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Article by Keith Borglum CHBC
(Certified Healthcare Business Consultant) at www.MedicalPracticeAppraisal.com
Licensed Medical Practice Broker and Appraiser for over 25 years
Author of the book Medical Practice Valuation - Appraisal Guidelines and Workbook
Member of the Institute of Business Appraisers and the National Association of Certified Valuation Analysts
Former Member Board of Directors of the National Association of Healthcare Consultants; former Marketing Committee Chairman of the National Association of Certified Healthcare Business Consultants
Medical Industry Expert to the business broker's valuation guidebook Business Reference Guide
Editorial Consultant to Medical Economics Magazine
Editor of the topics of Business Appraisal and Healthcare Marketing for the Open Directory Project proving content to Google and AOL
Faculty and author on medical practice valuation for state and national health care associations including the American Academy of Dermatology- just "Google" his name
You ask: How do I determine the value of a MedSpa for sale?
This is a simple question with a complex answer. (I will provide a simple rule of thumb later in the article – but you should read the article first to understand the rule).
There are many books on the topic (I authored one) –and a fair amount of debate– and the answer differs depending on the MediSpa and particular situation of the buyer. Usually in a buy/sell situation both parties are interested in "Fair Market Value".
Fair market value for buy-sell (you can also have fair market value without a transaction – like in a divorce settlement) means the value in arm’s-length transactions that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party; or the compensation that would be included in a service agreement as a result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition or at the time of the service agreement. Usually the fair market price is the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition, or the compensation that has been included in bona fide service agreements with comparable terms at the time of the agreement.
An example of "not fair market value" might be "what the dermatologist next-door paid the distressed widow of the MedSpa owner whose lease also coincidentally expired the same day as the owner did, and who must immediately find a custodian for the medical records and a new office". A distress-sale value is not the same as fair market value.
According to the IRS Business Valuation Guidelines, the three generally accepted valuation approaches are the asset-based approach, the market approach and the income approach. An appraiser or buyer should consider all three approaches in valuing a particular MediSpa, even if one approach or more is ultimately used, or rejected. Professional judgment should be used to select the approaches used that best indicate the value of the practice. Medical appraisers are trained in this, and the training and continuing education is not cheap. Expect to pay an expert appraiser $0-$10,000 for an appraisal (after 25 years doing it I can tell pretty quick if a MediSpa is worth zero; accurate value above-that takes a lot more work)
IRS Revenue Ruling 59-60 states that earnings are preeminent for the valuation of operating companies. Earnings (or income) driven methods therefore are most important for the appraiser and buyer to consider. Most appraisers favor the income approach in valuing small, privately-held professional services businesses, as it best reflects the impact of profit or dividends rather than just gross collections. I'll tell you why shortly.
Did you know there are different kinds of "income"? There is some confusion surrounding using a word –or words– which represents the stream-of-returns on earnings –or "income"– used in the name of the "income method". These words have included the use of "earnings" (which excludes cash flow), "cash flow" (which excludes pure earnings), "discounted cash flow, returns, benefits, economic income, pre-tax, after-tax, dividends", etc. In the end, it is "dividend paying capacity" which is encouraged in Revenue Ruling 59-60. I'll explain that soon.
Different "income streams" use different "methods" to determine value. I usually use pre-tax normalized net cash flow after considering the equivalent market-rate compensation of the owner as if the owner were employed, and the remaining cash flow was available to shareholders/investors; or "dividends" as the IRS calls it. This provides a perspective as if the owner were instead employed; and the balance was a return on investment to ownership. Another way to look at this is; the result is the income available to the owner on his/her dollar investment in the practice, if the owner couldn't work, and had to hire an equivalent replacement licensed professional to see the patients.
The income approach cares about the monetary investment by the owner., and the return on that monetary investment in dollars. Some owners say "I invested years of blood, sweat and tears to build this business so it is worth X dollars". Blood, sweat and tears don't count, unless the owner is willing to accept bodily fluids as payment for the practice instead of dollars. It doesn't work that way.
Think about the good logic of the income approach using "dividends" or return-on-investment to the buyer. A dermatologist can easily earn $350,000 per year as an employee of a medical group without seeing even one cosmetic patient (in addition to being an appraiser, I am a consultant on faculty for the American Academy of Dermatology and the American Academy of Family Physicians practice management courses where I lecture on practice start-ups, practice profitability, and physician compensation, and I am a Director of a national association tracking physician overhead and incomes so I am quite sure of my facts here). If you were that dermatologist, how much would you pay to buy a MediSpa where you would work full time, and that earned you less than $350,000 per year? Nothing, right? There would be no way to get your investment back via profit, much less any return on investment. If you are a family physician wherein a job pays $150,000, its a different story.
Why bother buying a business that pays less than a job unless you had a reason other than a financial reason? You would be better off just taking a job and putting your money in a savings account.
If you bought a MediSpa where you would be the Medical Director and you only worked 10 hours per week supervising the treating nurses, you would still expect to earn more than $87,500 per year for your labors before you got any return on your investment.
Lets say you as the dermatologist found a MediSpa where you could replace the retiring physician, work full time, and earn $500,000 per year. In that situation, you could earn $150,000 per year more than you would at a $350,000 job. That $150,000 is what would provide you a return on your investment (ie investment "dividends"), rather than pay for your labor. The formula could be different if you were an FP, or in a state without a ban on the corporate practice of medicine.
To find the value of those "dividends", you then divide the return on investment by a capitalization or "cap" rate. A cap rate includes the return needed to an investor to invest money in equity, ie the ownership of a business. The cap rate differs from an interest rate in that interest is a return on debt rather than equity, just like in the stock market. For example, a 33% interest rate equals a .33 cap rate, so that in the prior example the $150,000 dividend would equal a business value of $450,000 (450,000/150,000). I'll explain further and provide a formula below.
To determine the cap rate, it is necessary to examine the rates of return on other investments competing for the investor's dollars, (in this case, qualified medical practice purchasers) and determine what rate of return will be required for this investment. This rate is calculated by building-up rates of risk and return, from the lowest/safest (often 20 year Treasury bonds) to the risk-adjusted level of risk in the particular investment. The "high-risk" of small businesses requires high returns. Appraisers can quantify anticipated future changes in returns by modifying revenue and cash flow assumptions appropriately; or, in the absence of adequate information about a proposed change (like pending future restrictions on ownership of Med Spa practices), by modifying the risk premium when developing a discount/cap rate. I usually prefer to modify the risk for uncertainty rather than the cash flow, as it does not require lots of little guesses about variables in the future. For example, before the new law passed limiting the practice of cosmetic medicine in Florida, there was a risk of the new law, and higher risk reduced values of MedSpas there. Now that the law is passed, the rules are clear, and the future risk for compliant spas is reduced, and value is up (even though some practices went bankrupt in the meantime due to non-compliance and an oversupply of distress sales).
"Goodwill" value in medical spas is the value of the "intangibles", like patient retention and practice reputation, or the value above the tangible assets such as tables and computers and tenant improvements. Goodwill is not separately valued in the income approach, as it might be when taking other approaches to valuation. The income approach results in a value that includes all tangible and intangible assets, including that described as goodwill. It does not separately seek to break out goodwill value, but to include it. The underlying concept is that when using income of the business as the approach for valuation, that income results from the value of both tangibles and intangibles together.
Most MediSpa practice sales do not include the real estate, debt or cash.
Most sales are "asset" sales rather than "entity" (like corporation, partnership or LLC) sales, so that the buyer does not take on the historic malpractice liability of the entity.
Is there a "Rule of Thumb" for valuing MediSpas?
The most simple rule of thumb –with any legitimacy, limited as it is– is using a grossly simplified Income Approach, the primary approach per IRS Revenue Ruling 59-60. This approach looks at the return on investment (ie dividends) to the buyer after market-rate compensation of one working owner.
Remember – the following is a rough estimation without considering the variables of the particular practice, like a rotten location or recent bad publicity for a badly laser-burned patient like happened to a practice in NY:
1) First add back to the owner's salary and profit all the economic benefits the current owner receives (like auto, life insurance, health insurance, etc), plus depreciation, Sec 179 expense, and interest (to equal a debt-free position).
2) Subtract the cost of employing a substitute person for the owner at market
rate, as if the owner were disabled and had to hire a replacement person to
treat patients (calculating market rate is often the most common error made
by persons/brokers familiar with valuation but unfamiliar with MediSpas. As
a shortcut, use $160,000 for a FP or $350,000 for a dermatologist)
3)Multiply the remainder by 1.5x to 2x. The result is your answer of the approximate value to a qualified buyer seeking a 50-65% ROI, a pretty typical dividend for working owners of licensed health care practices. The identified pre-tax rate of return may sound high until compared with alternative investments available to "any-willing-buyers" at comparable risks. For example, It is not unusual to see capitalization rates of 20-35% for pretax earnings after owner's compensation for professional practices like accounting, law, architecture and engineering which are not subject to clinical malpractice risks, or Medicare or insurance company changing reimbursement limitations or denials.Obviously, there are many other details that impact the outcome.
Here's a few good books on the topic for appraisers if you want to learn more:
My book, Medical
Practice Valuation - Appraisal Guidelines & Workbook was written more
for the typical buyer and seller of small practices to perform a do-it-yourself
valuation or a reality check on an existing asking price. You can find it at
Medical Practice Valuation Guidebook 2001/2002 by Dietrich
Valuing Small Businesses and Professional Practices by Shannon Pratt
Both are available through Amazon.com or any big retailer.
Choosing a MediSpa Appraiser
MediSpa valuation is not a licensed activity in most states, so competency varies considerably. I have seen some really ridiculous valuations of MediSpas by general brokers who know nothing about medical practice and can't tell a laser from a taser, or MediSpa consultants who know nothing about valuation. In a case of overpayment, a buyer would never maker their investment back above what they could earn at a job in a MediSpa.
There are standards authorized by Congress and the IRS for how to prepare valid appraisals, referred to as the Uniform Standards of Professional Appraisal Practice (USPAP). You should demand that any appraisal you get or appraiser you use complies with USPAP. These rules can most easily be found at www.AppraisalFoundation.org. Ask your potential appraiser or broker "Do you write USPAP (pronounced use-pap) compliant appraisals?". If they say "Huh?", keep looking.
Good appraisal reports generally contain background information and documentation so the reasonings and math are clear, and data can be confirmed. Bias (or favoritism) in an appraisal in favor of a buyer or seller is a violation of USPAP and a violation of appraiser professional ethics. There are unethical appraisers and brokers out there (surprised? – probably not!).
You should demand to have the appraiser present the resources they used, the currency of his/her data bases (data from one 1996 database that some appraisers use may not still apply!), and the assumptions and reasoning underlying their opinion. Many so-called appraisers and brokers appear to base their valuations on rumors and hearsay, with little-to-no substantiation of their opinions (for example "practices sell for one times gross"). I recently had a business-broker in Southern California tell me that the extraordinary asking price she placed on a MediSpa with her "appraisal" was based on "like Dude - that's what the seller wants – Duh!" (!) I have seen a practice priced millions of dollars above what could logically and financially be supported by the return on investment.Of course it never sold.
The Principle of Substitution says that a knowledgeable buyer would not pay more for a business than it would cost to replicate. If you can build a MediSpa for $200,000, why pay $300,000 for an equivalent unless there is extra value? They are not that hard to start instead of buy. I help start them every year for clients.
There are a few different legitimate professional appraiser associations, but most appraisers won't touch medical practices, so the easiest way to find a medical practice appraiser is to do an internet search for "medical practice valuation" or "medical practice appraisal" on your favorite search engine(s), then check the credentials of the appraiser to verify that they specialize in medical practices and belong to a professional appraisal association. Most general business appraisers don't know about things like corporate practice of medicine prohibition laws, fee-splitting prohibition laws, or normalization-of-income databases for MediSpa buyers. I don't know of any appraiser or broker who specializes just in Medi Spas, though a few of us just specialize in medical or healthcare businesses. Most medical appraisers work nationally. In 90% of the valuations that I perform, I never have to visit the location to do a good valuation, in order to keep costs down for the client. Click here for information on my appraisal and broker services.
In summary - an appraiser's opinion of value is like the Kelly Blue Book for used cars; it's just an expert opinion based on the marketplace. A particular buyer and a particular seller may logically agree on a price different sfrom the expert opinion, just like for a used car. For example, an ill or desperate seller may sell for a price below the market value, and a big company might pay more than fair market value because of strategic leverage they bring to the acquisition.
Bottom line - a transaction at Fair Market Value with both parties having full knowledge of all the facts and options is probably fair to both the buyer and seller.
By Keith Borglum CHBC of www.MedicalPracticeAppraisal.com
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