Selling Your Business?
In this second installment of our three-part series, we look at goodwill and how the optical valuation formula can be applied
By Mark Gilbert with Erinn Morgan

Last month, we covered who should be involved in the appraisal process and where to start with valuing your assets. In this issue, we will talk further about the value of goodwill and give examples of how the optical valuation formula can be utilized.

"A business is worth two things—its hard, physical, tangible assets, and its goodwill, which is an intangible asset," says Bill Nolan of the Williams Group in Lincoln, Neb. Professionally appraising these assets can be a valuable tool to assist in the sale. Depending on the level of services you require, an appraisal can be reasonable, timely, and done with information you supply without the appraiser having to visit your office.

IMPORTANT FACTORS

When listing the tangible assets, make the list as complete as possible. Don't forget to include things like on-hand supplies. A quality patient record system also is desirable, especially if computer based. To estimate how many patient records are in an uncomputerized practice's files, count the number of patients whose last name begins with "S" and multiply by 10. A close look at the quality and quantity of the firm's receivables is important as well.

Other things that can make a business more desirable are the willingness of the seller to sign a non-compete and to remain during the transition. This transitional time is when the practice is at its greatest risk. The seller can help by being available during the transitional period. Following are other considerations.

Net income. "This is a huge factor," says Dick Kattouf, OD, an optical consultant in Bonita Springs, Fla. "A healthy net for an independent optometric practice is 38 percent." If the net income has seen a plateau or even declined, that's going to make it less desirable and a greater risk.

Mode of the practice. "Everybody does general care. If the practice is maximizing its medical licensure or has a specialty, it will likely be more desirable," says Kattouf. Specialties include high-end products, low vision, or pediatrics.

Standard operating procedures. A well-organized staff that adheres to policies and procedures is valuable. "If you are taking over a business and the staff has no boundaries, you are going to want to shoot yourself after about a month," says Kattouf. Staff stability and commitment are important.

Insurance. Another aspect is the practice's insurance programs. Participation in quality insurance programs that go with the medical plans in the area is an asset. But, if a practice sees 20 patients a day, all on insurance, the overall desirability of the practice will suffer.

Patient information. Are the patient records retained and in good shape? Is the office computerized? How well does the practice retain patients? What is its recall percentage? These issues will impact a practice's desirability.

FORMULA IN ACTION

One way to value a practice is by applying the optical valuation formula:

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

Based on this formula, the value of an optical concern (OV) is equal to T, the fair market value of tangible assets, including equipment inventory and real estate, plus WC, the working capital needed to operate the practice (i.e., cash on hand for deposits/daily operations and funds needed for accounts receivable), plus I, the investment in the operation in excess of working capital, plus C, an appropriate capitalization rate, times Ex, the expected earnings, minus S, the fair return on the owner's time (salary), plus R, a fair market return on a long-term investment, times T, tangible assets, minus WC, working capital, minus L, long-term liabilities. The formula is not as complicated as it sounds and can be valuable as a tool in negotiating.

Looking at all the information will enable you to assign an appropriate capitalization rate—the return on investment in a practice's goodwill—to a practice. When investing in a practice, you will likely face medium to heavy risks in purchasing goodwill and the capitalization rate should reflect that.

If the factors of goodwill (good patient growth, practice reputation, etc.) are strong and point to a medium risk on the buyer's part, then you will probably pay more for that goodwill and settle on a cap rate of 4 to 5, recovering your investment in 4 to 5 years. When goodwill is questionable, you'll pay less and expect a better, faster return on your investment. Remember, the higher the cap rate, the longer it takes to recover your investment.

Below, we apply the optical valuation formula and discuss cap rate for two very different practices.

PRACTICE A

How can a practice doing $920,000 a year be worth one third as much as a practice doing $645,000? Compare this example, Practice A, with Practice B, and you will see how goodwill—the intangible asset, whose fair value can be elusive—plays a major role.

Practice A is an optometric practice with annual sales of $645,000. It sells upscale eyewear to patients within a five-mile radius of the office whose annual average household income is $125,000.

It has no real estate, has liabilities of $54,500, and the majority of its accounts receivable are considered collectable.The equipment and fixtures are in excellent condition, the staff is well trained, and since contact lenses are not currently dispensed, there is an opportunity for a prospective purchaser to increase sales by about 15 percent.

The owner has agreed to sign a five-year non-compete, remain on staff full-time for six months and then part-time for six more months.

Let's look at how each of these factors affects the ultimate value of the business, keeping in mind that a practice's reputation, quality of staff, and care offered are not considered to generate absolute dollars to the bottom line. These "unqualified benefits" help the purchaser weigh the pros and cons of a purchase.

Sales volume is important, but for valuation purposes the important number is Ex (expected earnings).

The average expected earnings (available from the firm's tax returns) is $228,000, about 35 percent of current volume and a number that's likely to increase.

The practice's current liabilities, a modest $54,500, are addressed using L and are deducted from the total of other asset values. Receivables are covered in C (operating capital). Equipment and fixtures are in excellent condition, and the formula reflects this in tangible assets (T) of $157,000, which include up-to-date inventory and well-maintained equipment. The facts that the owner will remain on staff for at least six months, the firm has a great reputation, and there is little staff turnover are not directly addressed by the formula.

However, when we look at the capitalization rate, and the risk involved in purchasing a practice, this is where these items are indirectly addressed.

Income has increased steadily during the past three years, and the potential for the new owner to continue this growth is excellent.

Because his risk factor is medium to good, the buyer is satisfied to get his investment repaid with excess earnings above his salary and return on investment—(S + R [T - WC])—in four years.

Because the cap rate is multiplied by the expected earnings, less a normal salary and return on investment (called excess expected earnings), the owner of Practice A, which produced excess expected earnings of $121,300, is rewarded for his good operation.

When we multiply this number by the assigned cap rate—in this case 4.0—the result is the value for goodwill of over $485,000.

We next add the total of the tangible assets, working capital, and investments (a total of $232,000), deduct the liabilities of $54,500, and come up with a handsome valuation of nearly $663,000. This is slightly higher than five times the earnings ($606,500) and one year's gross sales ($645,000).

Here's how we did the math:

OV = 157,000 + 60,000 + 15,000 + 4.0 (228,000 - [85,000 + .10 (157,000 - 60,000)]) - 54,500

OV = 232,000 + 4.0 (121,300) - 54,500

OV = 232,000 + 485,200 - 54,500

OV = $662,700

PRACTICE B

At annual sales of $920,000, Practice B does 40 percent more volume than A. However, Practice B sells value packages (with exams included) in a high-turnover, inner-city location. The practice owns its building (recently refinanced), has liabilities of $172,000, and half its receivables are over 120 days old. Equipment/fixtures are in poor condition, staff turnover is high, the store will probably need to move within five years, and the owner is retiring within 30 days of the sale.

The expected earnings are $165,000, a number that has been declining and is less than 18 percent of current gross sales. Liabilities include a mortgage on the real estate, and its receivables are valued at only 47 cents on the dollar because of the percentage of over-120 day receivables.

This business has problems, and by assigning a cap rate of 2.0, the risk of buying it is addressed. The buyer will have a chance to turn the business around while getting his capital investment returned faster.

Using the formula with expected earnings of $165,000, excess expected earnings after deducting for salary, and return on investment of $63,700, and a cap rate of 2.0, the value of Practice B is $253,400.

Here's how the numbers run:

OV = 197,000 + 85,000 + 16,000 + 2.0 (165,000 - [80,000 + .10 (197,000 - 16,000)]) - 172,000

OV = 298,000 + 2.0 (63,700) - 172,000

OV = $253,400

Once you have done your homework, the formula is easy to use and can be a great starting point for negotiations. Further, as a buyer, it can be a good test to compare values either suggested by the seller or presented in a practice valuation report.