Selling or Buying a Practice?

From the book “Navigating the business of Optometry”

Buying a practice is complicated and will always remain a daunting task to the first-timer. It involves several components that are best handled by professionals, but the buyer will be well advised to stay as close to the deal as possible. It is vital not to fall into the “I-don’t-know-what-I-don’t-know” category here. The buyer must know about everything. Some of the decision-making will be intuitive and the buyer will be the one to step into the breach. Usually, the biggest challenge is finding funding. Few buyers are fortunate enough to have the money available. More often than not, the bank will attempt to convince the seller to

assist with the funding in one way or another. From the seller’s point of view, this is not a good idea, but sometimes the seller capitulates in order to save the deal. Understanding the mechanics and the process of buying practice will help you to navigate a safe passage through the whole process.

Due diligence – minimise risk

The decision to buy a business should be based on numbers. There is no room for emotion in the deal, but there may well be an intuitive component to the decision-making. The onus is on the buyer to verify the numbers and to ask the right questions. Nothing will be gained by blaming the seller for not disclosing information.

An example of a comprehensive due diligence master plan appears at the end of this chapter. This document is very detailed and leaves very little to chance. The level of detail at which due diligence is conducted will depend on a number of issues, such as the value of the deal; the cost of the exercise; the experience of the buyer; and the relationship between buyer and seller. The buyer must take every precaution to minimise the risk. There must be no reason to suspect that the practice will not succeed. The buyer must also ensure that there is nothing that could devalue the business or jeopardise the net profit after the deal has been signed off.

Why do businesses fail?

Before buying a practice, it may be worthwhile pondering this question. Although there could be a myriad of reasons, there are two big ones worth pointing out. The first is poor gearing. This means that too much money has been borrowed relative to the price. This goes hand in hand with insufficient start-up capital, a lack of working capital and a shortfall in cash-flow. Chances are, the practice will struggle to reach a stage of positive cash-flow and often never does. Cash-flow is the most common reason for failure, but it usually has its roots elsewhere: There wasn’t enough money from the start. Term loan finance is costly and becomes a significant expense on the income statement. Positive cash-flow is crucial when building a business. It allows one to buy products for cash and improve gross profit. It also usually takes longer than anticipated to build up revenue, so working capital is required to keep the business afloat until it generates its own cash.

The second reason is that the principal officer, in this case the optometrist, is over-optimistic about the business’s potential. It is easy to get pumped up and full of great ideas, but this can lead to inflated forecasts. If these forecasts are not achieved, there are not likely to be sufficient cash reserves to solve this dilemma.

But, nothing happens without risk. The true entrepreneur is prepared to face adversity. This chapter is about identifying and managing risk.

A practice with the capacity for two or more optometrists offers so much more scope when it comes to planning one’s exit in the future. It places the ECP in a stronger position to gradually phase out of the practice while still drawing an income from it.

Professional help

At some point, the buyer will have to involve a chartered accountant and an attorney. Consider carefully whom you commission. Avoid appointing a high-flying attorney with high-flying corporates on his client list. Although the purchase of a practice will be a huge event

to the ECP, this type of attorney would consider it a small deal and it would not take preference over the big clients who monopolise their focus and time. These professionals have their reputations and professional codes to consider, so things often become complicated when they get involved. This is where the buyer plays an important role. While attorneys usually see things in black and white, the intuitive component of the deal cannot be ignored.

Specialised expertise is essential for issues such as tax, financial due diligence, and the sales agreement and shareholders’ agreement. It would be ideal for a buyer and seller to reach consensus on the basis of a deal, and together brief one accountant and one attorney. Should any discomfort exist, a second opinion would be in order. It is always best to avoid having too many professionals in either camp, and stands-offs on too many issues, which could jeopardise the deal. It is always best to get all the accounting inputs sorted out before

going to an attorney for the agreements. This will ensure that the agreement addresses all of the tax issues, resulting in the correct financial transaction. An ideal situation would be if the accountants had an in-house legal department, which allowed the two disciplines to work hand-in-hand on the deal.

Finding the seller, finding the buyer

The buyer often knows the seller and simply needs help to realise that. One should think about this before going to a broker. Optometry is a small community, yet still opportunities may pass one by. It is possible for the buyer and the seller to create the deal. This means that the prospective buyer becomes an employee or even a partner, with the view to buying the practice at a specified future date. There are many obvious benefits to this route. The most important one is that the buyer gets to know the business, and should know it inside out by the time the deal is done. Such a deal presents no surprises.

The seller, knowing the buyer as an employee, may be more inclined to assist in funding the deal in some way in order to make it happen. A potential buyer with great clinical skills, an attractive personal brand and added value to offer the practice, can be very attractive to a future seller and certainly expands the scope of a potential deal.

There are, of course, also many conventional ways to advertise a practice for sale, such as industry journals and online advertisers.

What is the price?

To reiterate, it is essentially about a willing seller and a willing buyer agreeing on a price. The bank will always apply pressure to lower the price in order to minimise risk. At the end of the day, a number of issues must pan out correctly:

The seller must accept a price that will make the deal work. The monthly payments to the bank must be within the capacity of the cash-flow.
The practice must be financially strong enough to justify the funding.
The buyer must be able to survive on drawings that the business can afford after paying the bank every month.

How much is too much?

At what point does the potential buyer walk away from the deal because the seller doesn’t want to budge on the price? The cash-flow of the business will, to a large extent, dictate the price. There must then be some buffer to pay for unforeseen events. However, it helps to

understand what an amount converts to in monthly repayments. For instance, the seller wants R100 000 more than the buyer wants to pay. Over five years, this extra amount represents R23 per R1 000 (a rule-of-thumb that changes with interest rates) at prime, in monthly payments. This is R2 300 per month. Looking at it from this point of view may make the buyer realise that the business can and will survive this relatively small expense.

These deals are usually structured over five years, but if things are tight, the bank may well offer the loan over seven years, which will reduce the monthly payment. Should there be a disagreement about the price, the question should be posed: Will the cash-flow be able to handle the additional burden?

What is the buyer buying?

Is it a good business that is a profit generator, or is the decision based on the perceived potential? It is wiser to buy a good business and pay a fair price rather than to buy something in the hope of turning it around. It may be suggested that a branch office has great potential, and all it needs is a young energetic optometrist on a full-time basis. Establish first if this was a full-time practice that has now deteriorated into a part-time practice. It usually takes quite a long time to mess up a good optometric practice, but by the same token, it takes even longer to fix, if ever.

Potential cannot be quantified or proven and therefore cannot be taken as justification for a higher price. It usually takes longer than expected to build a sustainable monthly turnover. The chances are that one will need twice as much working capital than originally thought. It is therefore far safer to buy a practice with a good financial history that also boasts an upward trend in all the benchmarks.

Assessing the location

This is essentially assessing the future. Ensure that there is nothing happening in the area that could be detrimental to business in the future. It would be a shame to discover after the fact that a bigger mall is going up across the road. Just like any business, locations such

as shopping malls have a lifecycle. They can only survive in the long run if reinvented or revamped along the way. Some locations become totally obsolete. New shopping malls have been popping up like daisies over the years, but it is important to recognise that new malls do not create new customers. All they really do is displace economies. A new mall could take three to five years to get going. During this period, the location will hardly ever justify the rent that tenants have to pay. One needs enough working capital to bridge this perilous period. Speak to neighbouring tenants and check with the local authorities what building plans have been submitted for the area. By observing customers in a mall, the buyer can learn a lot. The clothes that customers wear, the parcels they carry, and the cars they drive all tell a story. Bear in mind that most tenants are not best friends with the landlord, so this could distort the feedback.

Target market

It is important to know the demographics of the patient base. For example, if the plan is to increase contact lens work, it would be good know that the target market can afford it. The practice software package should provide one with the necessary information. Print out the postal codes that show where the patients live. If you can assess the property prices in the area, this will tell you a lot about their income levels. Another good report is a list of the top 10 medical aids, according to the amount of business done with them. Some will be conspicuous by their absence. Knowing the age breakdown of the patient base can also be very useful, bearing in mind that the fifty-something group is likely to generate the best turnover.

What are the tax implications?

Buying and selling a practice is not a simple matter and taxation is just one of the important aspects to consider and evaluate. The appropriate structure is not only driven by the taxation implications for the seller and buyer, but by other legal requirements, such as those stipulated by the HPCSA, as well as issues with underlying business entities.Taxation implications are always complicated and not necessarily aligned for the buyer and the seller. This means that a benefit to the seller may be a disadvantage to the buyer and vice versa.

The two transaction options

Option 1

Buy all of the assets, including intellectual property, such as trademarks; existing contracts; the business as a going concern; and liabilities from the seller. These could be individual, a partnership or a company. However, the business entity is not purchased and a new business entity is established to purchase the assets and conduct the business.

Option 2

Buy the shareholding and beneficial interest, such as shares, plus loan accounts. In other words, the business entity is purchased in its entirety.

Tax implications of Option 1

The seller realises the value of the transaction through the sale of individual assets, such as goodwill; trademarks; optometric equipment; stock; and debtors.
Each individual asset will result in a potential profit. Depending on the nature thereof, SA Normal taxation or Capital Gains Tax (CGT) will be realised.
Optometric equipment will result in the recouping of depreciation previously written off. This will be taxed as SA Normal taxation. Capital assets, such as goodwill, will be taxed at Capital Gains Tax rates.
Capital Gains Tax is substantially lower than SA Normal tax. The seller will always attempt to sell capital assets at the highest possible value.
The buyer will not often be able to write off all of the capital assets and would therefore desire the opposite from a taxation point of view.
Tax rates applicable to the seller will depend on the business entity, individual and partnership at rates applicable, with a maximum of 40 percent. Other entities will be taxed at applicable rates, with the company rate at 28 percent.
The buyer, or buying entity, will depreciate the applicable assets, such as optometric equipment, and enjoy the benefits of the taxation write-off. This is based on the buyer or buying entity’s taxation rate. For example:
- Value allocated to the optometric equipment is R500 000.
- Assume a five-year write-off at 20 percent per annum, or R100 000.
The taxation benefit to the buyer will be calculated as the write-off multiplied by the applicable taxation rate. Assuming a company, the benefit will be R100 000 at 28 percent, which amounts to R28 000 per annum for five years.
The seller is left with the business entity that has sold the business and assets to the buyer. In the event of the entity being a company, additional complications could result as the seller is not the recipient of the purchase price and may have to declare a dividend in order to obtain the funds. This could result in dividends being taxed at 15 percent.

Taxation implications of Option 2

The seller will realise the value of his interest in the business entity sold. In a company, this will be the shares and loan account.
The seller should realise a capital gain on the value of the transaction and be taxed at the applicable CGT rates. The capital gain will be the profit over the base cost of the beneficial interest (shares plus loan account) in a company. In the event of selling shares, the seller receives the funds directly and the taxation is limited to CGT. All other taxes in Option 1 are avoided. This method of selling is often beneficial to the seller, as CGT is relatively low compared to other taxes.
The status and nature of the seller will determine the actual CGT rates.
The buyer is taking over the existing business entity and there is no change to the taxation status. The buyer is merely acquiring the beneficial interest (shares plus loan account, if a company) in the business entity. The entity will usually continue without disruption. The buyer establishes a base cost for CGT purposes and for future transactions involving the beneficial interest.
The business entity purchased by the buyer will be taxed according to the existing taxation principles and at the relevant taxation rates (28 percent, if a company). The entity will continue to write off depreciation on allowable assets, such as equipment, based on thehistorical values. This is done without being impacted by the value that might be placed on the transaction in Option 2.
A benefit of taking over an existing entity might arise should the entity reflect a taxation loss/assessed loss. Future profits will be written off against the assessed loss. Assuming a taxable profit of R100 000 during a year, and an assessed loss of the same amount, would result in the profit not being taxed (due to the write-off against the assessed loss), thus resulting in a saving of R28 000. There are strict rules regarding the use and purchase of a company with assessed losses, and an expert should be consulted to structure such a transaction.
A potentially major complication could arise (if the business entity is a company with reserves), thus forcing the shareholders to draw excess profits by way of dividends. This would result in a 15 percent dividend tax. Very often existing companies are “rich” in potential dividends that are locked up in reserves (retained earnings). A potential buyer should always be aware of this during the evaluation and structuring of a transaction. A buyer could easily end up taking over the potential dividend tax liability (15 percent of reserves) without a discount on the transaction price, in order to recognise the potential liability. Shareholders’ loans are often valuable and could limit the need to declare dividends, but this is also complicated. An expert should always help deal with dividends, shareholders’ loans, and related matters.

Which business entity is best?

Buying the business’s assets and the business in a new company (Option 1) is the safest way to proceed. This should be the preferred option. This option eliminates future risks that may arise from claims against the seller (company or close corporation) that may not have been disclosed, or even recognised, at the time of the transaction. The main benefit of trading as a company is that it is a legal entity with limited liability. The company is responsible for its actions and liabilities, and the shareholders are not liable. The situation is more complex with regards to directors, but under normal circumstances, neither the shareholders nor the directors will be liable for the debt of a company. However, if a shareholder or director signed surety for the debt or liabilities of the company, those individuals would be liable for

that particular debt. In the past, companies were often shunned as a result of the compulsory annual audit, but this has changed in recent years. Very small companies may now be exempt from audit. Medium sized companies should be subjected to an annual review, resulting in substantially reduced compliance and auditing costs. Companies may still elect to be audited and in general, large companies will still be audited on a mandatory basis. A close corporation used to be a popular choice with small-to medium-sized businesses because it was cheaper to operate but afforded some level of limited liability. However, under the new Companies Act, new close corporations may no longer be registered. The Health Professionals Council of South Africa (HPCSA) has ruled that there is

a conflict between limited liability and professional liability. In terms of HPCSA requirements, optometrists are not allowed to practice as a private company. It would be advisable to get a professional opinion in order to implement the optimal structure for you. It is often beneficial to separate the professional or clinical practice from the retail business. This involves setting up an incorporated company.

Funding of transactions

An optometric practice is often funded by a bank or similar loan that bears interest. When weighing up the two options, ensure that the interest on the loan is deductible for taxation purposes.

In summary

Option 1– purchasing the business and assets. With this option, the buyer or buying entity will be obtaining funding and receiving all of the business income. The interest on the loan and funding will be deductible for tax purposes. This option is thus very effective from a funding point of view.
Option 2 – buying the entity. This results in the retention of the business entity and the buyer acquires a beneficial interest in the entity – often a company. Profits will thus be drawn as dividends, and SARS disallows the interest on loans that generate dividends. There are ways to address this problem, but professional advice should be sought. The latest amendments to the Income Tax Act allow relief under certain circumstances, but there are very specific requirements.

Equipment

The ECP is the best person to assess the equipment. The purpose is simply to see if everything listed in the assets register is there and in an acceptable condition. Optometric equipment can depreciate in value at 20 percent per annum. This means that after five years, it has no value in the books. However, the lifespan of many types of optical equipment can be far longer. The seller will therefore attach a value, even though written off in the books.

Patient records

Practice management software should be able to reveal the number of current records. Patients seen during the past six years can be considered current. The number of new patients seen on a monthly basis gives an important clue as to growth.

Debtors, stock and creditors

These numbers have to be verified, and in the case of stock and debtors, a decision must be made about how much should be written off. How much of the debtors’ book is old and not recoverable? How much of the stock is old or damaged? How the creditors are settled is significant. It is common for these numbers to vary while the deal is being negotiated. What is important is that the sum of all three elements remains fairly constant from the time recorded until the effective date, in which case nobody loses out. If the CVM, discussed in Chapter 16, is applied, then one should not be pedantic about stock and debtors since the focus is on the net profit. However, the CMV does not promote that the debtors and stock be ignored altogether.

Supplier discounts

Any change here will impact on the GP%. The buyer needs to be assured that the same discounts will apply, and this is best verified directly with the suppliers themselves. This is also the most likely area where gross profit can be improved by better supplier deals.

Unbanked income

If the seller was understating the turnover in order to avoid paying tax, this presents a sticky problem at the time of the sale. The buyer cannot be expected to accept a higher value than is reflected in the audited financial statements.

Average invoice

This number tells a valuable story about how well the practice sells to its customers. Should this value be abnormally low, it may present a good opportunity to improve turnover. One should also look at the historical trend in this number.

Benchmarks

Financial benchmarks are of great value in assessing the financial position. Good benchmarks will engender confidence in the deal, but poor benchmarks can sometimes indicate opportunities to improve the business, as is the case with a low GP%. This can easily be fixed by introducing the right protocols.

Claims against the business

Assurance must be given that there is no pending legal action against the business. This is the main reason why accountants favour starting a new company.

The rental agreement

The buyer must meet the landlord personally in order to establish a relationship and get the reassurance that the lease will be transferred to the new owner. It would be advisable to consult an attorney to go over the agreement. One of the clauses to guard against would be a turnover clause, which usually stipulates that the rent is either a fixed amount, or a percentage of turnover, whichever is greater. Moreover, the lease agreement sometimes states that the tenant has to inform the landlord in writing six months before the lease lapses, about an intention to renew the lease. If this is not done, the tenant forfeits the option to renew the lease on the terms set out in the existing lease agreement. This means that the landlord can present a new lease agreement that is very different from the original agreement. This could mean an unreasonable increase in rent because the landlord knows that the tenant will find it almost impossible to relocate his business at such short notice. It is vital that the tenant initiate negotiations to renew the lease at least 12 months before it expires. If the buyer is faced with taking over the practice with a relatively short period remaining on the lease, the lease should be renegotiated before the effective date of sale. One of the suspensive conditions in the sales agreement should be that the deal is subject to a satisfactory lease agreement being signed over to the new owner. Trading hours and what actually happens in the practice could also become issues. If it is in the rental agreement the landlord could demand those trading hours at any point in time. Lastly, the agreement should protect the tenant against new optometric practices opening up in the shopping centre or mall.

The lease agreements

Equipment on a lease agreement or instalment sale does not belong to the practice and cannot be sold as such. Photostat machines are typically on a rental agreement, which usually stipulates that unless cancelled six months before the end of the term, the agreement is automatically renewed for another term. It is wise to diarise these dates. It is also cumbersome to transfer these agreements to the new owner. An easier solution can be found by addressing this in the sales agreement.

Employment records

The buyer must carefully study the employment agreements of staff. If there are no records in place, this is the opportunity to renegotiate employment contracts. One does not want surprises later on, such as discovering that a dispenser for instance, only works every second Saturday.

Winning over the team

The buyer inherits the terms and conditions of all the employment agreements. Most people do not deal well with change. The new boss will be inclined to do some things differently, and staff are inclined to hang on to their old ways of doing things. For the buyer and new boss, this presents a mammoth challenge. It is a tall order to have to gel with

a whole new group of people. Experience dictates that in this scenario, staff turnover in the first few months is inevitable. It is probably best not to make too many changes too soon. Involve employees by asking each individual what changes they would suggest.

The effective date

Raising a loan always takes longer than anticipated. Bank salespeople invariably paint a pretty picture, but once the credit committee gets involved, it becomes a very different story. A two- to three-month wait is not uncommon, provided that all of the required information and documents are well organised and ready. The buyer must avoid making promises to the seller based on what the bank’s marketing people say. This can cause a lot of unnecessary anxiety and stress. If there are repeated delays, the seller may start to doubt the buyer’s word, but the buyer can only pass on promises from bank officials. The aim should be for payment and change of ownership to happen simultaneously on the effective date. Bear in mind, every professional involved gets paid to look after the client’s interests. It can be handy if the effective date coincides with the year-end, but this should certainly not be a deal-breaker.

The sales agreement

The sales agreement ensures that both parties do what was promised. Much of this agreement is made up of standard clauses. The important parts are the suspensive conditions, and how and when payment will take place. One of these conditions may state, for instance, that the buyer will only proceed if a loan is granted. Every effort should be made to keep the agreement as simple as possible without exposing one’s self to risk. Some attorneys can draft very complex documents, written in a legal jargon that is difficult to understand. This is unnecessary.

Restraint of trade

The restraint of trade will be dealt with in the sales agreement as a matter of course. It prohibits the seller from competing with the buyer in the same catchment area after the sale of the business. A restraint of trade agreement must be realistic and reasonable in order to hold up in court. It cannot prevent the seller from plying a trade to make a living. For instance, it would be unreasonable to restrain the seller from practicing anywhere in Gauteng for a period of 10 years. There are two main restraints in play: Time and distance. When paying good money for a business, a restraint of a 10km radius and seven-year period would probably be reasonable.

Positive cash-flow

Recognise at the outset that the bank owns the business, or is the main shareholder. The first objective in the new business should be to get rid of the gearing. In other words, pay the bank as soon as possible. By understanding the mechanics of cash-flow, one can plan to maximise it with the aim of becoming completely debt-free and paying all bills over 30 days. This involves keeping a tight rein on debtors and stock control, and buying smart. When cash-flow dips, a common but ugly practice is holding back on creditor payments. This can easily become a nasty habit and is akin to a gambling problem. In the long run, this game plan catches up with the ECP, and the outcome can be catastrophic. The personal lifestyle and spending of the owner should be in line with what the business can afford. The key to understanding what the business can afford to pay the owner lies in the presentation of good financial management information.

New patients

Real growth means getting new patients and keeping them. If one manages to do this, turnover will grow. To this end, forecasts and planning are essential. It is advisable to base this on the Gap model, which forces one to explain how new business will be attracted.

The buyer should consider the following:

How do I maintain the current turnover?
How do I ensure that the patients don’t leave with the previous owner?
What do staff tell people about the take-over?
How do I budget?
How do I deal with the creditors during the first two months?
When do I address my new staff – before or after the deal is sealed?
Must I renew staff contracts?
Can I retrench anybody I don’t want?
How do I select a wholesaler and negotiate discounts?
Should I continue with the previous auditors, or appoint a new firm?
How much do I pay myself?
How will I let people know I am here?
New VAT registration can delay your VAT claims.
Medical aid payments can be delayed if your practice and banking details change.

Due diligence

The process of the purchase of a business can almost be totally covered by the process of due diligence. What follows is a comprehensive example of a standard due diligence document. The due diligence procedure laid out here is very detailed and may well stretch beyond what is required in the purchase of an optometric 38 practice. However, it will give the reader insight into the depths it can plumb.

Due diligence request list:

Last three years’ audit financial statements for the group (including consolidated financial statements).
Last three years’ tax calculations and tax returns.
Last three years’ tax assessments.
Group structure and details of subsidiaries.
Organisational chart and management structure.
Names, addresses and contact details of the attorneys, auditors, principal bankers and insurance brokers.
Brief history of business activities.
Summary of all legal agreements, as applicable (distribution agreement; finance leases; royalty fees; trademarks/copyrights; funding structures; agreement with co-operatives; restraint on trade agreements).
List of current directors (details of age; qualifications; position; service agreements; profit share arrangements; remuneration; and any other benefits).
List of current managers (details of age; qualifications; position; service agreements; profit-share arrangements; remuneration; and other benefits).
Summary of current wage and salary structure detailed per employee.
Brief description of, and documentation on, foreign exchange exposure.
List of current customers, detailing average sales to each.
List of debtors’ age analysis, on review date and the prior year.
Working papers on bad debt provision, on review date and the prior year.
List main suppliers, detailing average purchases from these suppliers, and credit and discount agreements.
List of creditors’ age analysis, on review date and the prior year.
List of accruals and provisions, on review date and the prior year.
Summary of current accounting policies employed by the company, if not disclosed in the annual financial statements.
Summary of share to dividends; votes; liquidation; conversion; redemption.
Details of any share options in existence, including the terms and conditions.
Shareholders’ loans, detailing key terms and conditions.
Summary of all long-term liabilities for the last financial year, as well as the year to date, detailing to the lender the terms of borrowing; repayment schedules, security given; interest rates; and guarantees.
Copy of the memorandum of articles of association of the company and of the subsidiaries.
Fixed assets registers, per category and per branch.
Brief description of the EDP software and hardware currently in use.
Schedule of all intangible assets, detailing the key terms and conditions.
Schedule of all other investments the company may have, detailing name; type of business; percentage holding; nature of investment; present market value and income received in recent years from the investment.
Inventory schedule, detailing breakdown of inventories as at the review date and the current year to date, together with an age analysis of all material items and details on frequency of inventory counts. Obtain details of all inventory adjustments and inventory write-offs in the last two years, and the reasoning for this.
Schedule of all bank accounts, detailing the purpose of each account.
Schedule of all bank accounts, detailing other facilities; guarantees; acceptances; credit limits; bills of exchange and standby facilities (if any); as well as the nature and value of any security issued.
Schedule of all intercompany/group loan accounts, detailing the terms and conditions, as applicable.
Details of any current pending or threatened litigation, or legal proceedings against or involving the company and/or its subsidiaries/associates.