Rules of Thumb are generalizations of what has been happening in the market as well as what is expected to happen in the market. Rules of Thumb do not consider specific elements of the practice being valued, but they provide a wider perspective to the dental practice value process.
Due to lack of specific comparisons, Rules of Thumb cannot assure an accurate value of a practice. The most important consideration when using a Rule of Thumb is the accuracy of the information provided. Sellers commonly state, “I understand that practices are selling for 70 percent of gross.” Or, “I understand that practices are selling for one times net.”
The only way to validate the accuracy of a Rule of Thumb is to evaluate enough actual market data to begin to see a legitimate trend, but the data must be relevant to your specific dental practice. In other words, if yours is a specialty practice, apply data from other niche practices like yours.
Determining the value of a dental practice is complex, and the cause for the valuation determines which method the appraiser utilizes. If litigation is necessary, a valuation is needed for estate planning or selling a practice. Be sure to select a qualified party with the experience and market resources to provide a supportable valuation.
If you’re curious as to what your practice is worth, use a Rule of Thumb – probably between 50 percent and 70 percent of gross (on a $600,000 gross revenue, value between $300,000 and $420,000. For a swing of $120,000, it’s probably worth getting a legitimate dental practice valuation).
Focusing on market reality minimizes much of the “tug of war” between buyers and sellers. Often, the buyer and correlating representatives think the appraised price is too high, while the seller and his/her representatives think the price is too low. If the price of your practice is in line with comparable sales of practices, and the terms enable profitability for the purchaser, then it’s likely that the price will be considered equitable by a prospective purchaser.
The Market Approach simply compares your dental practice price with other nearby dental practice sales that recently sold. The theory behind this method is that a ready, willing, and able buyer paid a seller a certain amount of money for a practice and neither party was under duress.
(1) AREA DESIRABILITY: Macro-geographic areas (small town vs. metropolitan areas) and micro-geographic areas (one area of a city vs. another) contribute to nearly identical practices selling for widely different prices. For example, practices in “high growth” areas typically sell at a higher price than “low growth” areas. In general, practices located in large urban areas are in greater demand than the suburbs, and practice values proportionately decrease the further out a practice resides. (Some coastal areas are an exception.) In addition, a dental practice sale’s price is directly related to areas with higher per capita income.
(2) PROJECTED PROFITABILITY: Projected profitability is based on past and present practice figures. Although it is difficult to sell future practice potential, any “windfall” profitability perceived by the purchaser will only enhance the potential selling price. Examples of potential “windfall” profits include specialty procedures such as endo, ortho, perio, implants, pedo, and other procedures that are referred out routinely to specialists rather service as “in house.” Although we are not able to translate potential into a specific dollar value, it can increase the likelihood of a sale at the desired price.
(3) SELLER FINANCING: The Seller’s willingness to finance a large part of the purchase price can often make an immense difference in the final selling price. This financing is preferably at a fixed interest rate and for a longer term than the usual bank financing.
(4) EXISTING EQUIPMENT AGE: Equipment value depreciates rapidly soon after its purchase. Overtime, it is less of a factor when determining overall practice value, especially in established practices.
The capitalization rate, or “cap rate”, is a percentage that determines the final value of a dental practice and is calculated by dividing earning by cap rate. Selecting the cap rate is market driven and reflects current economic and industry conditions, such as interest rates, inflation and the outlook for the profession and the community.
The most common method for determining the cap rate relies on an valuation of the risk factors that go into investing in a dental practice versus other investments. Most risk factors associated with the purchase of a dental practice versus the purchase of some other type of business are generally low, and the risk tolerance of each individual investor is, to a large extent, a personal matter. Common risk factors to consider when evaluating the cap rate used in the valuation of a dental practice are:
- Practice productivity trend
- Number of dental offices in a 5-mile radius
- Transferability
- New patient flow
- Years in practice in the area/years at current location
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- Overall office appearance
- Age/quality of equipment
- Existing or future lease and terms
- Seller/bank financing
- Local economic outlook
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- Other practices for sale in the area
- Staff attitude/turnover/skills
- Office Systems
- Accounts receivable/collections policy
- Parking/office access
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Most appraisers use their knowledge of the market, the demographics of the community and the practice data to select an appropriate cap rate. The range of cap rates used to value dental practices varies from 18 to 35 percent, the lower rate representing less risk, and the higher rate representing greater risk.
It is also important to note that the cap rate only reflects the return on investment. It does not consider the fact that the new owner works in the practice to contribute to the overall gross collections. Selection of the cap rate is the most subjective process in the approach to determining the value of a dental practice.
Elements that increase the risk of purchasing a practice will decrease its value and vice versa. If a purchaser wants to be in a certain geographical area, and an established practice with sufficient cash flow is near the preferred location, risk factors include the number of practices in the area or the age/quality of the existing equipment may become negligible factors in the mind of potential buyer.
The biggest dilemma in purchasing an existing dental office is the question of transferability. The value of the practice goodwill to a buyer and the practice numbers should only be considered if transferability is not an issue.
Transferability is dependent upon the seller’s ability to hand over the goodwill to the purchaser. The seller’s ability to transfer staff loyalty to the new doctor is, in turn, a risk factor directly related to the transferability of the practice to the purchaser. In addition, the seller’s willingness to slow down and work less in the practice post sale also plays a big role in determining the success of patients and staff shifting their allegiance to the new owner.
