How the valuation of a veterinary practice works
As a business owner, it’s important to know the present value and profitability of your veterinary practice, especially for purposes such as insurance, taxation or possible sale. In today’s market, you need to understand that standard financial reports, tax returns and profit-and-loss statements show only cash flow and don’t reflect profitability. In addition, many veterinary practices don’t follow GAAP rules as compliance is not required state-wide. Determining the true profitability is an entirely different process, but the effort is worth it and a number you need to know if you are seeking to expand the practice or take out a loan.
EBITDA (earnings before interest, taxes, depreciation, and amortization) is a formula you may be unfamiliar with, but is the best way to determine the profitability of your veterinary practice. In this post, we’ll discuss when the valuation of a veterinary practice is necessary, the difference between the most common valuation approaches, and why EBITDA is a significant component of your practice valuation.
Why do you need a practice valuation?
There are many reasons why you might want to determine how much your veterinary practice is worth. Here are four of the most common reasons:
- Practice sale. The most common reason to value a veterinary practice is if you plan to sell. You want to know how much profit you can get from selling the practice and its evaluation is the first step.
- Sales management tool. Terminal cash flow will define how much your practice is worth when you decide to sell. Knowing the value of the practice helps to see whether you are taking steps to enhance the value of the clinic and improve its profitability.
- Partnership insurance. Partnership insurance plays a vital role when one of the partner’s leaves, retires, or dies. The insurance helps the practice owners secure their share of the total value of the practice. A valuation is needed to accurately determine each partner’s share.
- Qualify for a loan. If you plan to apply for a business or personal loan, some or all of your practice may be assessed or used as collateral. That’s why it’s important to know the fair market value.
Understand the standard of value
Before we delve into valuation methods, let’s get familiar with the basic legal concept that is called the standard of value. You will need to understand and use the proper standard of value to accurately determine the value of your veterinary practice, and it will influence which valuation method will be used. Fair market value is the standard of value in veterinary practice appraisal that is commonly used in tax matters.
Let’s take an example where you own only 25 percent of a practice, which makes you a minority owner. The value per share ranges accordingly, depending on what percentage of the clinic you own. Minority owners often play the role of a silent partner as they do not participate in strategic direction or operational management. According to fair market value, the minority owner will be worth less than the partner who owns 75 percent, which will have to be reflected in the transaction.
Valuation methods for a veterinary practice
Here are some classic simple valuation methods that you, as a practice owner or manager, can apply right now. You should consider three fundamental approaches to value: income, market, and asset.
Income Approach: Determining income is the most popular and preferred method. The value of the practice depends on the profit, and the income approach focuses on the cash flow of the practice. Cash flow helps to determine the level of risk of the practice and its growth prospects. The income approach requires the seller to estimate the company’s risk:
- Geographic risk. Shows the dependency of a practice on the economy of the area in which it is located;
- Size risk. Pertains mostly to small businesses;
- Keyman risk. Determines if the business relies on a single veterinarian (solo practitioner).
Market Approach: This approach assesses a value based on the value of similar veterinary practices in your region.The difficulty with the market approach is associated with the availability and accuracy of data from public companies. As most acquisitions are private, it becomes challenging to evaluate the practice adequately.
Asset approach: This approach focuses on determining the value of the practice’s net asset value (NAV), which is how much the current tangible assets are worth. It also includes goodwill. Goodwill represents the fair value of the company’s assets minus the market value of its liabilities. Goodwill is an intangible asset that is based on the reputation of the practice, its clientele, value of future patronage, etc.
EBITDA as the primary number for veterinary practice appraisal
Despite the reason you have for the practice valuation, it’s important to accurately assess EBITDA. As mentioned above, EBITDA stands for earnings before interest, taxes, depreciation and amortization. Other than profitability, EBITDA also shows the ability to repay debt. This measure is significant as it shows earnings before accounting and financial deductions.
While EBITDA is not based on any accounting standards, it shows a more realistic number for the buyer as it excludes owner benefits, rent, and other factors that have nothing to do with the actual profit of the practice. Another variable to keep in mind is that practice owners frequently make management decisions based on quality of patient care as opposed to profitability. Factors that distinguish EBITDA from profitability are shown below:
|What factor in|
|Owner comp / benefits||✓|
|Family working in practice||✓|
|Other discretionary spending||✓|
Veterinary practice valuation formula
Even though assessing actual EBITDA is vital, there are other numbers, such as net income and SDE, that can be considered in the veterinary practice appraisal.
SDE stands for Seller’s Discretionary Earnings and is calculated by adding EBITDA to the owner’s income and benefits. Net income defines earnings after the deduction of all the expenses; subtract total costs from total revenues. One of the veterinary practice valuation formulas uses valuation multiples, as shown in the example below:
|Multiple||$||Multiple value||Practice value|
|Average Practice Value||$245,200|
The idea is to determine annual net sales, net income, EBITDA and SDE. Once you have these numbers, you set an appropriate multiple depending on the market. Finally, you calculate the average practice value.
Other factors affecting the sale
Determining the price is not the only factor affecting the sale. While price is one of the most objective negotiation points, there are numerous subjective factors. You and the buyer may not agree on the value, your role in the clinic or other circumstances. The following tips can help you to successfully negotiate with the buyer
- Clean-up your bookkeeping. If your bookkeeping is haphazard and not transparent, invest in having a CPA come in and organize your recordkeeping. There are good off-the-shelf software options that are easy to implement and use. It will make it much easier to compile reports. Decide how you want the buyer to pay you out. For instance, you may choose to roll some of the expenses back to the business
- Decide what you want the partnership to look like. First of all, determine if you wish to stay in the practice or leave. In case you decide to stay, consider what role you want to take on (doctor/administrator) and how much your salary should be, including benefits and profit sharing. (if any).
- Think about how to improve performance. It is also a good idea to consider factors that affect the clinic’s performance as it impacts your profitability and value. For instance, finding ways to manage your staff efficiently and dealing with inventory helps to improve the profit.
Understanding the basic concepts of veterinary practice appraisal can come into play when you decide to sell or add a partner. Whether you are thinking about selling or want to know more about the process, valuation can be beneficial. Consider calculating the actual EBITDA and continuously improving your practice’s performance. It will pay off in the long run.