash flow of the dermatology practice on a debt-free basis as the best predictor of their return on investment. This has led to the focus on EBITDA as a measure of a dermatology practice’s performance.
What is the Right Multiple?
There is no easy answer to that question, because the multiple is meant to assess the following:
- The opportunity of the investment
- Its relative riskiness
- Whether it provides a reasonable rate of return for investors
There are many factors that influence multiples, including location, trained staff, stable or growing revenue stream, payor mix, condition of the facility, mix of services, patient demographics, and profitability.
Valuing Group Practices
For group practices, having a pipeline for future growth is important. However, the most significant influence on the multiple is historical growth. It is also important to recognize that higher multiples are applied to those businesses that have a qualified management team in place. This management supports continued growth and ensures replicable earnings. Documented policies and procedures to scale the business also contribute to the higher multiples. Dermatology practice owners often focus exclusively on the multiple. They do not recognize that equally as important as the multiple is the number that the multiple is being applied—the EBITDA.
Valuing a Solo Practitioner’s Office
The traditional valuation of a solo practitioner’s office is based on the historical performance of the business as a predictor of future performance. The typical adjustments applied to the historical financials are to 1) bring owner compensation to fair market value and 2) account for nonrecurring and discretionary expenses.
In contrast, the valuation of a group practice is typically done on a prospective basis. This involves forecasting the performance of the business and includes making adjustments for owner compensation, nonrecurring expenses, and discretionary expenses. The purpose of forecasting for group practices is to help a prospective investor see the true investment opportunity, which may not be reflected in the historical financial performance. For example, if a group acquired a practice part way through a given year, the historical financials only reflect that partial additional impact on revenue and EBITDA. The EBITDA adjustment in this example is to show the prospective investor the impact of the acquisition for a full year.
Understanding Different Buyers
The other nuance in today’s marketplace is the different perspective on earnings from different buyers. A private equity firm is generally looking to make an investment in a business or partner with the founder of the business. They, therefore, will want to keep as many members of the management team in place as possible to operate the business and drive performance. However, they may make a downward EBITDA adjustment if they feel additional management team members are needed to continue to grow and support the business.
Conversely, strategic buyers (those who have existing group practices and experience in the industry) may make upward EBITDA adjustments for synergies including:
- Duplicative management team members or third-party vendors
- More favorable lab and supply contracts
- More favorable payor contracts
Generally speaking, a private equity firm will likely pay a higher multiple but on a lower EBITDA, whereas a strategic buyer will likely pay a lower multiple on a higher EBITDA.
Fair Market Value (FMV)
If you are considering selling your dermatology practice, make sure you understand terms and appraisal definitions. For starters, value is not an absolute number. A dermatology practice’s tangible and intangible assets can be grouped into two broad categories: physical assets and nonphysical assets.
Oftentimes, a dermatologist will ask their accountant to appraise the business. But the physician may be surprised to find that the “book value” given by the accountant is far different than the FMV that he/she could actually receive at the time of sale. It is not that the accountant is incorrect. Rather, the accountant and the dermatologist may be operating under a different set of terms and definitions, without knowledge of each other’s perspectives.
Realizing that there is no absolute sales price is the essence of FMV. When determining valuation, look for a price range with a reasonable floor and ceiling. Practice appraisers use FMV as the standard to derive a reasonable value for a practice. FMV means an arm’s length transaction between an unpressured, informed buyer and an unpressured, informed seller. Other types of valuations to be aware of include:
- Business enterprise value (BEV): The BEV of a practice equals a combination of all assets (tangible and intangible), plus the working capital, of a continuing business
- Owner’s equity: The value of owner’s equity equals the combined values of all practice assets (tangible and intangible) less all practice liabilities (booked and contingent)
- Working capital value (WCV): WCV equals the excess of current assets (cash, accounts receivable, supplies, inventory, prepaid expenses, etc) over current liabilities (accounts payable, accrued liabilities, etc)
Practice Valuation Can Make or Break a Business Sale
Valuation can make or break a business sale because for many dermatologists, attaching a dollar value to their practice is a touchy subject. This is especially true if they have spent years building it from a fledgling start-up practice to a profitable business entity. If you are considering a transition, aside from the valuation of your business, it is critical to understand the other terms necessary to close a transaction. In many cases, there are legal provisions that can have significant economic consequences and therefore should be considered when looking at the “value” of the business.
Left unchecked, the valuation process can quickly devolve into a pricing routine that is rooted in personal attachments and other subjective inputs rather than solid data based on marketplace realities. Using an experienced consultant will ensure that you negotiate the best price and transaction terms for your given situation.
Mr Hernandez is the chief executive officer and founder of ABISA, LLC, a consultancy specializing in strategic health care initiatives (www.abisallc.com).
Disclosure: The author reports no relevant financial relationships.
