Most doctors go through a long process of deciding what to look for when buying a practice. Unfortunately, during their four years of professional education, there isn’t much covered on the business aspects of purchasing a practice or the realities of ownership. The answers to these concerns will ultimately be premised on one thing: the determination of what a practice is worth.
Over the last several years, the value of optometric practices has declined. Twenty-five years ago, a standard rule of thumb for evaluating practices would be some multiple of gross revenue. It was quite common to expect one year’s gross revenue—meaning that if I had a $600,000 practice, I would expect to sell it for nearly $600,000.
Over the last two decades, traditional valuation formulas no longer apply, and the real intrinsic value is closer to 50% or 60% of a year’s collected revenue. An optometric practice is like any business—it is worth a combination of only two things: assets and earnings. It might be helpful to have a common understanding of what optometric assets and earnings really represent. In the following few paragraphs, we’ll look at the commonly accepted formulas used to appraise an optometric practice.
First, assets are either tangible or intangible. Tangible assets would include items such as ophthalmic equipment, computers, frame inventory, contact lens inventory, furnishings, and supplies. Some examples of intangible assets would be goodwill or a covenant not to compete. In my experience, the ophthalmic equipment—a large part of any optometric practice asset base—is the most difficult for which to determine value.
Hard tangible assets can be valued using one of three methodologies: book value, replacement value, or fair market value. An understanding of what these terms mean will help you get a better grasp of what these assets are worth.
- BOOK VALUE is simply the value of an asset carried on the books of the business. This value generally is acquisition costs net of accumulated depreciation. For example, if in 1990 you bought a slit lamp for $18,000 and its current accumulated depreciation is $12,000 on the company books, this asset would have a value of $6,000.
- REPLACEMENT VALUE is the cost of replacing that piece of equipment in today’s market. Using the slit lamp example, if the slit lamp (which was purchased in 1990 for $18,000) was destroyed in a fire and needed to be replaced, its replacement value may be closer to $22,000 or $23,000—the cost of replacing it brand new in today’s market.
Because it is not traded regularly in a public marketplace, assessing equipment’s value is difficult. It is often advisable to bring in a third party to appraise ophthalmic equipment. There are many companies that specialize and deal in previously owned equipment, and they can provide this service for your practice.
If buyer and seller cannot mutually agree on the value of assets, it is advisable to hire an independent appraiser.
- FAIR MARKET VALUE is the most subjective of the three accounting concepts, especially as it applies to ophthalmic equipment. It is nonetheless the concept that is most often applied to determining the value of hard tangible assets like equipment.
WHAT IS GOODWILL WORTH?
Once all tangible, physical assets—equipment, frames, contact lenses, etc.—are accounted for, some value needs to be put on the goodwill or “blue sky” of the practice.
Though often misunderstood, goodwill is the expectation of future earnings based on the management skill, know-how, and favorable reputation a business has with its customers or patient base. After an optometric practice is purchased, goodwill is generally transferred to the new doctor, and thus has a rightful place as an intangible asset.
There are many ways to look at the overall value of a practice. Typically, they are the net value of assets, capitalization of earnings, and percentage of revenue stream (though the last is useful mainly for checks and balances for the other two methods).
- NET VALUE OF ASSETS is a methodology that determines the net fair market value of the assets previously discussed, including goodwill. Net value of assets, of course, deducts any outstanding debt on the practice at the time of sale.
For example, if a $600,000 practice appraised for $275,000 and is still encumbered by $200,000 of debt, the value of the assets would be $75,000.
In many cases, when an associate doctor buys into an existing practice, he or she may do so through a combination of cash and acquired debt. For example, if I agree to a purchase price of $275,000 to buy a 50% interest, and the practice had $100,000 of outstanding debt, the terms of my buy-in would be $225,000 in cash and $50,000 in acquired debt.
- CAPITALIZATION OF EARNINGS values the net earnings of a business as an investment. A cap rate is determined, which is an assumed return on investment for the buyer. Using this methodology, no specific value is determined for the assets, but rather the assets’ ability to produce income.
The trick in this methodology is to determine the true net income of the business. Generally, the net income of the business is all dollars paid to or on behalf of the equity owners, including doctor salaries, allocation of income for things like automobiles, country club memberships, certain insurance policies, and funded retirement accounts. From this total earnings pool, an amount is subtracted that represents the optometric compensation. The balance is the true net earnings of the business. This dollar figure is divided by the capitalization rate to arrive at the overall value of the practice as an investment.
- PERCENTAGE REVENUE STREAM is used to determine some sense of value. Currently, good practices are appraising for between 50% to 65% of a year’s collected receipts. This means a $500,000 practice will appraise for between $250,000 and $300,000.
This multiple of revenue is helpful because many banks will not lend money for a practice purchase if the appraised value exceeds 70% to 75% of collected revenue. If a buyer pays more than these multiples as the appraised value, the practice will have a hard time with cash flow to provide an adequate salary for the optometrist and the debt service needed to buy out the practice.
As important as determining the intrinsic value is to this process, it is by no means the only issue to consider. When buying a dream practice, remember that an optometric practice is unlike anything else you will do in your financial life. There is a small market for potential buyers and sellers wishing to transfer ownership of a practice. Most are other optometrists, which by definition limits the liquidity of the marketplace. Occasionally, some other entity may buy a practice, but these are few and far between.
Location, demographics, and economic vitality of a community are important issues to address when buying your first practice. One additional factor often overlooked is where optometry has a strong presence and is supported by the state’s legislative practice act. There is no doubt that in certain regions of the country our profession has thrived and been a key player in the healthcare debate due to hard-fought battles and victories in state legislatures.
APPRAISING EYEWEAR INVENTORY
Frame and contact lens inventory is the easiest of the assets to appraise. Generally, these items will go into the appraisal at wholesale acquisition costs and be discounted for any obsolete or damaged merchandise. If the practice has a 600-frame inventory, it would typically be appraised at between $28,000 and $33,000, net of any adjustments for obsolete material. This process continues until all assets in the practice have an established value.
Another key component is the saturation levels of optometrists to populations. The American Optometric Association (AOA) reports a desirable level should be one O.D. for every 7,500 residents in a community. That means that if your target market has a level of saturation of one optometrist to a population of 4,000, you will be in a very competitive and difficult market for short-term growth. Due to the competition in this market, you should be sure to look for a strong and vibrant practice to purchase.
Intrinsic value, as well as location, optometrist/population ratios, demographics, etc., should all be analyzed and weighed. Applying the best of these important factors will increase the odds of successful practice ownership.
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Executive Vice President of Williams Group