[Editor's Note: Today's guest post was submitted by Brent Hecht, MBA of iqcalculators.com. Brent is an accountant in the greater Kansas City area that advises doctors as they go through the process of evaluating medical practice buy-ins. We get a lot of questions on this topic, but my personal experience with it is pretty limited, so we thought a guest post on it would be useful. We have no financial relationship.]
Maybe you're a doctor that's just getting started, or perhaps you're looking at changing jobs from a hospital doctor to a family practice office. Regardless of the reason, let's assume you'd like to buy into a practice, and you have some options but aren't sure which is the best route to take. First, this is probably not something you'll want to do alone or solely based on the advice in this article. There are experts that can help you in this process. More specifically, there are legal and financial experts that specialize in this sort of thing and can be a great resource to you (for a fee of course).
Much of the screening process will come down to personal preference. I wish I could tell you there is one straightforward way that most offices structure their buy-ins. But, fortunately for the doctors out there, buy-ins are structured in as many different ways as there are doctor's offices. This variance should be considered an advantage to the doctor as each doctor has differences in their preferences.
Doctor's Pay Structure
When evaluating a buy-in, first you'll want to understand how the payment will be structured not only for you as a doctor, but also as a part-owner. The doctor pay will likely be some mixture of equal pay and incentive-based pay. And along with that, equal expenses and incentive-based expenses. When I say incentive-based expenses, I mean expenses that will get split in a way that incentivizes the doctors not to incur said expenses. You, the doctor, have to determine what type of revenue and expense sharing structure will suit you best. The ideal circumstance probably sits somewhere in the middle of equal and incentive-based pay.
One of the most critical aspects of the compensation plan is that it gets laid out in simple terms and that it gets communicated clearly. It is unfortunate if the compensation plan is so elaborate that it is difficult to track or if it doesn't get communicated clearly enough that disagreements arise after things are agreed upon in writing. It needs to be simple and clear so that it is measurable and manageable.
As I've already said, there are two sides to the income spectrum: equal pay and incentive-based pay. The advantage of equal pay is it incentivizes strong teamwork, and it is easiest to track and calculate. However, if there is a significant variance in individual productivity, then equal pay may not be the best.
On the other end, the advantages of incentive-based pay are it motivates individuals to work harder as well as being more responsible for expenses. On the other hand, in a 100 percent incentive-based pay system, the team aspect of an office can be lost, and every man for himself mentality can dominate. Further, it may incentivize individuals to game the system, depending on how the compensation gets calculated. This fact leads to the point that the pay may be more challenging to figure with incentive-based compensation.
That is why some combination or a blend of the two types of compensation is probably best. One example might be that the expenses get split evenly while the income is divided based on productivity. That is unless there's a significant expense that increases as productivity increases, which would make sense to correlate to productivity somehow.
When it comes to expenses, there are only a few major ones. There's support staff, equipment, supplies, office space, and malpractice insurance. There are others, but those identify the big-ticket items.
Keep in mind that whatever system is in place currently, it may not be the system that is in place shortly after you buy into the practice. These things can change, so if you think you found a buy-in with a system that is right for you, be sure to ask if they have any plans to change the policy in the near future.
As part-owner in the practice, you are entitled to share in the profits that the company earns annually. It's important to familiarize yourself with what this amount was in the past, and if this is the expectation going forward. What percentage of the profits will you be entitled to?
You'll want to examine the income statement and cash flow statement to determine what this amount has been in the past and what direction this number is trending year over year for the past 3 to 5 years. This is essential in order to project cash flows so you can accurately value the buy-in.
What Are You Bringing To The Table?
Although you are the one buying-in, it is essential to remember that you may also be bringing something to the table. You may have been a staff doctor at another office in the town where you built up a loyal following of patients, and it will be safe to assume that some of those patients will follow you to your new location. What is this worth to the practice asking you to buy-in?
It's also possible that you have highly coveted skills in a specialized area that this doctor's office needs, to have a more complete offering. However, it is more difficult for this to be a selling point because, hopefully, you'll also be joining a great team that also has skills and experience. And hopefully, that makes it a mutually beneficial arrangement that cancels most of the leverage you may have.
Evaluating The Buy-In Price for a Medical Practice
Everything we've covered up to this point has been to get to a point where we can evaluate the buy-in price. It's impossible to assess the buy-in price without understanding precisely what you will get in return.
When you evaluate the buy-in price, there will be components of value that are tangible and intangible. We've discussed some of the intangible components already. But only you know the “intangibles” that you value more than others. Therefore, it doesn't benefit the reader if we discuss those. Instead, we will discuss the tangible benefits of a buy-in, namely, the financial benefits.
Accounts receivable is a line item on the balance sheet where what their patients owe the practice gets accounted for. Only 30 to 40 percent of practices require you to purchase accounts receivable when you buy-in. If you aren't required to purchase accounts receivable, this can mean substantial savings in the buy-in price.
The book value of a company is the company's assets minus its liabilities. It is also known as equity on the balance sheet. The book value is useful because it forms a baseline for the company's value. The value of a company is almost always higher than the book value. It is higher because the assets of the company get used to create future cash flows. To purchase the company at a fair value, you must pay for the future cash flows as well.
Here are some questions to ask about the book value of a company. Does the book value include real estate ownership? If so, does the buy-in price include ownership in the real estate assets? Is there anything in the book value of a company that gets excluded from the buy-in agreement?
When using the comparable sales method of valuation, a sales to book value metric can be used to form a relative valuation. More on the comparable sales method below.
Goodwill is something that appears on a company's balance sheet after they purchase another company. In this context, goodwill is the amount of money above the book value. Some say that the money paid above book value is for intangible benefits like the company's location or brand. However, it's better to look at it as paying for future cash flows of the company.
I'd be remiss if I didn’t discuss cash flow. Cash flow is the item that primarily gets used to run different valuation methods named below.
Technically, cash flow is the total revenue minus all expenses to arrive at a net income, then adding back in all of the non-cash expenses such as depreciation, to equal cash flow. Cash flow will be used in conjunction with the time value of money to determine the fair value of the buy-in.
The comparable sales method looks at similar sales that have happened in the geographical area in the recent past, similar to buying real estate. Based on the selling price and the financial information of the practice, it will give you an idea of relative value to other buy-ins.
This information will be hard to come by apart from help from an industry professional. That is because you will need to know something about the financial reports of the practice as well as the selling price. If you are going through this process without the help of a professional, you may want to rely on a different method to make your decision as the data likely won't be public.
If you do have access to the data, then a relative valuation can be used. You will want to look at different ratios such as “sales price relative to book value,” or “sales price to revenue,” or “sales price to free cash flow.” These are three metrics that can help you use the comparative sales method to derive a relative value. You'll want to use several parameters in case one metric is skewed for whatever reason.
Discounted Cash Flow Method
The discounted cash flow method is another valuation method that gets used. Out of all the methods that can be used, this may be one of the better methods, although the best approach is probably a combination of all of the methods. The discounted cash flow method simply projects out 5 to 10 years of future cash flows and uses a discount rate to discount the cash flows back to a present value.
To choose a discount rate, choose a reasonable rate of return that you'd like to receive on your investment in the practice. Some say a reasonable discount rate is somewhere in the 15 to 20 percent range. The more perceived risk involved, the higher the discount rate should be, and vice versa.
What counts or defines a future cash flow? Future cash flow is money that you will receive after all expenses, interest, and taxes get paid. This cash flow may come in the form of a regular paycheck and a dividend check based on the practice's profitability.
Important: When determining future cash flows, it is best not to factor in the normal average salary you could earn as a doctor if you worked at a regular job without an ownership interest.
Let's say you have an option to buy-in to a practice that will pay you $300,000 as an annual salary as a partner in the practice as well as the potential for dividend checks each year of $100,000 if annual profits warrant it. Now let's say that you could earn $200,000 at a regular job without ownership interest. You would subtract the $200,000 from the $400,000 to arrive at $200,000 of annual cash flow above what you could earn at a regular job.
This calculation is necessary because you don't want to pay for future cash flow when that cash flow (your paycheck) is a function of the time you're sacrificing at work. In other words, you should pay for your paycheck with your time and not your money also. Let's face it, part of the reason if not the main reason to participate in ownership is to get paid more than you would as an associate without ownership.
To discount future cash flow, use the present value formula:
Present Value of Future Cash Flows = Future Cash Flow/(1 + r)n + Future Cash Flow2/(1+r)n+1…
Where: r = Discount Rate
n = year cash flow received
If the total of the discounted cash flows is higher than the purchase price, then that means the rate of return is higher than the discount rate and should be purchased. This method is also sometimes known as the net present value of future cash flows. A present value calculator can help with these calculations.
Internal Rate of Return
The internal rate of return takes the discounted cash flow method a step further. The internal rate of return is a valuation method that should not get calculated without an IRR calculator. That's because it is very time consuming and would take many iterations to arrive at the correct IRR calculation by hand.
The internal rate of return takes five to ten years of cash flow projections and calculates an annualized rate of return from those cash flows, also known as the IRR.
The problem with the IRR method, similar to the discounted cash flow method, is that it is only as good as the cash flow projections that it gets based upon. That's why it is crucial to understand several previous year's actual cash flows so that an accurate forecast of future cash flows can get made.
Here is a visual to help you understand IRR better.
Payback Period Method
The payback period is another method that can get used, albeit it is much simpler than the other methods. The payback period method focuses on how quickly you expect to get paid back from your investment. The typical payback period from buying a practice or buying into a practice is five years or less. This payback period means that if you purchase a practice for one million dollars, then you should receive that back in no more than five years.
The payback period is simple, but if you want to take it a step further, you can use the discounted payback period, which uses discounted cash flows to determine if it reaches the required payback threshold. If you are doing the discounted cash flow method, then a discounted payback period calculator can simplify your efforts.
This article discusses several methods to evaluate the buy-in price, which are all very effective in their own way. However, it is always best to use multiple methods to avoid the chance of error. And don't forget to consult with experts in the industry whose job it is to help you make the best decision possible. Sure, they will cost money, but it will likely pay for itself in the end by helping avoid costly mistakes when striking a buy-in agreement.
What do you think? What do you think are the best methods for evaluating a practice for buy-in? Comment below!