Has the time come for veterinary practice appraisers and brokers to reconsider the parameters of fair market value for the general small animal practice? For the past several years, corporate America has told us so, and now commercial lenders are beginning to open their coffers a bit more.
Over the years, veterinary practice lenders, brokers, and investors have discovered the relative asset safety in owning a veterinary practice. At less than one-half of one percent, the loan default rate, according to Small Business Administration (SBA) data, is almost nonexistent (a remarkable testimony to our profession).
Practice ownership demand is high, and availability is low. Also, the veterinary profession is very resistant to recessionary forces. Considering these influences, practices, appraisers, and brokers are entering an era when we should rethink current paradigms of practice value and sale price-to-gross ratio.
Once, everyone knew all veterinary practices were worth 100 percent of gross revenues as this was the typical selling price. Commercial lenders were scarce, and buyers had no down payment available. The practice sale was financed by the owner with commercial loan assistance for the real estate portion.
However, in the late 1970s, the Veterinary Economics valuation formula was introduced and became the paradigm. This methodology was essentially based upon an income approach to value whereby the profit (earnings before interest, depreciation, taxes, and amortization—[EBIDTA]) was determined, then, based upon certain risk factors, was capitalized to convert to a practice value. For most clinics, price-to-gross ratio ended up being around 80 percent.
In its simplest form, the formula suggested a general small animal practice was worth five times its earnings. (Actually, it was excess earnings, but that concept and discussion transcend this article; so we’ll just stick to earnings as being close enough for our purposes.) Since then, it has become the statistical norm that, all factors considered, the general small animal practice is typically worth somewhere between four and six times EBIDTA (capitalization rate of 25 percent to 18 percent, rounded) with outliers on both ends.
Although actual sale statistics verify these multiples pursuant to formula, those same stats were created and validated by us, the appraisal and brokerage industry, since the late 1970s. Restated—valuations and sale prices were structured around these multiples, then entered into the archives of statistics. So, the sales stats have preserved the formula, which in turn has perpetuated the stats. As Walt Kelly’s comic character, Pogo, once said, “We have met the enemy and he is us.”
Although this is a reliable, objective valuation method, the market has changed, and it is time we rethink and expand this approach. While income capitalization is the proper valuation methodology for most practices, it is the high capitalization rate (low multiple of earnings), the limitation of price-to-gross ratio, and inattention to adjusted net cash flow that warrant reconsideration under current circumstances.
There are five reasons for this.
1) Market competition
Corporate America has discovered the investment security of our profession and are paying EBIDTA multiples of approximately eight to 18 percent (cap rates 12 percent to six percent, rounded) for premium high-grossing practices, again with outliers on both ends. With these multiples, it is difficult for the practice owner to reject this kind of return on investment.
Reports from the American Veterinary Medical Association (AVMA) indicate approximately 20 percent of practices are owned by corporations, and the percentage is rapidly increasing. The obvious extension of this is the privately-owned practice we have all known will eventually become non-existent.
Interestingly, the corporate consolidators are paying these prices and are still able to report an attractive profit to their investors and shareholders. As unpleasant as it may be for many, no longer can the private owner of a premium practice prudently resist the financial windfall and sell at the industry’s historical fair market value of four to six times EBIDTA.
2) Build-up method of valuation
This is a method used by practice appraisers (and other industry business appraisers), which takes into consideration various risk factors to calculate an income capitalization rate specific to the subject practice. Major risk factors include risk-free investment (U.S. Treasury Bill), cost of capital, industry-specific investment risks of general veterinary practice ownership, specific risks associated with the subject practice, and others.
If we consider these risk factors alone, we can see the risk of ownership has decreased significantly, and an investment in many general small animal veterinary practices warrants a lower rate of return (higher EBIDTA multiple), i.e. a higher value. When warranted by low-risk factors, we should not be bothered by a capitalization rate less than 18 percent (EBIDTA multiple greater than six).
3) Lender recognition
With readily available commercial lender and SBA data, lenders are recognizing the low risk of goodwill (intangible) lending to veterinarians and are now offering significantly improved lending amounts and terms. This makes it easier for the veterinary associate to purchase a practice, even at a higher EBIDTA multiple.
4) Cash flow influence
The limitation of price-to-gross ratio to a certain percentage of gross should be eliminated. As to fair market value, it largely has to do with capitalized EBIDTA. As to actual price, lenders and the transaction parties are involved at this point, and it all has to do with adjusted net cash flow. Here is how this works with lenders.
Simply, cash flow is the total amount of money available for the owner to draw from the practice and spend at the owner’s discretion. Cash flow includes owner’s compensation, perks, fringe benefits, capital expenses, and other nonoperating expenses, such as depreciation and amortization. (Fair market real estate rent is not a part of cash flow. It is an operating expense. The tenant must pay rent to the landlord even if they are of the same party.)
A healthy cash flow is about 30 percent of gross. Lenders will ensure the practice cash flow is adequate to service the buyer’s acquisition debt and their personal lifestyle requirements and still have a contingency reserve. They have specific criteria for this as an earnings-to-debt service ratio (E/DS).
If the E/DS exceeds their requirement, and all other factors, such as buyer credit, practice strength, etc., fall into place, they make the loan. If not, they will not. Lenders today are beginning to disregard a maximum price-to-gross ratio if all else qualifies. Some are lending 100 percent of gross with the selling owner financing the balance of the price above gross. And they seldom, if ever, pay attention to EBIDTA as a lending parameter. It is all about cash flow.
Without clouding the issue with precise math, suffice it to say for many practices and buyers a price/gross ratio well exceeding gross revenues would pass the E/DS scrutiny for a significant portion of the lending industry, and the sale could transpire.
5) More than ROI
There is the lifestyle, autonomy, and pride of ownership. Another is the personal after-debt income available in almost all transactions whereby a buyer’s personal income increases significantly with ownership (often double or more), and with hardly any personal down payment, if at all.
Lastly, is the equity acquired from mortgage retirement and asset growth over time. It is all these attributes and more that matter to a buyer and inspire ownership, even if the price is a bit higher and return on investment a bit lower.
Past leading to future
For all the reasons mentioned herein, my beckon to the veterinary practice appraisal and brokerage industry is to acknowledge our past and reassess our future paradigm of veterinary practice valuation and pricing structure in an effort to enhance and properly reward private ownership. And to the lending industry, to follow the lead of visionary lenders and relax lending policies. Accordingly, it is my hope and expectation that private ownership becomes more available to associate veterinarians.
Doyle Watson, DVM, is co-founder and CEO of Simmons and Associates Inc., on St. Simons Island, Ga.