In any career, you get out what you put in. That’s especially true for doctors. As an MD, your salary as an employed physician is significantly higher than most workers. But there is the potential to earn much more. How? you ask. By taking control of your destiny! Doctors who own their businesses not only experience greater job satisfaction they make more money, too. There are many paths available to physicians who want to strike out on their own, including starting your own private practice, starting a group practice, or starting a side business as a consultant. But the easiest way is to buy into an existing practice. A medical practice buy-in allows you to enjoy some of the freedom and higher wages enjoyed by business owners without having to carry the burden of risk and responsibility on your own.
When you buy into a practice, you become part owner. You share in the revenue, and you usually have a vote in important decisions that will affect the business. It’s more responsibility, but it comes with more money and more of a voice in the company management.
The option to become a partner is a pretty common feature of many private medical practices. Often, information about the process of buying in is included in the initial offer of employment. Generally, the option doesn’t kick in until after two to three years, at which point the prospective co-owner has hopefully proven their grit.
Buying into a medical practice can be a fantastic opportunity, but when the day finally comes to take that step, many doctors question whether it is worth it.
Will buying-in tie me down to the practice for the rest of my career? Will the extra income I earn adequately offset the extra responsibility and potential risk I’m taking on? If the practice is bought out by a hospital (an increasingly likely occurrence these days), will I lose money?
These are all very legitimate questions, and in this article, we will provide some useful information to guide you through the process of determining whether buying into a particular practice is a smart move. But before we begin, please note that it is absolutely essential to go over your contract with a lawyer and/or an accountant. The information below will help you know what questions to ask your expert advisor, but without the expert experience of your lawyer or accountant, it’s easy to be led astray.
With that said, let’s review the most important points to look at when determining the financial health of the business you wish to buy into. Here are some factors that you should familiarize yourself with before you can determine whether buying into practice is worth it.
Determining the Value of the Practice
You’ll want to know for sure how much the business is worth. Often a value will be tossed out during negotiation – it’s probably best not to trust it. Often, that value based on gross revenue – the least reliable method of valuation. Gross revenue is the revenue generated by the company, leaving out expenses, debt, and many other factors that affect the actual value of the business. It’s the easiest to calculate and often provides the most bloated value estimate, which is why it is probably what will be provided.
Instead of essentially taking a shot in the dark by basing your decision on value based on gross revenue, you and your accountant should sit down and calculate the value of the company yourselves, taking into account the factors described below.
Accounts receivable is the the amount of money that patients owe the practice but have not paid. This money is included on the balance sheet, but it isn’t actually in hand. It’s future revenue, but generally practices don’t expect to receive 100% of their accounts receivable due patient’s failure to pay. Taking a look at the business’ accounts receivable-to-sales ratio can – which, in the case of a medical practice would be its accounts receivable by the total number of patients who have been billed – can give you an idea of how effective the practice’s collection efforts are. This will factor into the overall health of the business.
Often when you are buying into a practice, you are required to purchase the accounts receivable. This can greatly increase the asking price, and in such a case it is even more important to look at the accounts receivable-to-sales ratio.
A company’s book value – also referred to as its equity – is its total assets minus liabilities. If the practice is burdened with substantial debts or expensive legal issues, then the book value will reflect that. However, the book is not the true value of a business. Most of the time, businesses are worth more than their book value.
Cash flow is the net income of a business. It’s revenue minus total expenses, with non-cash expenses such as depreciation added back in. Positive cash flow is essential to the financial health of a business. It is possible for a company to make profits yet still experience negative cash flow because those profits are tied up in accounts receivable or hard assets. Without positive cash flow, there is no cash to pay the bills.
Using the discounted cash flow method – which we will go into more detail about later – you can determine the market value of the practice.
Goodwill is defined as all of a company’s intangible assets, such as reputation or location. Goodwill is the most difficult asset to value, but it’s usually the most expensive asset you will be purchasing. Goodwill accounts for 70 percent of the asking price in most buy-ins, according to Medical Economics. Think of it as the security of the investment. If a practice has an excellent location and a solid base of loyal patients, then chances are it’s a secure investment that’s going to see solid returns for a long while.
Everything that the practice owns has value, from the desks and chairs to the high-tech equipment to the pencils. Often this will amount to only a small portion of the business’ value, but there are some exceptions. If a practice owns the building in which it resides, then often, the value of that property, and the right to collect earnings for the sale of that property, are included in ownership contracts. In such cases, it’s important to assess the value of the property, determine the business’s equity, and how much remains on the mortgage.
Determining the Valuation of a Buy-In
Now that we’ve covered the basics of valuing the practice, and understanding what you can gain by becoming an owner, let’s dive into determining how much you should be paying to buy in. Usually, when you become a part-owner of a practice, you purchase shares. Often every owner receives an equal number of shares. Sometimes, though, there is a tiered system of ownership wherein partners are able to acquire more shares the longer they stay with the practice. This is something that you will want to look into, especially if you don’t plan on staying with that practice your entire career.
Pay Structure for Partners
When you are a part-owner of a practice, you collect a share of the profits earned by the practice annually. When evaluating your contract for a partnership, it’s useful to look at the past annual cash flow of the practice – and income statements as well – to get an idea of how much you might expect to earn. However, keep in mind that there are other factors besides profits that affect what your individual dividends will be.
Generally, private medical practices have some combination of equal pay and incentive-based pay for their partners. In an equal pay setup, partners receive an equal share of the profits, while in incentive-based pay, partners are paid depending on how much they work. Of course, there are pros and cons to each side of the coin, with equal pay promoting teamwork but also encouraging less motivated team members to stagnate, and incentive-based models promoting competitiveness but also encouraging certain individuals to try to cheat the system. That’s why most doctor’s offices utilize some combination of the two methods.
These same principles are applied to expenses as well. As a part-owner, you are entitled to receive a portion of the revenue and profit, but you are also responsible for covering a portion of the expenses. That’s not to say that you get paid a certain amount, then have to pay back expenses. Expenses are paid out of revenue, and then the profits are distributed to each owner. If the pay structure is production-based, then each individual’s earnings are adjusted based on the expenses that the individual has incurred. If equally split, then all owner profits are deducted evenly.
What this boils down to is that production-based expense allocation can mean that expenses eat into your profits. Conversely, Equality-based expense allocation can see you paying for expenses incurred by someone else. With that in mind, it’s important to take a look at your peers, and also a look and the payment/expenses system in your office, and determine whether you’re comfortable with the arrangement they utilize.
The P/E ratio is the ratio of a company’s share price to the company’s earnings per share. The product of the ratio is the amount of time it will take for you to earn back the money you invested.
For example, if shares for a company are trading at $50 and earnings per share for the most recent 12-month period are $5, the P/E ratio is 50/5 =10. Basically, that means that the purchaser of the share is investing 10 dollars for every dollar of annual earnings. Put another way: it would take ten years for the buyer to earn back what they paid for the stock.
For the purposes of evaluating your investment in a medical practice, you can use a simplified version of the P/E ratio, often referred to as the payback period. To calculate your payback period, simply divide your investment by your estimated annual earnings as a partner. Do not include your salary – which your are already earning – only the additional income from business profits that you will earn as a partner.
For example, imagine the buy-in price is $500,000. Now let’s say that as a part-owner, you are estimated to make an extra $100,000 per year -on top of your present earnings – from dividends.
500,000/100,000 = 5
So, it will take you five years to make back your investment. After that, you will begin profiting from you investment.
Discounted Cash Flow Method
The discount cash flow method is another simple but useful method of determining the value of a buy-in. Basically, you decide what you think is a reasonable rate of return for your investment – usually, 15% is considered a reasonable range when buying into a medical practice – then discount the next five to ten years of projected profits by that number to arrive at a fair price.
For example, imagine that you are earning $200,000 a year currently as a salaried employee of a practice, while partners make around $300,000 after receiving dividends. That means that if you become a partner, your annual returns on your initial investment to buy-in will be around $100,000.
Plug that information, plus the industry average discount rate of 15%:
CF1 = projected cash flow for year one
CF2 = projected cash flow for year two
CFN = projected cash flow for the next year
Complete this formula using the average discount rate for the healthcare industry and your projected earnings, then see how close the solution is to the asking price for the buy. The closer the two numbers are, the better because that means you can expect to gain an acceptable financial return from your investment. Of course, this is a very simple example. In real life, you will need to factor in the gradual growth of returns. Ideally, the cash flow in this equation should be getting a little bigger each year.
The discounted cash flow method is a stand-by for investors in many industries. However, it does have limitations, the biggest one being that it relies on estimates. There’s no guarantee that your actual future profits will reflect your projected ones. Add to that the many additional uncertainties of economics, and it becomes apparent why you should take this estimate with a grain of salt.
The discounted cash flow method can also be used to determine the value of the entire business. Simply replace your expected return with the business’ projected future cash flow.
Comparable Sales Method
This method looks at similar sales that have happened in your geographic area in the recent past. You should be able to get an idea of what a fair buy-in looks like by seeing what other doctors are paying to buy into similar practices in your area. Unfortunately, this information is not public. So unless you have lots of close colleagues who might be willing to divulge details of their contract to you buying into practices in your area, this method may not be practicable.
If you do have access to this information, keep in mind that it’s not just the price you want to look at; it’s the sale price in relation to the book value of the company, or in relation to revenue, or cash flow. There is a good chance that the practice involved in the sale is either more or less profitable than the practice you are considering buying into. So you need to look at the ratio of these numbers and apply that to your practice.
How Hippo Can Help
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