How to Value Your Business
In this first of a three-part series about buying and selling a business, we discuss how to place an accurate value on your practice
By Mark Gilbert with Erinn Morgan

There are many reasons why going through the exercise of placing a value on a business makes sense. While the most obvious is the purchase and sale of the practice, other significant uses include:

• Buying in and out of a partial interest in an office and determining a fair value for new partners or shareholders.
• In estate planning, income tax planning, and postmortem planning, the valuation formula featured in this article can be used to set a value for the practice and provide a basis for the living partners to plan and fund their estate.
• Divorce litigation requires accurate valuations, especially as many states are awarding an equitable portion of the practice's value as a marital asset to the spouse of the practitioner—not only tangible assets, but also goodwill.

Whatever the reason for doing it, a valuation should not be based on rules of thumb or on conventions that lack factual substance. Whether you are a buyer or seller, to stay on track, you should approach the valuation as a third-party investor would. In other words, be detached and unemotional.

GETTING STARTED

There are many professionals who can be of assistance when it comes to determining the value of your optical business. Whether you use the services available from your CPA or hire a consultant, remember that the most thorough valuation will likely be obtained with you acting as the quarterback and the CPA or consultant serving as coach.

An experienced business valuation consultant, especially one who works specifically with the eyecare industry, can be very helpful.

There are firms that will value your business, based on information you provide, without ever having to visit it. Costs for this service can run as little as $1,250 to $2,000. Al Cleinman, president of Cleinman Performance Partners in Oneonta, N.Y., suggests providing three years of tax returns, operational data, an equipment list, photographs of the facility, and a list of employees.

Interview the consultant yourself. Questions include: What is your valuation philosophy? What elements do you consider in an appraisal? What is your experience? What references can you provide? "The most important thing is references," says Dick Kattouf, OD, an optical consultant in Bonita Springs, Fla.

Appraisers methods. While some ECPs choose to use rules of thumb to value their own business, professional appraisers usually employ several methodologies to get that all-important number. As Bill Nolan, of Williams Group in Lincoln, Neb., explains: "We use four methodologies and average them. These include asset and earnings models (a fair market value for the hard assets, not including real estate), capitalization of earnings, discounted cash flow, and a debt service model (the principal value of the business without debt or interest)."

ASSET VALUATION METHODS

There are three basic ways to value assets: The income method, market method, and cost method.

The income method. This utilizes the excess income produced by the asset—that is, a capitalization rate based on the estimated long-term return on investment. That return is based on the type of asset to be valued and the returns currently available in the marketplace for a similar risk factor.

The market method. Your asset's value is determined by comparing it with a similar asset that recently sold. For example, if a neighbor's house sold for $300,000 and your home is similar in size and features, then it, too, should be worth $300,000. The market method is good for valuing real estate, but may not be appropriate for other assets.

The cost method. This involves the current replacement cost of an asset. You arrive at the asset's value by deducting wear and tear from the asset's replacement cost. Essentially, replacement cost less depreciation equals the asset's approximate value.

Several variations of the cost method are available when valuing the assets of an optical practice. (For more information, see the sidebar on p. 52.)

Seller's actual cost. This is what the practice originally paid for the equipment or asset. Such information should be available from the seller's accountant and can be substantiated by referring to the seller's tax returns. Unfortunately, this method does not consider inflation, obsolescence, or wear and tear.

Net book value. This is the seller's actual cost, less accumulated depreciation. However, for smaller businesses, depreciation expense is a convention for cost recovery and may not be a true estimate of an asset's value. For example, a nine-year-old, $1,000 lensometer that was properly cared for and depreciated over 10 years is likely to be worth more than its current $100 net book value to a prospective purchaser.

Actual cash value. For a typical optical practice, this method is likely to be the most valuable. It takes today's replacement cost and multiplies by a pre-determined factor. The numerator of the factor is the remaining useful life of the asset, and the denominator is the total useful life of the asset. This method rewards practitioners who take good care of assets and penalizes those who don't.

Where appropriate, more than one method can be used to value a single asset. However, depending on the specific circumstances, one method may be more appropriate than the others. (See the table comparison of cost valuations methods on p. 50.)

CATEGORIZING ASSETS

A simple way to categorize assets is to group them in terms of ease of valuing. Realty and tangible property are the easiest to value.

Accounts receivable, followed by a non-compete agreement, and seller's assistance in the transition, are next.

Conversely, the most difficult areas to value are the intangible assets, including goodwill.

Realty. The land and buildings should be reviewed by a professional real estate appraiser. If the real estate is substantial, both the buyer and the seller should engage appraisers to develop independent viewpoints. The difference between their two figures should be minimal.

Tangible property. In an optical practice, this includes supplies, inventory, professional and office equipment, vehicles, and most other assets used to generate income.

Either the cost or the market method is generally used to value tangible property. For expensive assets, such as a high-tech edger or a retinal camera, equipment vendors can help you calculate a fair value for these assets.

Don't be afraid to ask these suppliers how they arrived at their figure.

If you are comfortable with how the value was determined, it's likely that the buyer will be, too.

VALUATION FORMULA

Further, if both the buyer and seller have access to the formula and its components, this can be an excellent tool to assist with final negotiations.

A good valuation formula that addresses the values of both the practice's assets and its probable good will provides a strong starting point for negotiations as solid numbers will be more readily understood and accepted.

The following formula was originally developed for the veterinary field, which faces valuation issues similar to those faced in optical:

OV = T + WC + I + C (Ex - [S + R (T + WC)]) - L

Here's what each abbreviation in the formula stands for:

OV: The valuation of an optical concern.

T: The fair market value of tangible assets (including equipment, real estate, and inventory).

WC: The working capital needed to operate the practice (i.e., cash on hand of $10,000 to $30,000 needed for accounts receivable, cash for operations, deposits, and net working capital to run the business).

I: The investment in the operation in excess of working capital to make the business viable.

C: The capitalization rate (based on the risk of the business). It usually ranges from a score of 1 to 5 and addresses: Overall risk, as well as the intangibles of the business; the quality of the marketing area; the remaining lease term; whether the owner is staying to help with the transition; and the potential future earnings. Based on these factors (and others), the buyer's risk in buying goodwill is converted into a number that may reward the seller or allow the buyer a faster return if the risk is higher.

Ex: Expected excess earnings (take the existing business and look at past earnings).

S: Fair market value return on the owner's time (that is, salary) as a total of compensation package.

R: Long-term fair return on investment.

L: Long-term liabilities, stated and contingent (long-term leases, for example).

This valuation model is a solid method that has room to allow both the seller and buyer to participate in and negotiate the process. For example, the goodwill of a very well-run business that has shown solid year-to-year growth may have an assigned capitalization rate of 4.5.

However, if the business has not shown consistent growth, assets are in need of replacement, and more risk is involved, then a lower capitalization rate is likely more appropriate.

The capitalization rate is a significant factor in determining the value of the business, and there is room for negotiation. If, for example, the seller has assigned a cap rate (C) in the formula of 4.0, and buyer thinks the value should be closer to a 3, they will probably meet at 3.6

On page 52, we offer an example of a valuation method in practice. Whether you are a buyer or seller, by being prepared and using the appropriate valuation method, a fair and accurate price can be established.

Next month: The Optical Valuation Formula in action—how it can be used, including how a practice doing $920,000 per year can be worth just one-third as much as a practice doing $645,000 a year.