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How To Value A Professional Practice

If you have seen the television show “Shark Tank,” you have probably heard this question: “How do people actually value a professional business?” Many factors go into a valuation, and “Mr. Wonderful” does not always have the right answer.

When valuing a professional practice, the first step is to determine the standard of value, which includes defining the valuation’s subject interest and how it will be valued. Let’s say that someone is selling a doctor’s office in rural upstate New York. For now, let’s assume that 100 percent of the business is being sold. This example will give context to the necessary research given the business’s location, how much of the business is being sold and the type of business being valued.

There are a few ways to value a business. The “fair market value” has been defined for federal tax purposes in Treasury Reg. 1.170A-1(c)(2) as: “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” This is the most specific standard that valuation analysts use. “Liquidation value,” another standard, is the value of the business’s assets if someone were to liquidate it. This usually produces a lower value than fair market value, since intangible assets are typically excluded.

Once the standard of value is determined, the next step is to define the valuation date. This is important for two principal reasons. First, fluctuations in the value of a corporation’s assets and liabilities will affect the net asset value of the subject interest. Second, changes in overall economic and market conditions can affect the rate of return that prospective purchasers of the subject interest would demand, thus influencing the price they would be willing to pay. The opinion of value should be considered most indicative of the fair market value of the subject interest on the valuation date.

To gain a better understanding of the state of the business and of the broader economy on the valuation date, a valuation analyst must conduct macro- and microeconomic research. The business-specific research will include evaluating the operations of the business and digging into its financial statements. The economic research is just as important to the final valuation. If the economy is declining, people may not have the ability to spend; on the other hand, the economy could be booming and markets could be at all-time highs, so people might be freely spending their disposable income.

Industry-specific trends will also factor into how a business is valued. To return to the example of the doctor’s office: What is the current state of the health care industry? What are typical wages of physicians, nurses and administrative assistants at the time of valuation? Understanding the macroeconomy as well as the specifics surrounding the business will provide more information about its real value.

A valuator also will need to conduct an analysis of new legislation during the research phase. The law is always changing, so it is important to ensure that the valuation is up-to-date with any new laws and regulations.

Understanding the regional population is also an important part of the valuation. In the doctor’s office example, a valuator might consider these questions, among others: What are the demographics of rural upstate New York? Is the population aging? How often do people in the area visit the doctor’s office? What is the median income of the area?

Perhaps the most important order of business is to get into the nitty-gritty of the practice itself. Analyzing the organizing documents of the business will reveal the shareholders’ freedoms and limitations. Some may include rules permitting only a certain number of shareholders at one time or banning the sale of shares without consent of the other shareholders. These will affect the overall valuation.

Once the overview is completed, it is time to dig into the financials: specifically, the balance sheet and income statement. A balance sheet summarizes a company’s assets, liabilities and shareholders’ equity on a particular date (month-end, quarter-end or year-end). An income statement depicts a company’s financial performance, or net profit, over a given period of time. To create a picture of the financial status of the practice, at least five years of statements are usually necessary. Analyzing income statements over time can offer insight about a company’s profitability. Determining where the business’s revenue comes from and where its expenses are incurred, as well as the consistency of these figures, will yield a more accurate valuation.

Sometimes, the financial statements can be inconsistent over time because of fluctuations in the market, changing demographics, larger-than-normal expenses related to new technology and so on. Because of these inconsistencies, the statements must be adjusted to match current market conditions and market averages. This could mean changing the value of assets to their current market value or moving salaries toward the annual mean for people who hold similar positions. Normalizing certain data points keeps financial statements consistent with current market and business-specific conditions.

Finally, once all the research has been gathered and adjustments have been made, the actual valuation of the company can begin. There are three approaches for obtaining the final valuation of a practice. These are the asset approach, the market approach and the income approach.

The principle of substitution states that a buyer would not pay more for an asset than it would cost to acquire or create another asset that would provide equal or greater economic benefit. This principle underlies both the asset and the market approaches to determining value.

The principle of future benefits states that a buyer would not pay more for an asset than the current value of the future benefits that the buyer expects to obtain from holding the asset. The current value must be calculated by referring to a rate that recognizes both the time value of money and the risk, or uncertainty, that the buyer will receive the expected stream of benefits. This principle underlies the income approach to determining value.

The adjusted net asset method (an example of the asset approach) determines the value of a business based on the difference between the fair market value of the business’s assets and its liabilities. Traditionally, the most important assets of a service company are its employees, its customers and its business systems. For small service companies, such intangible assets are difficult to value without reference to completed sales of similar practices. In the absence of concrete data by which to value the company’s assets, this methodology can create misleading results. The asset approach to business valuation can also greatly distort the fair market value of an operating business because it gives no consideration to the value of future earnings.

The market approach uses market data on the sale of comparable companies, often in the form of earnings or revenue multiples, to determine a company’s value. This method expresses a relationship between the estimated future amount of net earnings and the estimated value of the business. Market multiples, such as a price/earnings ratio or a price/EBITDA (earnings before interest, taxes, depreciation and amortization) ratio, are compared with those of similar companies to determine the subject interest’s value. While this method is a great way to estimate the value of businesses that are large and diversified, it is difficult to use to compare small, private companies because of the lack of a public market to provide comparables.

In general, the income approach is most appropriate in determining the value of an asset that provides its owner with direct access to future cash flows. Examples of such assets would include a debt instrument or ownership in an operating business entity that may yield cash dividends or distributions.

The most widely used income approach is the discounted earnings method, also known as the discounted cash flow method. This method entails a number of steps. First, the valuator must determine the estimated future earnings of the business (usually for the next five years). This can be done using the adjustments to the income statement and applying an average growth rate to the projected future earnings. Second, the analyst must determine a terminal value for the business at the end of the fifth year. Then a discount rate can be established and should incorporate the principle that investors require a greater return on riskier classes of assets. Finally, the estimated future earnings and the terminal value are discounted to the current value and summed using the discount rate. This figure is the total value of the business.

When the valuation is complete, discounts must be applied in certain situations. Consider a business worth $10 million that has one shareholder. The shareholder wants to sell 30 percent of the business and retain the other 70 percent. Although the pro rata value of 30 percent of this business is $3 million, that figure would not be the fair market value. The original owner still holds the majority of the shares, so he will have the final say in all decisions. A discount for lack of control would need to be applied for the 30 percent interest in the company to be appealing to a buyer. Such a discount could range from 10 percent to 30 percent or more.

Further, since this is a private company, there is no readily available market for its shares. Therefore, another discount would need to be applied to account for the inability to quickly turn the investment into cash. This discount could be around 30 percent, but courts have supported discounts far higher than that for lack of marketability.

After determining the value of the company, applying the ownership percentage of the subject interest and applying any relevant discounts, the valuation analyst has finally arrived at the opinion of value.

Understanding the various ways of valuing a professional practice may take time, and a business owner typically will need to hire a qualified valuation analyst to arrive at a reliable value. But for many business owners, it will be a crucial piece of information to know when they are trying to get a shark to say, “Do we have a deal?”