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
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!
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 payingreporting 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.
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.