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Valuation Q&A

Family Members on the Payroll
Health Insurance Expenditures
Owner Compensation
Owner Perks
Rent Determination
Restrictive Covenants
Valuing Your Practice
 

Q:  Some appraisers add back the owner’s health insurance premiums as an owner’s discretionary expense, and other appraisers leave them as an ongoing practice expenditure. Which is correct?

A:  There is no single right or wrong answer to this question, and it is at least partly dependent on the purpose of the valuation, i.e., whether it is for an open market sale or for a buy-in. There also needs to be consideration of the type of business entity: sole proprietorship, partnership, LLC, C or S corporation, since that impacts how and where the expense is reported for income tax purposes.

Clearly, medical insurance represents dollars the owner receives by taking a tax-free benefit in lieu of taxable salary. Additionally, if the business entity is a sole proprietorship, LLC, partnership or S corporation, then the owner’s health insurance is not treated on the tax returns the same as it would be on a regular corporate return, and additional analysis may be needed to isolate the owner’s premiums. Using these arguments, it would seem logical to add back to profit the costs related to the owner’s health insurance.

The opposite logic is that most buyers will need to maintain health insurance for themselves anyway, so the premiums are an expense no matter what, and should be left in as an ongoing practice expenditure. But the actual figure may need to be adjusted based on the current premiums for the owner versus the estimated premiums for the buyer. Often the owner is older and possibly in ill health, resulting in premiums that would be much higher than for the average, young, healthy
buyer.

A final consideration is whether the valuation is for a buy-in or for an open market sale. If for a buy-in, it would be appropriate to leave the owner’s premiums in the expenses, no matter how high, simply because that expense will continue following the buy-in.

A further issue is the advent of HSA’s (Health Savings Accounts) which are rapidly growing in use. The owner may elect a high deductible health insurance plan for the practice and its employees and then fund (or have the employees fund) a Health Savings Account for each participant. This account represents funds available to the owner or employee for immediate or future health expenses. An owner may increase his/her salary to fund an HSA up to the maximum allowed each year but then choose to spend no funds from the accountundefinedsaving all for future use. In these cases, an adjustment to reflect premiums with less aggressive HSA funding should be considered, since an outside buyer may or may not choose to maintain the high deductible health insurance plan.

In any case, the appraiser should explain in the report what modifications, if any, were made to historical expenses relating to the owner’s medical insurance premiums and why those adjustments seemed appropriate for the valuation.

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Q:  Covenants Not To Compete: How Do They Impact Valuation? How Much Of the Overall Practice Price Should Be Allocated To Them?

A:  Covenants not to compete (aka restrictive covenants) refer to contractual restrictions on where a person leaving a practice can work for a specific period of time and may also limit the ability to contact clients or staff at the old practice. The purpose is to protect a practice from former employees or owners who go into practice nearby and take with them a following of clients (and possibly some valued staff members).

Overall, restrictive covenants can be divided into two categories: (1) those between employers and employees and (2) those between buyers and sellers when a practice is sold.

Contracts with associates or other employees
Contracts with associates sometimes contain restrictive covenants. Be aware that some states prohibit these, so be sure you know the law in your state. Even when restrictive covenants are allowed under local law, courts generally do not favor such restrictions between employers and employees. To be enforceable, restrictive covenants generally must be reasonable in both duration and geographical area, show that the practice would indeed be damaged in the absence of the covenant, and/or not unduly restrict the employee’s right to earn a living. Language protecting a departing associate’s access to staff can be included as part of the restrictive covenant or employment contract.

Contracts as part of the sale or purchase of a practice
A restrictive covenant will likely be required as a contingency of sale whenever a practice is sold. Buyers want to know that the patients, clients and staff, which make up an important part of the practice’s value, will remain after the seller has gone. The departing owner/doctor can be constrained from competing with the buyer. Language typically states that the seller or sellers agree not to compete in any way with the practice being sold for a period of time (3-5 years) for a reasonable distance. A reasonable distance is thought by some to be that radius that contains 80-90% of the practice clients of record. This form of restrictive covenant is highly enforceable when challenged in a court of law.

In the sale of multiple doctor practices, any and all veterinarians, in addition to the sellers, should be bound by a restrictive covenant. When covenants are absent, the goodwill of the practice is at risk. If state law prohibits restrictive covenants with associates or if practice owners fail to properly require restrictive covenants, the buyer must risk that an associate in a practice being sold could decide to leave the practice and take a significant number of clients. The effect of this risk is to reduce the goodwill value of the practice, since goodwill value correlates directly with practice profitability. If protections are not in place, it is perfectly legitimate for a potential buyer to object to payment of the entire calculated goodwill value. A seller can expect to be paid only for the goodwill that can be delivered.

What value should be assigned to a restrictive covenant?
The value placed on the restrictive covenant is generally negotiated and the discussion likely is driven by U.S. income tax law. The potential damage done by violation of a restrictive covenant need not correlate to the value placed on it in the purchase agreement. Assessment of damages in a fixed amount can be spelled out in the language of the restrictive covenant independent of the price allocated to the restrictive covenant.

A restrictive covenant in a purchase and sale agreement is an asset that has value and it is considered to be an intangible asset; goodwill is likewise an intangible asset. However, the restrictive covenant sale proceeds are taxed to the seller at ordinary income tax rates (often more than 30%) while goodwill is taxed at capital gains rates (now at a maximum of 15% at the federal level). Clearly a seller would prefer an allocation of intangible assets in the sale to be heavily weighted in the goodwill category rather than to the restrictive covenant. For the buyer, it is a tax neutral issue as both goodwill and restrictive covenants may be written off over a 15 year period of time. Attorneys generally recommend allocating enough value to the covenant to reinforce that the buyer faces significant risk should the covenant be violated.

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Q: The practice owners also own the practice’s building and they set the rent to equal their mortgage payment.  What is reasonable rent for a practice? What do I do about normalizing the practice’s rent expense if I have a real estate appraisal? What if I don’t have an appraisal?

A: Generally, a mortgage payment will not equate to fair market rent. In most circumstances, the costs of servicing a 25 year mortgage will be less than fair market value (FMV) lease cost. Because the rent determination can have a significant impact on business value, it is important to develop an accurate rent assessment. There are several approaches for developing a reasonable lease value for appraisal purposes.

A favored approach is to base fair market value rent on a real estate appraisal performed by a qualified MAI commercial real estate appraiser. When a qualified real estate appraisal is available, there are two possible ways an appraiser can derive FMV rent for the practice. The first and more commonly used is the return on investment approach. This method is founded on the logic that an owner of commercial real estate normally expects to earn a reasonable return for investing in the property. In most regions of the country, a reasonable return for investment in practice real estate is 10%-12% per year. This annual return is equivalent to a FMV triple-net lease.

Many commercial appraisals provide adequate information for a second way to determine FMV rent based on square footage. Generally, a commercial appraisal report will base the opinion of property value on three approaches, one of which will be the income approach. This discussion will set forth actual rent for comparable properties and will also estimate reasonable annual rent for the property being appraised. Be sure to review what is included in the total square footage and make any adjustments needed to reflect only the space used by the practice.

In circumstances where the real estate is not actually being sold, many commercial appraisers will provide a FMV rent determination directly, i.e. the property is not valued, but the appraiser will estimate a FMV rent based on comparable costs for similar property in the region. While less costly, this approach is useful only when the real property is not involved in the sale transaction.

If an appraisal is not available, it is time to do some research. Sometimes the practice owner will know the going rental rate in the area. Many owners are involved in community affairs and readily have this information available. The next alternative to obtain the dollar/square foot price is from a commercial realtor in the area. The practice owner may be able to provide a contact.

If these options do not work, the internet is the next best resource. Many large realtors publish data quarterly for their cities and surrounding suburbs which can be purchased over the world-wide-web. However, this can be fairly pricey; one such report for the Philadelphia area cost $325. Also, data in rural areas may not be available through these sources.

The internet also provides a myriad of business magazines with articles reporting commercial rent for most major cities near or at the practice’s location. Since commercial properties are generally high-rises, office complexes, or manufacturing facilities, the prices obtained will need fine-tuning to reflect the actual practice site. With any of these methods, the difficulty lies in finding rent for comparable properties. Because of the build-out required in veterinary practices, rent for commercial office space is generally not comparable without some adjustments reflecting the costs of additional plumbing, sound proofing, etc. Unfortunately, there is not a lot of data available, even to commercial appraisers, on actual rent paid for veterinary hospital facilities because these transactions are often between private
individuals or closely held businesses.

If you cannot locate rent for comparable real estate, a useful source of information is industry data, such as that available from AAHA or AVMA, that report rent as a percentage of gross revenue. Use the data most applicable to the practice being valued to normalize the rent expense. For example, if AAHA reports that practice rent in a particular geographic region is 6.2% of gross fees, this might provide a figure to use as a base in computing whether the actual rent being paid is higher or lower than average.

Sometimes rent which exceeds or falls significantly under these benchmarks is an indication that the practice is operating in a facility which is either too large or too small for the size of the practice. This requires further analysis to determine the likelihood of the practice remaining at this location for several years without expanding, remodeling, renegotiating the lease, or relocating.

As a final point, remember to remove (add back) expenses in other accounts that would normally be incorporated into a rental fee, such as real estate/school taxes, major building repairs and maintenance (like re-roofing or replacing a furnace), mortgage interest, property/liability insurance and depreciation on the building and leasehold improvements.

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Q: Owners seem to vary widely as to how they pay themselves. What’s the appropriate adjustment to make to owner(s)’ compensation when valuing a veterinary practice?

A: In calculating a practice’s operating cash flow, the following adjustments are made to Net Income on the Profit and Loss statement regarding owner compensation:

Step 1. Add the owner compensation amount back to the profit and loss statement; remember that sole proprietors don’t pay themselves a salary, so there would be no addback for those practices.

Step 2. Add the payroll taxes associated with the actual salary (7.65% up to the FICA limit and 1.45% on the excess).

Step 3. Subtract an amount that represents reasonable compensation for the owner’s work as a practicing veterinarian. Example: 18-22% of the owner(s)’ actual veterinary production; consider an amount that reflects pay for a doctor with similar skills and experience and the cost of a replacement veterinarian in a given region where the practice operates.

Step 4. Subtract an amount which represents reasonable compensation for the owner(s)’ management services. Example: Total practice management compensation generally equals 2-5% of the practice’s gross fees. The amount which should be allocated to the owner depends on how many other staff members are also involved in management. Therefore, an owner who delegates much of the management responsibility would be allocated a smaller percentage than one who maintains more control over the practice’s operations and spends more of his or her time managing the practice. An alternative might be to allocate 1.5% of gross fees to the owner(s) for practice leadership, which assumes that other staff members are handling the remaining management tasks for the leader.

Step 5. Subtract the payroll taxes that the practice would pay on both the production and management compensation computed above. Again, the current percentage would be 7.65% of salary up to the current FICA limit and 1.45% of the excess.

Note: As with any adjustment to reported profits, you should explain in your report what modifications you made to owner(s)’ compensation and why you believed those adjustments were appropriate.

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Q:  What do I do about owner’s “perks” like pet food, veterinary services, auto expense, and barter arrangements?

A:  Tax advisors often recommend that business owners minimize their income tax liability by maximizing expenses that are charged to the business. This is a sound tax strategy as long as it is within the proper and legal guidelines, but valuators often see these “perks” taken to extremes.

In the adjustment process, the valuator’s job is to create a realistic picture of the true financial benefits the owner actually is deriving from the business. This includes the owner’s salary, dividends, retirement contributions, and possibly owner’s health insurance. But it also might include “perks” such as personal pet food, cleaning supplies, treatment for personal pets, personal auto expense, vacations associated with CE, home repairs, personal lawn maintenance, excess wages to family members, and bartering arrangements for personal benefit.

If the valuator intends to add these items back to profit (thus increasing cash flow and, therefore, practice value), then there must be proper and complete documentation. Buyers and accountants are hesitant to accept these “add backs” without a high comfort level for their accuracy. A simple estimate of the expense or a charge card payment is not sufficient. Even with documentation, the buyer may or may not accept these “creative” accounting items. Lenders will often reject them unless the owner is willing to submit amended tax returns, removing these “personal” expenses. Both buyers and lenders need to be comfortable that these add backs will actually increase future practice cash flow over and above the amounts shown on the income tax returns as filed.

As a general rule, it is strongly advisable to eliminate or at least minimize these perks at least three to five years prior to an anticipated sale so they won’t further complicate an already complicated review process. Yes, it will increase the tax burden, but it also will increase practice value. Remember, that for every dollar that makes it to the “bottom line”, the practice value will typically increase by three to five dollars in value! If a $1,000 “perk” item is removed from annual expenses, the tax on that amount will be $250 – $450 for each year. But that becomes an excellent investment, returning $3,000 – 5,000 in increased practice value.

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Q: Is there some rule of thumb that I can use to approximate a practice’ value?    

A: Rules of thumb are sometimes used by valuation experts in other industries to test comprehensive valuation conclusions. They are more accurate in industries where revenues and costs are easily predictable and where there are similar customers, suppliers and business processes. Fuel oil dealerships are an excellent example where rules of thumb can be applied with reasonable accuracy.

Unfortunately, there are no accurate rules of thumb (nor have there ever been) in the veterinary industry. We have all heard rumored rules of thumb thrown out by practice owners and by consultants over the years. Some of these have appeared in veterinary publications, but printing a rumor doesn’ make it more valuable or useful; it is still a rumor. No owner or potential owner of a veterinary practice should consider entering into one of the most significant financial transactions of a lifetime based on a rumor.

Consider these two practices. Practice A and Practice B have the same gross revenue. For simplicity, we will say total fees are $1,000,000 in each. If practices sold according to a rule of thumb that valued them at one times gross (an old myth that keeps resurfacing), then we would conclude that each practice is worth the same, or $1,000,000. Now assume Practice A is located in a growing population area with highly affluent residents who have young families, buy single family homes, and tend to own at least one pet. The revenues in Practice A have been increasing 20% over each of the past two years. Revenues are 80% from veterinary services and only 20% from products. The practice has educated clients on the latest vaccination protocols, and clients routinely visit the clinic for wellness exams (not just for vaccinations). Practice B, on the other hand, is in a community whose population has been steadily declining over the past ten years, and one of the town’ largest employers has announced that it will be closing and moving its operations south of the border. The practice’ revenues have been declining in recent years, even before this announcement, and profitability is also on a decline. Practice B has historically relied heavily on vaccination revenue and sale of products.

Most of us would instinctively pay less for Practice B than Practice A, if we had all the facts. No matter what a rule of thumb might otherwise suggest, we understand that there is more potential in Practice A than in Practice B. By using a rule of thumb that looks at only one figure (gross revenue), we might be tempted to shortcut our due diligence and not get all the facts about these two practices. We therefore wouldn’ know about the service mix or the local demographics in either practice. The results could be disastrous for a buyer of Practice B, and the seller of Practice A might be shortchanged.

To be useful, rules of thumb must be developed from actual industry transactions over a long period of time. If the economic, social, industry and business environments remain stable, such a rule of thumb might remain reasonably applicable; however, changes in any of these environments impacts the accuracy of the rule of thumb. And when did we ever see such stability in veterinary medicine or the general marketplace?

We at VetPartners are in the process of developing a database of actual transactions to explore whether there is enough commonality to develop any relationships between key financial data and the actual price used in the transaction. To date, we do not have enough data to make any statistically valid conclusions. Whether or not this database will lead to a meaningful rule of thumb over time remains to be seen.

In the meantime, as practice consultants, we should be very cautious about using or advocating any rule of thumb relating to veterinary practice valuations.

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Q: What should I consider when an owner has family members on the payroll?

A: This is a fairly common fact pattern, where family members of the veterinary practice owner receive salary and benefits from the practice. Often the purpose is to shift some of the practice profits into lower income tax brackets. In addition, family members are sometimes on the payroll for purposes of enhancing certain health, travel, or retirement benefits as well. In many cases, little or no work is actually done to earn these salaries and benefits. Conversely, some relatives (usually the owner’s spouse) actually provide significant services to the practice but are paid little or nothing for doing so. All these situations require further analysis.

Spouses and children are the usual family members working in the veterinary practice, though siblings and parents sometimes are involved as well. In most cases, hospitals with multiple owners don’t pay excess salary and benefits to family members, since some adjustment would be needed to create parity among the owners. For this reason the situation usually exists in single owner practices. The particular circumstances may involve a spouse working as a hospital manager, bookkeeper, technician, receptionist, veterinary assistant or practically not working at all. The same is seen for children. They may have only a ceremonial position for the purpose of receiving a paycheck.

Even when provided with an employee list, the appraiser is still faced with the challenge of identifying which family members are receiving these benefits and determining the extent to which the relatives are providing services equivalent to the wages they are receiving. In determining the fair market value of the practice, the appraiser must ask the question, “Will this be an ongoing expense to the buyer of this practice? If so, will the amount paid in the future be greater or smaller than what has been paid in the past for the services actually performed?”

Any compensation, including health, medical and retirement plan contributions, and the employer’s share of payroll taxes, should be adjusted to reflect fair payment for the services being provided. Excess salary and benefits represent additional owner’s discretionary income and should be added back to increase cash flow. Payroll taxes paid on these amounts as well as employee benefits should also be added back. These adjustments will have the effect of increasing the value of the practice. On the other hand, if a family member has been providing services for less than what the practice would pay a non-family member to do the same work, then the fair value of those services (less the actual amount paid) should be subtracted from projected cash flow. Payroll taxes and benefits related to this additional compensation should also be subtracted in order to approximate a realistic cost to replace the family member’s services. This will have the effect of reducing the benefit stream and, therefore, the value of the practice.

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