The outside of Dr. Kling’s office. He says that it’s important to consider the methodology that will go into the valuation of your practice. You may be surprised at the figure that’s arrived at.
Part 2 of two-part article on determining how much your practice is worth. Click HERE to read part one.
By Mick Kling OD
July 24, 2024
In part one of What’s My Practice Worth, we discussed the difference between tangible and intangible assets when determining the value of a practice.
We also discussed the importance of understanding goodwill – the positive reputation, customer loyalty and perceived value associated with your brand – as it usually represents the largest portion of value of a practice.
In part two, we’ll discuss common valuation methodologies used to determine the worth of an optometry practice.
Understanding Practice Appraisals
To provide some framework around a practice’s worth, many sellers (and sometimes buyers) will obtain an appraisal by a qualified practice appraiser to help determine the value of a business. Appraisals attempt to look at the business from multiple aspects to try to predict what a willing buyer may agree to pay.
While appraisals can be very helpful for organizing information into a single document, it’s important to keep in mind that they may have limited value since they don’t take into consideration the emotional (and sometimes mathematical) element of purchasing the business. That is, “Is this a business I really want, and what am I willing to pay for it?”
Although practice appraisers may disagree, I have seen appraisals that appear biased toward the person hiring the appraiser. Although well-intended, they require some degree of subjectivity (and guesswork) to determine value, and it’s only natural for both the appraiser and client to seek a favorable result.
It is my opinion that the value of any business is ultimately determined by what the cash flow will support from a debt service standpoint. That is, after all the bills are paid, what’s left over to repay the debt, assuming a buyer is borrowing money to make the purchase. Applying valuation methodologies that aren’t supported by what the business can afford in terms of cash flow are of little value, and can create unrealistic expectations for the seller.
Following is a brief overview of a few of the valuation methods used by optometric practice appraisers. There are others, but this will give you some sense of how they come to their conclusions. It’s important to understand that most practices sell for what a bank is willing to lend a buyer, assuming the buyer is borrowing money to purchase the practice. That’s a hard pill to swallow for many sellers, especially if they have paid for an appraisal that reflects a much higher value than a bank will lend on the practice.
Other Articles to Explore
Common Valuation Methods
% of Practice Revenue
Often misused and misquoted, many believe the value of a practice is simply a percentage of the practice’s past revenue. While it’s true that most optometry practices sell in the range of 40-80 percent of one year’s revenue, it’s a poor method for valuing a practice without considering other factors.
The problem with this strategy is that two equally sized (in revenue) practices may be entirely different. One could be very well run, newly remodeled, in an excellent location with new equipment and highly profitable, while the other may be poorly managed, have a lousy culture, outdated equipment and furnishings and little profit. In this case, it’s easy to see these two practices are not worth the same. Using a percentage of revenue would not truly reflect the value of each of these practices.
Summation of Practice Assets
The summation of assets valuation strategy involves adding the value of the tangible assets (furniture, fixtures, equipment, supplies, frame inventory, etc) to the value of intangible assets (goodwill), which is usually valued as a multiple (often 1-3X) of the adjusted cash flow of the practice.
While determining the replacement value of the tangible assets can be fairly straightforward, choosing which multiple of the adjusted cash flow to use can significantly impact the valuation of the practice, which injects subjectivity into the equation.
Multiple of Practice Earnings
The earnings of an optometry practice are usually considered what’s left over after all the bills are paid, but BEFORE the doctor(s) get paid. This is sometimes referred to as the “optometric net.”
The idea behind this number is that it includes both the fair market wage of the practicing OD plus the “ownership premium,” that is, the inherent value that an owner receives above the fair wage of a practicing OD.
Outside of optometry, this is often referred to as seller’s discretionary earnings (SDE), which represents the total benefit to the owner including wages, profit from the business and discretionary spending such as auto expenses, cell phone, meals and travel. Most practices see SDE at 25-35 percent (or more) of revenue, and sell for 2-3 times this value.
Capitalization of Earnings
Capitalization of earnings attempts to value a business based on its future predicted profits and the performance of the business. It takes into consideration the current cash flow of the practice, then attempts to come to the value by applying a capitalization rate. That is, the rate of return that an investor could expect if they were to make an investment into this type of business venture.
Capitalization rates vary based on risk, are subjective and can greatly affect the value of a business. It is based on the theory that a low risk investment (such as government bonds) would warrant a low return on investment and a risky investment, such as a speculative stock, should yield a higher return.
Owning an optometry practice falls somewhere between owning an S&P 500 Index Fund, which has a historical return of around 10 percent and venture capital investments which often expect returns of 25-35 percent. The formula for this method is:
I have seen capitalization rates for optometry practices range from 15-20 percent. A higher cap rate suggests a riskier venture and results in a lower valuation. By way of example, a practice with $100,000 in adjusted earnings and a cap rate of 17 percent would be valued at $588,235 while a cap rate of 19 percent would place the value at $526,316.
Multiple of EBITDA
Revenue and EBITDA are often considered the two most basic and important pieces of financial information. Multiple of EBITDA is a common valuation strategy used by private equity investors.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization, and attempts to value the business based on its current cash flow without taking into consideration the impact of debt payments (interest), taxes owed and the non-cash accounting expenses of depreciation and amortization.
EBITDA removes the profit distorting effects of taxes, interest, depreciation and amortization from the company financials. The idea is that EBITDA allows a potential investor to compare two similar businesses by removing the variability of debt on the practice, and the tax strategies used by accountants when determining taxes owed.
For example, how (and when) depreciation and amortization are taken from an accounting standpoint can greatly affect the tax liability of the business. Removing these variables provides a clearer picture of the practice’s financial performance.
Multiples offered are somewhat subjective and based on many factors such as practice revenue, profit, operational controls, competition, management team, reputation and location. Multiples for most practices usually range from 3-6 times EBITDA, while large, multi-location and multi-million dollar practices can command higher multiples.
Greatly impacting the EBITDA calculation are something called “add backs.” Add backs represent the expenses run through the business that would be indirectly considered another form of personal income. Some examples of add backs include:
- Auto expenses
- Donations
- Continuing education
- Personal cell phone
- One-time repairs
- Travel and meals
- Depreciation/amortization
- Interest
- Personal taxes
- Excess owner compensation
- Staff wages above market rate (e.g, family members)
- Certain legal fees
- Excess rent payments (if owner owns the real estate)
These expenses are “added back” to the net income of the practice to determine the true earnings (and cash flow) of the business. Not all PE firms allow the same add backs, which creates some degree of subjectivity when measuring EBITDA.
Debt Service Model
I feel that the only true and reliable way to determine the value of a practice is by measuring what the practice will support from a debt service standpoint. That is, after all the bills are paid, including a fair market wage for the OD seeing patients, what’s left to pay the principal and interest to the bank, and taxes to the IRS.
Although still somewhat subjective, this methodology removes most of the subjectivity from practice valuations that plague other valuation strategies. This is the strategy almost all lenders use, as they essentially “work the math backwards” to determine how much they might be willing to lend on the practice.
Most lenders will only lend around 80 percent of the available cash flow, and have an arbitrary lending limit of 70-80 percent of practice revenue, so even if the practice finances support a higher debt service, these lending caps often limit the amount of the practice loan.
For practices that sell higher than this limit, the buyer would need to find an alternate lending source (family, friends, seller financed, loan shark, personal savings, etc.) to make up the difference between what the bank would lend and the selling price.
It’s important for sellers to understand that lenders will often combine the cash flow of the practice along with the personal spending habits of the borrower (referred to as “global cash flow”) when determining how much they will lend on the practice. This measure is used to evaluate the total financial health and creditworthiness of a borrower.
Borrowers with a large amount of personal or student loan debt, high mortgages, car payments, credit card debt and little in savings would likely qualify for a lower loan amount (if at all). This means the “value” of a practice is directly related to the creditworthiness of the borrower, a concept difficult for many sellers to accept.
Hybrids and Averages
It’s not uncommon to see practice appraisers utilize a hybrid of the above methods, or simply perform each method and take the average (or weighted averages) to come to their final valuation. The subjectivity lies in how and when these averages are used to settle on the final value of the practice.
Conclusion
Determining the value of an optometry practice involves a nuanced approach that takes into account both tangible and intangible assets, with particular emphasis on goodwill.
The various valuation methodologies discussed here each provide unique insights, but also introduce a degree of subjectivity and potential bias. Ultimately, the most reliable method is the debt service model, which assesses a practice’s value based on its ability to support the debt payments. This approach aligns more closely with what lenders consider when financing practice purchases.
Sellers must understand that while appraisals can be helpful, they can also create unrealistic expectations and are often ignored by lenders. The actual value of a practice frequently comes down to simply what a bank is willing to lend, influenced by the buyer’s overall financial health and creditworthiness.
M
ick Kling, OD, is the president of Impact Leadership and the founder and CEO of Invision Optometry in San Diego, Calif. Dr. Kling is also the Practice Management and Transition Advisor for Vision Source. To contact him: dr.kling@invisioncare.com
