This is an article from our good friends at Dental CPAs. www.dentalcpas.com | www.dentalcpas.blogspot.com
These are my top five examples of how proper due diligence can avoid the overpayment for a practice, or worse, a buyer having to claim bankruptcy!
1. Missing dental supplies – Normalization, good intentions, bad results I gathered the information from the seller’s advisors and prepared my analysis worksheets. I noticed there wasn’t a specific category called dental supplies. That may not be an issue as they may have been thrown in with office supplies and expenses which were around 7-8% or revenue – right ? However, since office supplies and expenses run around 1-1.5% the person who did the valuation eliminated around 6% of the office supplies and expenses, adding profit of approximately $50,000 to the bottom line. So I ask two questions: the first: “why did you reduce office supplies and expenses from 7-8% down to 1-1.5%?” The reply was “because office supplies and expense are usually in that range and when we asked the seller why they were that high they said that’s the category that they run their perks through”. Fair enough, however, my next question was “so where are the dental supplies? Don’t they typically run 4-7%?” ….silence… so then I ask “isn’t it likely that the dental supplies were included in the office supplies and expenses and that’s why they’re 7-8%?” I was right and the price dropped by over $150,000 because of this one oversight!
2. Income, now you see it, now you don’t – Poof post settlement After gathering all the information to prepare my assessment I was comparing the annual practice management reports of production, adjustments, collections by provider and everything looked normal. Then, I compared the practice management collections to the collections reported on the tax returns and the tax return collections for the past three years were higher by at least $85,000 and $110,000 at the most. Generally the collections between the practice management reports, tax returns and profit and loss reports are different, however, they should be close and most of the times the practice management report collections are HIGHER than the tax returns, so this was strange. After asking the question to the broker, who had to ask the seller, we learn that the seller was working a day a week in another office about an hour away from his office to earn extra money. The seller did nothing wrong as they were reporting the income for income tax purposes as they should. However, the broker only used the income tax returns for their valuation (apparently) and failed to compare them to the practice management reports. Therefore, the practice price was inflated by more than $75,000 because that income would have disappeared right after settlement…at least for the buyer!
3. Prostho practice in sheep’s clothing – Do the referrals even know you?
I was hired by a doctor to assess a GP practice that was doing just over $1 million per year in revenue, with overhead lower than 50% at a price of $765,000. On the surface nothing seems out of place so far. So we ask for the information necessary to assess the price and the practice performance and I begin my analysis. Right away I notice staff wages are hovering around 15-18%, strange, but great if that’s what the seller has been able to achieve in a GP practice. Then, as I’m going through the productionadjustmentscollections by provider I notice hygiene production is only $90,000 on average. I then compare the staff wages and sure enough, hygiene wages are only around $35,000 annually. So I do some quick math and determine the dentistry should be around $270,000 for a GP practice of maybe $400,000 at best…so where’s the $1 million in revenue coming from? The seller does a ton of full mouth restoration work and we ask where these cases come from. The reply is through seminars and referrals from other professionals. Apparently this doctor had made a name for himself doing these full mouth cases and was getting referrals from other local GPs, plastic surgeons and ER docs that saw broken teeth accidents. Unfortunately the broker had valued the practice as though it was a GP practice without doing any analysis on the make-up of the revenue. My client really wanted this practice and against my advice they agreed to a $600k offer with $50k contingent on future revenue. I had suggested a base offer of $350k (the premium price for a GP practice doing $400k) plus $150k contingent on future revenue because I suspected the buyer would NOT see much, if any referrals from these other professionals. I was right, revenue in the first 12 months dropped to just over $750k only because part of the deal was that the seller would remain for two years to finish up some cases and help with the goodwill transfer. Revenues in the next 12 months barely topped $700k. On the upside my client didn’t get sucked into paying $765k, the downside is they overpaid at $600k and they are feeling it now.
4. Invisible perks – No double-dipping allowed!
I had gathered much of the information needed to assess the asking price for a practice before getting the valuation that was performed by the broker. After receiving their valuation report I saw that their asking price was more than $300,000 higher than the top end of my price range…which is quite unusual. So as I review their valuation report I noticed that the broker had added back to profit exactly $100,000 each year and labeled it “owner perks”. This was in addition to the correct add backs of pension, automobile, travel, ce, meals & entertainment, and other expense category normalizations. So we asked for a breakdown of the $100,000 of additional “perks” and the reply was “we asked the owner how much in perks they run thru the office and he replied well over $100,000, so we just stopped at $100,000”. Then I asked “did you ask the seller what made up the figure he gave to you? We need to see the details”. They hadn’t, however, they did after we brought it to their attention and the owner was including many of the adjustments they broker had already correctly made so in essence, they were adding back many of these expenses twice. They took the practice off the market shortly after that, we suspect because the seller realized he wasn’t going to get 95% of revenue for his practice!
5. Created profits – The tale of two offices
A buyer wanted us to evaluate an opportunity where he was offered to purchase the satellite office from a doctor who had a primary office about 30 minutes away. Our first question was if the seller kept these locations in two separate entities and the answer was yes. Great, that’s usually good news since having two locations in ONE entity can be a very complicated assessment as you have to try to separate the two locations just to evaluate one of them. initially we only got the tax returns and we saw a practice doing about $600k in revenue with expenses of $300,000, 50% overhead… that’s pretty good. They had established a price of $475,000 for this practice which seemed reasonable based on everything we saw, especially the low overhead. So as the asset purchase agreement was being drafted and negotiated we continued to ask for the practices production reports and w-2s for the staff. We finally get the information just about when the asset purchase agreement was getting finalized (coincidence you think?) so we compared the w-2’s with the wages deductions on the tax returns and the w-2 totals were higher… that’s not right. We then compared the PM collection reports with the collections per tax returns and the tax returns were higher… that’s not right. Here’s what we determined even though the seller would not admit it: 1. They were reporting some collections from the primary location into the satellite location to inflate the income. And 2. They were paying
eporting some of the satellite expenses from the primary location to deflate expenses. the result was the appearance of a highly profitable practice worth nearly 80% of revenue when it was a practice probably doing between $500k-$550k in revenue with expenses closer to $350k, 67% overhead worth maybe $300k, a price difference of $175k.
Buyers Beware! You really need to make sure you perform a thorough due diligence and if you don’t know how to do that or what to look for you could be setting yourself up for failure at worse, a very difficult road for the term of your loan at best.
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Original article found at http://dentalcpas.blogspot.com/2013/05/real-life-dental-practice-purchase-case.html