What is Your Practice Worth? By Thomas A. Climo Dr. Climo Consulting Las Vegas, Nevada

Transcription

1 What is Your Practice Worth? By Thomas A. Climo Dr. Climo Consulting Las Vegas, Nevada

2 Abstract The dental industry has not exhibited state of the art financial reporting, either in the area of standardization among practices affording easy comparisons of performance, or in the correct calculation of important line item expenses such as depreciation or summary results such as EBITDA and Net Income. This presentation returns to the root of the revenues made from clinic activities and shows how to best account for this revenue generation to determine the resultant line items that determine valuation. Four methods of valuation are discussed, in order of refinement and suitability to the prospective buyer of a dental practice. The idea of an annual internal audit to strengthen the financial recordkeeping at a dental practice will round out the presentation.

3 AADGP Sample 2014 Balance Sheet as provided by practice CPA

4 Why are Buyers Paying Sellers for Receivables? Valuation of a Business Entity Assumes that the A/R from the prior year converts to cash in the present year at the same amount and rate A/R Cash A/R Cash

5 AADGP Sample 2014 Income Statement as provided by practice CPA

6 AADGP Sample 2014 Income Statement with Line Item Changes, Line Item Recalibrations and Operating Percentages Operating % Operating % Number of Practices (actual) (recalibration) 2014 RECAL 2014 ACTUAL REVENUES -- FEES [1] Associate Dentists [2] Dr. Owner [2] Hygienists Interest Income TOTAL REVENUES [3] $ 1,055,828 $ 1,055, % % Fee Refunds $ (510) $ (510) -0.05% -0.05% Net Revenues before Other Income and Other Expense $ 1,055,318 $ 1,055, % 99.95% Other Income $ 229 $ % 0.02% Other Expense $ (6,689) $ (6,689) 0.00% -0.63% Net Revenues $ 1,048,858 $ 1,048, % Less: Cost of Fee Services Owner-Dentist $ - $ 175,839 Change % 0.00% Associate Dentists Hygienists Assistants Office and Support Staff Payroll $ 281,086 $ 281, % 26.62% Employee Benefits $ 1,176 $ 1, % 0.11% Payroll Taxes $ 22,969 $ 22, % 2.18% Total Cost of Fee Services $ 305,231 $ 481, % 28.91% GROSS PROFIT $ 743,627 $ 567, % 70.43% Less: Direct Variable Costs Dental Supplies $ 100,177 $ 63,350 Change % 9.49% Dental Labs $ 76,578 $ 52,791 Change % 7.25% Total Variable Costs $ 176,755 $ 116, % 16.74% Less: Administrative Costs Advertizing and Promotion $ 40,830 $ 40, % 3.87% Bank Service Charges $ 2 $ % 0.00% Charitable Contributions $ 2,340 $ 2, % 0.22% Computer $ 28,323 $ 28, % 2.68% Credit Card Fees $ 9,324 $ 9, % 0.88% Dues & Subscriptions $ 2,317 $ 2, % 0.22% e-claims Insurance Processing $ 359 $ % 0.03% Insurance $ 37,392 $ 37, % 3.54% Janitorial Services $ 2,300 $ 2, % 0.22% Laundry Service $ 581 $ % 0.06% Legal & Accounting $ - $ 6,863 Change % 0.00% Licenses and Permites $ 1,955 $ 1, % 0.19% Postage and Delivery $ 1,624 $ 1, % 0.15% Professional Development $ 9,485 $ 9, % 0.90% Professional Fees $ 9,105 $ 9, % 0.86% Rent $ 129,000 $ 129, % 12.22% Maintenance -- General $ 1,831 $ 1, % 0.17% Maintenance -- Exterior $ 5,246 $ 21, % 0.50% Miscellaneous $ 995 $ % 0.09% Repairs $ 14,085 $ 14, % 1.33% Small Tools $ 4,283 $ 4, % 0.41% Telephone $ 5,524 $ 5, % 0.52% Temporary RDH $ 755 $ % 0.07% Travel & Ent $ 14,188 $ 7, % 1.34% Utilities $ 13,805 $ 13, % 1.31% Waste Management $ 3,777 $ 3, % 0.36% Total Administrative Costs $ 339,426 $ 355, % 32.15% EBIDTA $ 227,446 $ 95, % 21.54% Less: Interest Expense $ 918 $ % 0.09% Taxes $ 13,084 $ 13, % 1.24% Depreciation Expense $ 11,492 $ 31,675 Change % 1.09% Amoritzation Expense $ 6,667 $ 6, % 0.63% Total Costs against EBITDA $ 32,161 $ 52, % 3.05% NET INCOME $ 195,285 $ 43, % 18.50%

7 Dental Industry Operating Cost Benchmarks INCOME STATEMENT January 1 through December 31 Cash Basis Other Than for Depreciation REVENUES Patient Fees % Cash Insurance Medicaid For Dentistry 70.00% For Hygiene 30.00% Total Revenue % Less: Fee Refunds 0.50% Net Revenues 99.50% Less: Cost of Services Sold Salary Owner 9.00% Salary Associates 20.00% Salary Hygienists 10.00% Salary Assistants 8.00% Salary Office 7.00% Employee Benefits 1.25% Payroll Taxes 2.25% Total Cost of Services Sold 57.50% Gross Profit 42.00% Less: Direct Variable Costs Dental Supplies 6.00% Lab Fees 5.00% Office Supplies & Expenses (incl. Computer) 1.00% Total Variable Costs 12.00% Less: Administrative Costs Advertising & Promotion 1.25% Continuing Education 0.40% Dues & Subscriptions 0.15% Merchant Fees 0.50% Heat, Light & Power 0.60% Insurance other than Health 0.80% Legal & Accounting 0.65% Leased Equipment 0.35% Licenses & Taxes 0.25% Outside Services 0.50% Postage 0.25% Rent 3.00% Repair & Maintenance 1.00% Telephone 0.30% Total Administrative Costs 10.00% EBITDA 20.00% Less: Interest Expense 1.00% Taxes other than Payroll and Admin 0.00% Depreciation 3.00% Amotrization 1.00% Total Costs Against EBITDA 5.00% Net Income 15.00%

8 AADGP Group Practice Benchmarks Practice Characteristics: Accounting & Finance Minimum Maximum Mean σ Monthly total revenue $ 45,000 $ 2,600,000 $ 514,000 $ 676,000 (for a single location during a typical month) Average monthly total expenses $ 37,000 $ 2,600,000 $ 457,000 $ 691,000 (for a single location during a typical month) Net Income $ 57,000 Net Income Margin 11.09% Contrasted with the Climo White Paper 15.00% Contrasted with Private Equity Cost of Capital 9.46% Sources: AADGP Benchmarking Survey Standardization of the Financial Reporting of Dental Practices NYU Stern School of Business -- Useful Data Sets

9 Focus on Line Item Recalibrations for: From To 1. Owner Dentist Contribution to Total Revenues 0.00% 16.65% 2. Dental Supplies 9.49% 6.00% 3. Dental Lab Fees 7.25% 5.00% 4. Legal & Accounting 0.00% 0.65% 5. Depreciation Expense 1.09% 3.00% 6. EBITDA 21.54% 9.07% 7. Net Income 18.50% 4.11%

10 Methods of Valuation 1) Percentage of prior year sales 2) Net income (the Warren Buffett approach) 3) EBITDA 4) Market rate multiples

11 Method 1 Percentage of Prior Year Sales Most Common Method Simplest No grounding in economic science or practice Two practices with same revenues are valued the same despite one having profit and the other loss How can that be? Suited to Solo Practitioner only Valuation is $1,055,828 X 75% = $791,871

12 Method 2 The Income Approach Income is the maximum amount a person can consume during a period, and still expect to be as well off at the end of the period as he was at the beginning of the period. J.R. Hicks, Value and Capital (1939) Importance of Depreciation Suited to Solo Practitioner or Group/DPM/DSO Valuation is $43, % = $461,290

13 Method 3 EBITDA Earnings before Interest, Taxes, Depreciation and Amortization Ignoring Depreciation is not a good idea From 2002 Berkshire Hathaway Annual Report Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a non cash charge. That s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for afixed asset to be useful for ten years). In the following nine years, compensation would be a non cash expense a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality? Suited to No One Valuation is $95, % = $1,011,755

14 Method 4 Market Rate Multiples Private Equity Preferred Minimum of $1 3 million of EBITDA Suited to Group Practices and DPM/DSO Valuation is $95,712 X 6 = $574,272 or Valuation is $95,712 X 3 = $287,136 Contingent on Private Pay vs. Medicaid

15 Summary Method 1 $791,871 Method 2 $461,290 Method 3 $1,011,755 Method 4 $574,272 $287,136

16 Cost of Capital Where does the 9.46% come from in Method 2? Difference between economics and accounting is use of a hurdle rate telling the investor that the return he could expect from the next best alternative investment is his opportunity cost basically, the return on investment expected from an investor for a business he or she is thinking of investing in. NYU Stern School of Business keeps annual empirical records on the cost of capital for over 100 industries, available at: htm Group practices having a mean Net Income Margin of 11.09% are attractive to private equity investment since its cost of capital is 9.46%.

17 Empirical Cost of Capital January 1, 2014 Industry name F I R M S B E T A Cost of equity E/(D+E) Cost of debt Tax rate Aftertax cost of debt D/(D+E) Cost of Capital Public/ private equity % 11.40% 78.40% 33.66% 4.04% 20.12% 2.42% 21.60% 9.46%

18 Importance of Record Keeping Accuracy of record keeping is essential Value is downgraded if record keeping is suspect Annual internal audit addresses this concern Annual internal audit consists of: Examination of practice Internal Controls, Cash Audit, Inventory Audit, Chart Review, Billings/Collections Audit including Insurance

19 Recalibrations can go Higher as well as Lower Recently, I made a presentation to a Dental Association canvassing much of the material we have looked at today. I took the same set of accounts and concluded that the prior year sales model valuing this practice at $791,871 was wrong and that $461,290 was right. The difference centered around my recalibration of the CPA report mostly having to do with a low depreciation expense and no cost of fee services for the production of the owner dentist. Of course, there are recalibrations that go in a positive and not negative direction. For example, had the Net Income of the practice included the doctor s cost of fee services, and listed depreciation at 3% of total sales, I would happily have used the Net Income disclosed by the CPA. If you remember, this was $195,285. $195, % = $2,064,323 At a Net Income Margin of 18.5%, your dental practice will earn a multiple on sales of 1.95!

20 Consensus Spreadsheet SAMPLE 2013 INCOME STATEMENT with OPERATING PRECENTAGES Column 0 Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 Column 10 Number of Practices Description of Operating Account Line Items % of Total Rev Actual Results % of Total Rev Climo Recal Climo Changes % of Total Rev Seller Recast % of Total Rev Buyer Recast % of Total Rev CONSENSUS REVENUES -- FEES [1] Associate Dentists [2] Dr. Owner [2] Hygienists Interest Income TOTAL REVENUES [3] % % $ 1,055,828 $ 1,055,828 Fee Refunds -0.05% -0.05% $ (510) $ (510) Net Revenues before Other Income and Other Expense 99.95% 99.95% $ 1,055,318 $ 1,055,318 Other Income 0.02% 0.00% $ 229 $ 229 Other Expense -0.63% 0.00% $ (6,689) $ (6,689) Net Revenues 99.34% $ 1,048,858 $ 1,048,858 Less: Cost of Fee Services Owner-Dentist 0.00% 16.65% $ - $ 175,839 Change 1 Associate Dentists Hygienists Assistants Office and Support Staff Payroll 26.62% 26.62% $ 281,086 $ 281,086 Employee Benefits 0.11% 0.11% $ 1,176 $ 1,176 Payroll Taxes 2.18% 2.18% $ 22,969 $ 22,969 Total Cost of Fee Services 28.91% 45.56% $ 305,231 $ 481,070 GROSS PROFIT 70.43% 53.78% $ 743,627 $ 567,788 Less: Direct Variable Costs Dental Supplies 9.49% 6.00% $ 100,177 $ 63,350 Change 2 Dental Labs 7.25% 5.00% $ 76,578 $ 52,791 Change 3 Total Variable Costs 16.74% 11.00% $ 176,755 $ 116,141 Less: Administrative Costs Advertizing and Promotion 3.87% 3.87% $ 40,830 $ 40,861 Bank Service Charges 0.00% 0.00% $ 2 $ 2 Charitable Contributions 0.22% 0.22% $ 2,340 $ 2,340 Computer 2.68% 2.68% $ 28,323 $ 28,323 Credit Card Fees 0.88% 0.88% $ 9,324 $ 9,324 Dues & Subscriptions 0.22% 0.22% $ 2,317 $ 2,317 e-claims Insurance Processing 0.03% 0.03% $ 359 $ 359 Insurance 3.54% 3.54% $ 37,392 $ 37,392 Janitorial Services 0.22% 0.22% $ 2,300 $ 2,300 Laundry Service 0.06% 0.06% $ 581 $ 581 Legal & Accounting 0.00% 0.65% $ - $ 6,863 Change 4 Licenses and Permites 0.19% 0.19% $ 1,955 $ 1,955 Postage and Delivery 0.15% 0.15% $ 1,624 $ 1,624 Professional Development 0.90% 0.90% $ 9,485 $ 9,485 Professional Fees 0.86% 0.86% $ 9,105 $ 9,105 Rent 12.22% 12.22% $ 129,000 $ 129,022 Maintenance -- General 0.17% 0.17% $ 1,831 $ 1,831 Maintenance -- Exterior 0.50% 2.00% $ 5,246 $ 21,164 Miscellaneous 0.09% 0.09% $ 995 $ 995 Repairs 1.33% 1.33% $ 14,085 $ 14,085 Small Tools 0.41% 0.41% $ 4,283 $ 4,283 Telephone 0.52% 0.52% $ 5,524 $ 5,524 Temporary RDH 0.07% 0.07% $ 755 $ 755 Travel & Ent 1.34% 0.74% $ 14,188 $ 7,863 Utilities 1.31% 1.31% $ 13,805 $ 13,805 Waste Management 0.36% 0.36% $ 3,777 $ 3,777 Total Administrative Costs 32.15% 33.71% $ 339,426 $ 355,935 EBIDTA 21.54% 9.07% $ 227,446 $ 95,712 Less: Interest Expense 0.09% 0.09% $ 918 $ 918 Taxes 1.24% 1.24% $ 13,084 $ 13,084 Depreciation Expense 1.09% 3.00% $ 11,492 $ 31,675 Change 5 Amoritzation Expense 0.63% 0.63% $ 6,667 $ 6,667 Total Costs against EBITDA 3.05% 4.96% $ 32,161 $ 52,344 NET INCOME 18.50% 4.11% $ 195,285 $ 43,368

21 It Is not Climo s Method It is the method of Nobel Laureates A couple days after the presentation referred to in the prior slide, I was informed by the President of the Dental Association that a CPA Group told him my Valuation and Valuation Methods were incorrect; this without so much as one reason why. It prompted the following two abridged responses, one to the President and one to the Members at my presentation. Mr. President: So, the CPAs are saying J.R. Hicks, J.M. Keynes, I. Fisher, H. Markowitz, W. Sharpe, F. Black, E. Fama, M. Miller, and W. Buffett are all incorrect, and that they are right. Stunning this CPA Group knows more about Value and Capital than five Nobel Laureates, three pioneers of modern financial economics, and maybe the richest man in the world. There is no substance as I see it behind their rejection of my method. They ve got over eighty years of confirmed and empirical research on the relevance of the findings of my method to rebuttal. I am anxious to see such a rebuttal from the CPA Group. I doubt they have the intellectual manpower to do so. Otherwise, lots of Laureates need to give their money back to the Swedish Academy. Lastly, ask the CPA Group why every investment firm in the world uses my method of valuation, including every private equity firm that invests in dentistry. Members: I have worked extremely hard my entire adult life learning the rudiments of income and capital, and how to price or value a business entity in a correct manner. To be told by a CPA Group that my method is incorrect without one iota of evidence or analytical rebuttal is an intellectual outrage. As you can read in my response above to your President, standing behind my approach I have nine very impressive individuals in the field of valuation. Please look at these names and contrast them with the names of the individuals in your CPA Group. If you think a comparison between five Nobel Laureates, three pioneers of modern financial economics, and the President of Berkshire Hathaway is inferior to named individuals in the CPA Group, then I wish all of you the best of luck when it comes time for your exit from dentistry. Will there be any buyers at the correct price established by your CPA? Forget private equity, they price the same as the incorrect method of Climo. But then, what does Wall Street know about the price to pay for a business? Postscript: [From the Executive Director of the Dental Association after four weeks had passed] I suspect, as in the famous care game Texas Hold em that you called them on their bluff. Their silence is deafening.

22 Two Methods Left Standing Margin/Multiple Valuation CPA 18.5% $2,064,323 Method 1 6.0% $ 791,871 Method 2 4.1% $ 461,290 Method 4 6 X EBITDA $ 574,272

23 Publications Related to Valuation by Thomas A. Climo What is your practice really worth? DrBicuspid.Com, July 11, A Financial Lesson for Dentists, DrBicuspid.Com, October 18, Earnings and dentistry: An island unto itself, DrBicuspid.com, November 20, Financial reporting is key when buying a dental practice, DrBicuspid.com, Aug. 27, Internal Audit Provides Inexpensive Financial Assurance, DrBicuspid.com, October 8, Dental industry outlook brightens as cost of capital falls in 2014, DrBicuspid.com, January 27, The solo practitioner and the 2 business models of dentistry, DrBicuspid.com, April 2, The Four Methods of Valuing Dental Practices, DrBicuspid.com, in 3 parts, June 9/16/23, Why your dental practice should exercise an annual internal audit, DrBicuspid.com, July 24, Standardizing the Financial Reporting of Dental Practices, Dental Economics, January White Paper: Standardizing the Financial Reporting of Dental Practices, available at: dentaleconomics.com.