Companion Animal Practices North America     900 Grier Drive Las Vegas, NV 89119    info@capna.com    Call Us: (702) 982-5100

Preparation is Not Only for Hurricanes

Preparation is Not Only for Hurricanes

Prepare for a potential practice transposition of sale

Preparation for the sale of a veterinary practice should commence five years prior to the actual time. Let’s not kid ourselves, rarely does that occur. Usually the motivation to sell results from a life changing event, a health issue, general distraction with continued practice, a desire to do other things (not enough items on the bucket list have been checked off and a sense of panic sets in), divorce, disability, and death.

We could go on about the reasons of logic that the occurrences over the last few years have been somewhat surprising and could be melodramatically reclassified as even alarming. Practitioners who have many years of practice life available are looking for alternatives.

The trending of doctors holding till their late 60s and early 70s before concluding practice and selling their equity interest have materially changed. We are noting doctors in their late 40’s and early 50’s deciding to sell now.

Not all individuals who sell their equity interest in their practice stop practicing. Most sales to aggregators require that the selling doctor stay at least 2 if not 3 years, contingent on the style and type of practice, dependency on the practice of the shareholder who is selling, and supply of doctors. Likewise, a sale to an associate usually requires continued involvement.

The purpose of this article is to explore what things could be done prior to the time of sale to enhance value for higher price. The focus is not only geared toward sale to aggregators but also to associates and individual doctors who wish to buy a practice.

Potency VS. Actuality

The myth of potency and actuality persists in veterinary practice transitions. Every seller hopes that the practice transaction can be based on the potential of what the practice “could” do in the future; whereas every buyer looks at the actual history and the reality in terms of what has actually been performed. Even then, a buyer will sometimes discount the activities of the practice, if the buyer believes they cannot be replicated.

The potency is best described as a narrative by the seller to any potential buyer that new things can be done in the practice to immediately change the gross income, operating margins, and profitability. The seller sees the potential as a reality that should automatically increase price. The buyer first questions why the seller wouldn’t have done those things to improve margin and profitability already.

This constant narrative between buyer and seller, between potency and actuality is a stumbling block. The viewpoints are POLAR. The polarity is further complicated by the advisors for each party.

Both are right. The seller most probably is correct that things could have been performed to dramatically improve margin. Expansion of hours, changes in fee schedules, better control of support staff scheduling, better review of doctor charges for missed items, etc. all could have improved the margin dramatically and yielded a higher price. The buyer looks at all of these items as sales points but by no means items that will increase the offering price. The buyer’s attitude is that if all of these items are true then the benefits should inure to the efforts and the industry of the buyer to make these changes after the practice has been transacted.

The competitive selling of a practice with multiple purchasing suitors may cause the buyer to use these potentials as a tool for garnering a higher price.

The issue of potency and actuality has become a major consideration and somewhat of a disappointment for selling doctors. The selling doctor then has to make a choice to either make the potency an actuality by not selling or to sell at a lesser price. This painful reality is even more apparent in the supercharged pricing structure that exists at the date of authorship of this essay, as what is occurring presently.

Small changes in margin can make big alterations in price based on capitalization factors that are used. These capitalization factors are not guaranteed to continue. High multiples that exist today may not be available in another month.

The manic realization that that which is, may not be guaranteed in the future is coupled with the desire to improve operating margins traditionally known as earnings before interest, taxes, depreciation, and amortization (EBITDA) before sale. The selling doctor realizes that this timeline could close at any moment, therefore, the DVM reverts to the doctrine of potency and actuality in hopes of gaining credit for that which was.

Short term changes/fees

The conceit is set. Let’s look at some items that could really help on the short term. Within 18 months of sale, a prudent practice owner will take a rather hard look at their entire fee structure and optimize the fee pricing structure to reflect current cost of operation and market conditions. Waiting a long time before changing fees does not do a seller much good. The seller then has to commit to fee increases after that point to maintain a standing of worth for time value of money. The mistake of waiting too long before a fee increase occurs significantly hampers the ultimate practice value because operating margins are sorely effected.

A fee increase could also change the character of potential purchasers. Most aggregators have the minimum practice gross that they will entertain purchasing. A fee increase could bump a practice from not being considered to a practice that would be considered.

Expansion of hours

Second form of aggrandizement relates to expansion of hours. The classic comment has been made that if you only open up the hours on Saturday and Sunday you’ll generate a lot more in income as represented by the seller to a potential buyer. The buyer again under the doctrine of potency and actuality will dismiss this issue.

The seller then becomes the person who needs to make the change in hours to convert the potency into an actuality.

Changing hours of operation is like a train that moves from the station. Kinetic energy must be gathered to educate the client base that the practice is available on an expansion of hours. Some sort of manifestation to the community as a whole would also be most helpful such as an email blast to both existing clients and potential new clients.

The practice needs time to convert the time that was not available precedent to time that clients can rely upon to bring their pet into the practice.  The practice will need approximately 2 years to fully realize benefit from expansion of hours but even a short-term effort will increase the gross income.

Being open Mondays and Thursdays till at least 7 will further increase the possibility of gross income.

Expansion of hours must be done very thoughtfully and with tactic towards minimization of support staff cost. The most efficacious way to introduce expansion of hours is by securing the services of the “A” team. A sparsely scheduled support staff coupled with one of the best doctors in the practice will minimize operating costs and optimize income generation. Often the most probable candidate to man the expanded hours is the practice owner coupled with the finest, the best, and the most confident support staff team. The secret is to keep the support staff team lean.

Reliable financial information

 The veterinary profession has been known as some of the most skilled providers of medical and surgical services. Part of that skill also develops into a severe interest in mitigating administrative costs.

One of the more prevalent costs are bookkeeping, payroll tax, and accounting expenses. Many practitioners will look to find the least expensive solution to these administrative costs. This tendency is a major mistake. Accurate and detailed accounting of results of operations and financial position significantly optimize price.

A great CPA who understands the practice and its operating activities will make available to a practitioner on an annual basis a management letter where differences and results of operations and financial position are readily noted, trended, and recommendations are made for potential change to improve margin, increase asset value, and mitigate liabilities. Usually the cost difference can be measured in one tenth of a percent (0.10%) variance but the impact is significant. A good history of reliable financial information will increase EBITDA as well as creditability of underlying financial information.

A seller must be put in the shoes of the purchaser to understand purchaser motivation. Representations are made to you by the seller that adjustments need to be made in the financial records because of extraordinarily creative decisions in classifying items of expense or capital expenditure. The purchaser already knows that the seller has signed under penalty of perjury that everything is true and correct. Now the seller wants the buyer to believe that that which was said and avowed under pain of perjury isn’t really true and there is a separate story that can be told. The seller at best is reticent. The seller will be duty bound to determine if those representations can be relied upon for adjustment in price. The buyer immediately becomes suspect of the seller’s competency both to maintain financial records and to produce a practice where the goodwill can be delivered. The honesty of the seller comes to question.

Alternatively, the seller who has little or no adjustments in their financial information usually results in an earnings level that is much higher right from the start. The higher earnings level attracts potential purchasers of practices. Too many adjustments that have to be made to earning to arrive at the earnings before interest tax depreciation and amortization (EBITDA) significantly decrease probability that the purchasers will offer multiples that are at the higher end of the market.

A great accountant will have counseled the seller years before any potential sale in ensuring that appropriate accounting conventions have been used. One specific item that comes to mind is the repair and maintenance convention. Any practice can elect to have its limit based upon the most current regulations of items to expense for either repairs or small capital assets purchased. This election and expensing convention for repairs and maintenance and small capital acquisitions is separate and distinct from the bonus depreciation elections that can be taken as well as section 179 expensing.

The convention for repairs and maintenance never hits the property records. In the adjustment for purchase of a practice, if those items legitimately deducted are buried in a whole plethora of categories, the seller or the seller’s representatives may be unable to reclassify all those levels of expense. Unfortunately, those items are then used as a reduction in the economic offering for the practice.

Expensing expenditures

Often in the effort to mitigate tax liability the true operating value of a practice is missed. Inventory inappropriately conducted by faulty pricing or counting at year end to determine the true cost of professional services materially affects price.

An understatement of inventory means an overstatement of costs for drugs and professional supplies. On the face, that this impact not only affects the inventory that is shown but also affects the costs. If an aggregator is making an offer based on profit and the capitalization factor for that profit, then that misstatement of inventory affects not only the perception of the aggregator as to assets held but also the operating results of operations.

Paternal/ Maternal management of staff

As the years progress in a practitioner’s life, the costs of daily living diminish. Children finally graduate from some university, the house is now paid, cars are being purchased with cash, and many items that are normally purchased as a couple pass through life have already been acquired.

The practice owner becomes lazy and sloppy in terms of operations. Since the wolf is no longer at the door, the practitioner may not work the same hours as previously worked. They rely upon the direction of other individuals such as practice managers or associate doctors to maintain the practice while they alternatively hone their skill-set in golf, sailing, hunting, fishing, or reintroduction of themselves with their family.

All of these items are noble, but they do sorely affect practice. The watchful eye of the practice owner is usually far more intense than the hired individuals who would be brought to assist. Over time, the practice owner covets their free moments away from practice and relies more upon the engaged skillset of lay staff and associate doctors.

At the point of sale, the practice owner may not even realize all of the activities that are occurring in practice. Safeguards in internal control, medical and surgical requirements, human resource compliance, etc., that the practice owner had thought were in place somehow are no longer part of the regiment for management.  The practice owner may not know upfront that there is a slipping away at margin or possibly doesn’t have as much of an acute interest since many of the practice owner’s needs have been already met.

Back at the practice, scheduling then becomes an issue not of need in the practice, but rather convenience for the employees or alternatively tools by which the scheduler can help the employee gain additional overtime hours. No one is worse for wear. The practice owner doesn’t complain. The employees like the inefficient scheduling. The scheduler then becomes a hero in the practice providing much needed additional hours.

The practice owner sometimes develops a rather paternalistic view of the whole process. They see their long-time employees as good friends and do not wish to displace that friendship by reinstituting good business practices. Alternatively, the practitioner owner crafts the position as generous benefactor as opposed to prudent practitioner.

A culture evolves from all of this. The employees believe they are working as hard as they ever could because of the laissez-faire attitude towards employee management becomes the norm. The employees believe that they are understaffed and need more assistance. They lobby for additional assistance so that chores and tasks that have heretofore been performed by one individual now require the assistance of 2 or more.

The associate doctors are by no means adverse to the idea of additional staff. Because veterinary medicine is based upon leverage, the more staffing assistance that a doctor has available at their disposal, the higher the probability their gross income will increase and therefore the commission upon they will be paid will similarly increase. Since the doctor will be credited for activities that the doctor has not necessarily performed but has been performed by an assistant accredited to the doctor, the associate doctor has no interest in making the staff efficacious.

Now comes the potential purchaser. They are asked to buy a culture that has evolved into this level of paternalistic basis. Margins have significantly slipped over that which they were 4 or 5 years ago. The seller expects the new potential owner to rake the ship; therefore, the seller expects that there be an adjustment in the calculation for staffing to reflect the skillset.

Purchasers look at the transaction and rightfully know that major disruptions will occur if the staff which has heretofore been used to a lax control is now put under proper reign. The purchaser is reticent to give credit for this potential savings under the fear that the staff will rise up in mutiny against the new practice owner.

The end result that the earnings are sorely affected unnecessarily in a downward trend. Proper control and management of this most precious and material resource in the practice, human service to the practice, is sorely hurting.

Internal Control

In the preceding narrative, the practice owner is spending less time in practice and depending more upon the controls of others. Besides staffing costs, significant erosion occurs in products that are utilized and small instruments that are acquired to perform medical and surgical activities.

The practice owner is not now physically present for as many hours a week. That temptation and tendency to steal might exist for both professional and support employees to help themselves to products available in the practice. In the most extreme examples, employees help themselves to the cash that is being generated by elaborate schemes that we will not amplify in the course of this article. The absconding of practice property, most notably inventory and small instruments as well as the potential understatement of income affects significantly the margins and dollars of profit for the practice so that a sale becomes even less attractive.

All of these factors have an effect on the price offered for the practice. The time to act on a potential sale is 18 months to at least 2 years before the transaction. The ideal time would be to establish a trending of 5 years preceding. Most practitioners have no idea that they will sell 5 years precedent to the point of sale. Anticipation of a sales event with maximum time to correct inefficiencies is most advantageous.

Please consider these points. Not all of them would apply to every practice in every instance, but enough of these things have occurred over the last few years that a material underpricing of practice has occurred. Purchasers have been able to sustain high prices that could have been even higher if the target practice they were acquiring was optimally run.

This article is just a humble commentary, a series in trending that is occurring. No mention was made of support staff and doctor availability, future trends in medicine and surgery, desires of consumerist clients, the effects of recession in trending for sale, etc. Future articles will consider these points but presently we are putting an all-points bulletin out for individuals.

Aggregators

As a final comment, understand what the word aggregator means. The aggregators that are interested in acquiring practices are not merely national aggregators. Practitioners in geographic areas have been known to acquire 3, 4, 5 practices or even more. They truly do become aggregators, but may not wish to admit that point.

Multi-practice owners believe that they are different. But they are aggregators still the same.

 Any potential seller of a practice should do a separate examination of operations possibly by bringing in an outside consultant to identify potential areas for improvement at least a few years prior to selling the practice.

The good news is that in some acquisition calculations by aggregators the cost of accounting, legal, and consultation for business purposes are usually an addback adjustment that does not affect their calculation of earnings before interest taxes depreciation and amortization. Each aggregator is different, but most will consider that to be a corporate load charge.

The message of this article is to take the initiate upfront now to optimize value to improve practice performance while you hold the assets and to optimize price at the point of sale.

~ Owen E. McCafferty, CPA, CVPM, FACFEI, CFF, CGMA

Share this Content