The question of practice valuation

(From the book Navigation the business of optometry)

Each practice valuation will be unique. For this reason, it is impossible to come up with a formula to value optometric practices across the board. Ask five people for the formula for valuing an optometric practice, and in all likelihood, you will get five different answers. There could be several reasons for wanting a practice evaluation. These could include a starting point for negotiations to sell a practice; settling an estate; the dissolution of a marriage; the dissolution of a partnership; or a planned retirement; relocation; emigration; or even illness. It is not unreasonable to expect a practice to one day feature strongly in a retirement package, but it would be disastrous if the practice was over-valued in one’s own estimation.

There are several approaches to determine the value of an optometric practice. Some of these are very complex and difficult to execute. At the end of the day, the price the seller gets is the price a buyer is prepared to pay. This is largely influenced by the money the  buyer is able to raise and the extent to which the cash-flow will service the repayments of the loan.

Fair market value

Fair market value is the maximum price a buyer will pay and the minimum price the seller will accept when all the facts are known and neither party is under pressure from unfavourable circumstances. If such a transaction occurs, then the actual transaction price is

the fair market value. The opinions of outsiders who are not actually buying or selling the asset have little meaning, because they are not active in the market. Therefore, fair market value is not the same as intrinsic value.

Intrinsic value

This is the value that different individuals may place on the same asset, based on their own formulae, experience, and opinions. The bank will usually have a strong opinion on the price, but this is influenced by the risk exposure of the transaction, which they want to minimise. The fact remains that outside opinions are meaningless in terms of fair market value.

Internal factors affecting the price

A desperate buyer or a desperate seller

The buyer may specifically want to live in a particular town or suburb. The seller may have an urgent need to acquire another asset or may need the money for a divorce settlement. These factors could clearly influence the fair market value. That is why you should ask why the business is being sold.

Practice trends over time

The trends of turnover, net profit, and the number of patients seen over the previous three to five years would have a direct bearing on the price. The buyer would want to pay less if there was a diminishing tendency. Likewise, the seller would have a strong case for a better 

price if he could prove an increasing tendency over time. Negative trends clearly spell trouble, unless a plausible reason can be found.

Practice Benchmarks

Comparing the practice benchmarks with industry standards can reveal a lot about the well-being of the business. For instance, the turnover may be impressive, but at least a 20 percent net profit and GP% of 67 percent should be realised.

Adjusted net cash-flow

This demonstrates the ability of the business to service the loan. To determine the true earning power of the business (for the business’s owner/manager), the pre-tax net profit is adjusted by adding back the owner’s salary; discretionary expenses; perks; depreciation; unusual one-off expenses; and interest expenses. In other words, all measures are used to create the cash-flow to pay back the loan. This means the buyer will have to accept less remuneration than what the seller had enjoyed at that point in time.

Undisclosed income

If the seller is guilty of tax evasion by not declaring the total turnover, this becomes problematic because the business valuation can only be based on what appears in the financial statements.

Staff

A well-trained, loyal, and experienced staff would enhance value. This should never be a deal-breaker, because the new leader will invariably develop a team in line with the new management’s style and personality.

A broad source of revenue

This would reflect positively on the value. Revenue should not be limited to one specific market segment, such as a big employer in the area, or a student patient base. To find this out, analyse the patient database by postal code and medical aid.

Local competition

Competition is not necessarily a bad thing. However, the type of competition is important. Differential advantage would be key. A particular mall may be perceived as an outstanding location, but when shared with four other optometrists at premium rentals, it may not 

turn out to be a good choice.

Location

Does the location have a future, or is it nearing the end of its tenure as a viable location? On a macroeconomic level, is there a migration of workers from the area? Will a new mall down the road displace the local economy?

The lease agreement

The buyer needs assurance that the business will be able to continue operating from the premises. Is there an option to renew the lease on acceptable terms?

Patient records

The condition and size of the database are important. It should be analysed to determine the demographics of the patient base in terms of age, medical aid, income group, and where they live (postal codes). Only patients seen in the past six years should be deemed significant.

Potential growth

Often sellers will promote the notion of potential growth and attempt to attach value to it. Unfortunately, this is not acceptable as potential can’t be quantified.

The financial statements

If the seller is battling to produce management accounts within a reasonable time frame, take this as a warning sign. It begs the question: “Does the seller know what is going on in the business?” Good financial management and the availability of real-time financial information are indicative of a healthy business. The tell-tale sign is the monthly stock-take. If the inventory is not measured on a month-to-month basis, quality accounts cannot be generated.

The practice brand

It may not be that simple to follow in the footsteps of a binocular vision specialist with a good reputation. In other words, how much goodwill will be lost when the selling optometrist departs? By the same token, if the practice looks and offers the same as everybody else in the neighbourhood, it could be hard to facilitate growth. Mediocrity 

is dangerous. Avoid more of the same.

Return on investment rate

The capitalisation rate is an indirect measure of how fast an investment will pay for itself. For example, if a practice is purchased for R2 million, and it produces R400 000 in positive net operating income during one year, it will have a five-year pay-back period. A business’s net operating income is the value after the operating expenses are deducted, but before income taxes and interest are deducted.

In this example, the asset’s return on investment rate is 20 percent and can be paid off in five years. In order to simplify the explanation, interest, and tax implications are not factored in.

External factors affecting the price

Optometry used to be a very attractive career choice. The relatively reasonable cost of education as well as low start-up costs drew people into the profession. The appeal was also the independent, entrepreneurial nature of the profession, the cultural and economic status gained within the community, and the constant demand for services. However, it appears that the supply of optometrists has overtaken the demand for optometric services. The following external factors may have a profound effect on the fair market value of optometric practices in South Africa.

Baby boomers

In South Africa, relatively few optometrists graduated in the 1970s. For instance, in 1974, only 16 optometrists graduated in the country. However, there was huge growth in the number of graduates through the 80s, 90s, and beyond. This means that there are relatively few optometrists (baby boomers) who are in the age category for retirement. It follows then that there are relatively few practices for sale in South Africa, which in turn means that the profession essentially grew through start-up practices.

Group practices for sale

During the early 2000s, blocks of practices were put up for sale, driven by corporate decisions by some of the bigger groups in South Africa. This can be deemed an unusual occurrence and the fair market value in this instance should be viewed in the context of the reason for selling.

Gender inequality

A sample of 761 optometrists registered with the HPCSA, over a period of five to seven years, showed a gender split of 70% female and 30% male. It could be argued that some women who have entered the optometric field might have chosen optometry because it allows the flexibility of practicing part-time, allowing the space to raise a family while still contributing to the household. However, working hours in mall practices have become very demanding. The gender issue may significantly reduce the number of potential buyers in the market, which may in turn affect the value of practices in general.

Availability of capital

It has become incredibly difficult to raise capital for big transactions in the optometric industry. In general terms, optometry is not deemed an attractive industry by banks. This is because a number of big optometric ventures involving huge amounts of money went belly-up over the past 10 years. Raising funds is perhaps the most telling factor when determining fair market value. The availability and cost of capital have a huge bearing on fair market value. This scenario works to the detriment of sellers who are constantly subjected to pressure by the banks to accept a lower price.

National and local economics

There is very little that the small business owner can do to counter the mighty force of macroeconomic trends. Should turnover drop on account of a lack of disposable income in the catchment area, the ability to service a loan will be jeopardised.

The formulae for price

There are many interesting and peculiar rules-of-thumb for determining price. Some examples are:

• One-and-a-half times net earnings plus replacement cost of the stock.

• Annual net profit times three.

• Seventy percent of the average of the last three years’ turnover.

• One year’s turnover.
  

The list goes on, but it would be unwise to attach too much value to 

these rules. There are too many other factors at play. There are a number 

of more sophisticated approaches, but these can be complicated and 

it is often difficult to obtain the information required.

What is the buyer buying?

Whether a practice is bought, or one is started from scratch, the idea is to acquire a future income stream that will afford an acceptable lifestyle. Buying a practice is really about buying a money-making machine. It is more about the practice’s ability to generate a consistent net profit than it is about the assets. A beautifully appointed practice with state-of-the-art equipment could generate a feeble profit every month. For a practice to be attractive to a buyer; it must generate a handsome net profit. It, therefore, stands to reason that the due diligence process should focus on the prospects of the business’s continued ability to deliver this bottom line. How much would one be prepared to pay for a “money-making machine” and how would it compare to other methods to obtain a future income? It may be prudent to get a handle on what it takes to start a practice, or on what constitutes success in the corporate world.

What return could be expected from a similar capital investment? The prospective buyer may develop a better appreciation of the true value of an optometric practice with a handsome bottom line once these comparisons have been made.

What constitutes a good income?

In order to come to terms with the value of an optometric practice that generates 20 percent net profit, it may be prudent to compare the income with corporate salaries. An optometric practice without any loans to pay off (no gearing) is capable of generating a 20 percent net profit. A practice with a monthly turnover of R416 000 per month (R5 000 000 p.a.) could generate a net profit of R1 million per annum. How does this compare to corporate salaries?

Corporate salaries

To put things in perspective, a corporate executive earning R1 million per annum will feature in the top 10 percent of salary earners in South Africa. Many optometrists will find themselves in this bracket. An income of R2 million per annum will happen for the top three percent of South Africans. This level of income from an optometric practice is not common, but it certainly exists.

A practice with a turnover of R250 000 per month is capable of generating R600 000 net profit per annum. This compares to executive level management in the 35 to 45-year age groups. On the whole, it appears that a thriving optometric practice provides an excellent comparative income in South Africa.

The truth about starting up a practice

In today’s economic climate, starting a practice from scratch is risky. It is also difficult to find good locations with untapped optometric markets. A common oversight is underestimating the working capital required to get to the stage where the practice is profitable. This invariably takes three to five years. The bottom line is that the ultimate cost to take a practice from set-up to financial success will invariably be much more than the initial budget.

The bank should not dictate the price

When the bank considers a loan application to buy a business, it has two main concerns:

• Will the borrower (the practice) be able to meet the monthly payments to the bank (cash-flow)?

• What will happen if the business fails (surety)?

To minimise this risk, the bank will want the purchase price to be as low as possible, with some headroom in the cash-flow. The bank knows that if the business ends up on auction, the value of the assets will plummet The seller should therefore guard against simply succumbing to the bank’s recommendation on the price. The situation is often compounded by the fact that the buyer has little to show by way of a deposit and needs to borrow close to the total asking price. Due to a vested interest, the bank’s valuation should always be considered with caution.

Consolidated valuation method (CVM devised by the writer)

This method, specifically for optometric practices, is based on a factor of 3.5 multiplied by the net profit before tax, and has been tried and tested over time. It takes into account the key factors that may have a bearing on the future viability of the business as a going concern. It also recognises that a component of the valuation process is intuitive.

The CVM can only be applied if the following holds true:

• The practice is a going concern.

• The practice has a history of profitability that extends at least three years.

Going concern

In accounting, “going concern” refers to a company’s ability to continue functioning as a business entity. This means that the business will be able to generate cash and meet its commitments, remaining in business for the foreseeable future.

Profitability

The only measure of success is the net profit, and therefore the lifestyle that a business provides. It makes no sense to link a valuation to anything other than the net profit. In the CVM, the net profit is the main factor. Financially speaking, all of the good and the bad in the practice will ultimately be reflected in the net profit.

The CVM comprises:

• The formula.

• The factors.

• Intuitive decisions.

The formula

Net profit before tax X 3.5 = base price

The factors

These are the factors that may influence the business’s performance as a going concern (there may be more). The primary factors could probably be considered potential deal-breakers. All the listed factors could have a bearing on the valuation of the business. The buyer should score the factors, either positive or negative, as part of the due diligence process. Should all the factors be positive, the seller would have a strong case for a value of net profit X 3.5.

If there were negatives, the buyer would have a strong case for a reduction in the price. The secondary factors would be viewed more intuitively. For example, some buyers might want to build their own staff team and therefore would not attach much value to the current staff. These factors create the platform for substantive negotiations on the price.

 

Factors influencing a business’s performance as a going concern .

• Primary factors

• Financial trends of the practice

• Benchmarks

• Location

• Lease

• Pay-back rate

• Seller’s drawings

• Secondary factors

• Patient records

• Sources of revenue

• Condition of assets

• Staff

• Practice brand

• Differential advantage

• Competition

• Growth potential

The intuitive component

The temptation arises to allocate a weighting to each factor and to link these to the formula net profit X 3.5, so that the price will be adjusted accordingly. However, this would be unwise because the intuitive component of the deal cannot be ignored and the concept 

of fair market value has to rule. So, one must not lose sight of the fact that the buyer and/or the seller may be under pressure due to unfavourable circumstances.

The premise of CVM

The premise of this method is that the buyer is essentially buying a money-making machine as a going concern. Therefore, the buyer should not be pedantic about the finer details of the debtors and stock and assets, since the focus is the net profit delivered consistently over

time. The 3.5 factor is based on the experience of the writer and is not the price earnings ratio per se. The price earnings ratio is difficult to apply to a small, private company. For the sake of clarification, the PE ratio formula is given below:

Issues surrounding funding and payments

In South Africa, the conventional funding method is a term loan taken over 60 months. More often than not, the buyer does not have a cash portion to contribute. Several tax issues come into play that are not all accounted for here. Three finance options are usually available. One is the 60-month term loan; the second utilises funds from a property bond; 

and the third is a combination of a 30 percent cash deposit and a 60-month term loan.

Pay-back – how it works

For the non-financial manager, the mechanics of loan instalments and the related tax implications often wreak havoc. Part of the instalment is allocated to the interest portion, and part to the capital portion of the loan. Professional help is required here.

Third-party involvement

It makes sense for the buyer or the seller to employ an attorney and/or accountant to guide them through the deal. There are many important issues relating to cash-flows, tax and agreements that are best dealt with by professionals.

A word of caution: Do not remain on the periphery of the deal. Personal insight is very important. It is possible for two professionals representing the two parties to become too focused on showing their professional prowess, and they could lose sight of the intuitive

aspect of the deal. It would be unwise to give a complete mandate to a third party. This could easily end in a no-deal situation, without the prospective buyer understanding why the final offer failed.

Final word

The seller will always strive for the highest price – and rightly so. Once the deal is struck, the effective date arrives and payment is made, the seller has no further involvement or risk. The seller does have the prerogative to turn down any offer. The buyer wants to buy a lifestyle or a money-making machine. The task at hand is to ensure that there is nothing that will impact negatively on the net profit in the foreseeable future. Usually, the buyer’s biggest challenge is raising the finance. This often shapes the deal. In the end, it all comes down to a fair market value – the maximum price a buyer will pay and the minimum price the seller will accept, when neither party is under pressure due to unfavourable circumstances and they know all of the facts. If unfavourable circumstances do exist, the price will change.

There are many vital forces that come into play when arriving at fair market value. It would be foolhardy to blindly latch on to only one of the formulae or methods. The key issues are the seller’s circumstances, the buyer’s circumstances, the availability of capital and, lastly, the assurance that the practice will continue to provide the income the buyer seeks (risk).

The Consolidated Valuation Method proposed is intended to serve as a framework to help the prospective buyer embrace all of the key issues, while recognising that intuition will always play a significant role.

In essence, the buyer is purchasing a future income and lifestyle and needs to be diligent to ensure that the long-term outcomes are in line with this expectation.

The adage goes: “There is no such thing as a devious seller, only a poor buyer.”