LITIGATION AND LEGISLATION UPDATE Litigation and legislation of particular hzterest to orthodontists will be reported under this section of the AMERICANJOURNALOF ORTHODONTICSAND DENTOFACIAL ORTHOPEDICS. Manuscripts for publication and readers' comments may be sttbmitted to Ms. Sally A. Bowers, American Association of Orthodontists, 401 N. Lindbergh Bh'd., St. Louis, MO 63141.

Determining the value of your practice Stanley L. Pollock, DMD, MS, BS, CFP, PhD, CPBC, CBA*

O r t h o d o n t i s t s value their practices for various reasons. Although most are related to buying and selling, there are other reasons, such as financial and estate planning, buy-sell agreements, associating and merging, credit and insurance designing, equitable distribution in disintegrated marriages and associateships, and even bankruptcy. The purpose and function of a valuation (appraisal), accordingly, are crucial and determinant. It is possible that a practice could have a different value at various times. VALUATION APPROACHES There are three general approaches to valuing orthodontic practices and professional corporations or associations. All methods apply the Rule of Substitution which states, simply, that a prudent orthodontist will pay no more for a practice than the cost of acquiring an equally desirable one in the open market. The three approaches are as follows: (1) the income or income capitalization approach, (2) the cost or adjusted asset appraisal approach, and (3) the market or comparative appraisal approach. These approaches are somewhat interrelated. Today, competent valuators use recognized methods of the three approaches to determine the accurate value of an orthodontic practice. The h~come approach assumes that an equally desirable substitute would be a practice that had similar "investment" characteristics. An important factor ~n the valuation of an orthodontic practice is earnings, both gross and net. In the income approach to appraising, the practice is viewed from the standpoint of its investment qualities. Earning capacity of the practice is a significant consideration. The cost approach refers, simply, to determining the total cost of replacing or duplicating all tangible and intangible assets and liabilities of a practice a~ cur-, rent market values. In other words, this approach addresses the matter of replacing the assets of an ortho*Oral and maxillofacial surgeon; certified financial planner, business consultant, and business appraiser. 811140910

482

dontic practice at today's costs. Of added concern with this approach is placing a realistic value on the intangible assets. The market approach comprises the reality of the marketplace--the price at which comparable practices have actually changed hands--and is direct and powerful. This approach, used a great deal in the real estate field for example, gives a clue as to the value of a home based upon sales of comparable homes in the same area. Although there are no organized markets which tabulate and maintain records of sales of orthodontic practices as in the real estate profession, if possible, the market approach should be used. Professional valuators, however, have knowledge of practice sales and transactions in various communities. Some have gathered reliable local data bases. The Institute of Business Appraisers has accumulated data on a national basis. To arrive at a realistic values under the three general approaches, a proficient valuator will select and use multiple recognized methods to determine a value indication of an orthodontic practice. FACTORS TO CONSIDER Unfortunately, there are no applicable formulas or "rules of thumb" to readily determine the true value of an orthodontic practice. At their best, "rules of thumb" are oversimplifications that merely express some relationship between gross or net earnings or some other operating result. They do not consider the orthodontist's investment of training, capital, time, skills, and efforts. Generally, they are "cop outs"! Finally, no reliable lending institute will accept so simple a proprietary method to value a professional practice. In its Rulings 59-60 and 68-609, the Internal Revenue Service established guidelines for the valuation of closely held businesses that have become the keystone of the appraisal industry. With only slight modification, they have also become the foundation for appraising orthodontic and other professional practices. Section 4 of Ruling 59-60 lists the major factors that apply to the valuation of an orthodontic practice.

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Litigation and legislation update 483

Number 5

They are (1) history of the practice, (2) general economy and economic outlook for the profession, (3) book value and financial condition of the practice, (4) earning capacity of the practice, (5) goodwill and other intangibles, and (6) recent sales and value. When you gather, organize, and analyze the factors and meld them together, you form the basis of realistic fair market value of your practice. Remember, please, that you are trying to reach a supportable and reasonable value on the basis of objective and subjective facts and findings. FINANCIAL CONDITION

To examine the financial condition of your practice, you should obtain and review the balance sheets (statements of assets and liabilities) for the past 3 to 5 years. These statements provide a financial "picture" of the practice. They will supply a great deal of information about capital structure, working capital, liquidity, shortand long-term indebtedness, as well as the equipment, furniture, instruments and accounts receivable. They provide valuable information concerning the fixed assets, any changes, the obsolescence and whether any may have to be replaced or purchased. As an orthodontist, you have and must consider the additional matter of "contracts liability"--that is, treatment in progress and under contract. In contrast to the accountant's balance sheet, which is fundamentally historical, generally conservative and tax-oriented, the orthodontic valuator must construct an economic balance sheet reflecting fair market values. When completed, this adjusted balance sheet will be the current financial representation of the practice. Fig. 1 shows an adjusted balance sheet and the method of calculating values. EARNINGS AND EARNING CAPACITY

The single, most important factor in valuing an orthodontic practice is earnings, both gross and net. The income and expense statement, known also as the profit and loss statement, and the tax reports provide the significant earnings information. Acquire, tabulate, and analyze the previous 3- to 5-year statements, especially the last 6 to 12 months. You will also have to procure the appropriate 3- to 5-year tax forms--Schedule C of IRS form 1040 for a sole proprietorship, 1165 for a partnership, and 1120 or 1120S for a corporation. Study and analyze the statements and reports in detail. Look for financial trends. You will want to know specifically how the earnings were produced, the types of services, how much came from insurance, private pay, capitation and medical/dental assistance cases, the source of referrals (professional, satisfied patients, advertisements), the number and type of staff, their benefits and length of service, and much more.

Pay particular attention to retirement plan contributions. Although depreciation, amortization, and interest are noncash items, they nevertheless contribute to the cash flow of the practice. You want to know exactly what is being depreciated and amortized. The orthodontic valuator must discern who owns the office building or condominium, the terms of the lease, amounts allocated for education, travel and entertainment, promotion, vehicle expenses, and so on. You should scrutinize any outlay that appears unusual or nonrecurring. The American Dental Association, the Societies of Medical-Dental Management Consultants and Professional Business Consultants, Dental Economics, and others have reliable information and surveys that are useful. In each case, you must determine what is reasonable and what is unreasonable, make the proper changes, and prepare an adjusted income and expense statement. (See Fig. 2) GOODWILL

Simply, goodwill refers to the income derived from patients who will continue to patronize the practice. Goh,g concern pertains to the orthodontic facility's being in place and functional. Other intangibles include a myriad of factors such as the doctor's and the pracrice's reputation, a loyal and trained staff, a current OSHA exposure plan and controls, policy and procedure manuals, the computer system working well, how long the orthodontist will be around, and others. Most orthodontic practices have goodwill value. As a matter of fact, goodwill is usually the largest asset of the practice. It is possible, however, that an orthodontic practice could have no or even negative goodwill. Unfortunately, the Big Three--goodwill, going concern and other intangibles--are difficult to measure. It is sort of like pinning Jell-O to the wall. In business and in appraising, they can be considered "excess" earnings. That is, earnings in excess of a fair return on the investment made in tangible assets and earnings in excess of those of other orthodontists in a similar geographic area. After you calculate the excess earnings amount, you must capitalize (convert to a value) or divide it by an assumed rate of return. Simply put, value = income + rate. Although not employable in every case, a rational and acceptable approach is (1) multiply the practice net tangible assets by 25% (a reasonable expected return on investment today); (2) average the practice adjusted net earnings for the past 3 years; (3) b - a = EXCESS earnings; (4) capitalize (divide) the excess earnings by 67% (an acceptable built-up rate based upon several risk factors); and (5) the result = GOODWILL value. What remains to reach the fair market value of the practice is to add goodwill to the net tangible asset

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Am. J. Orthod. Dentofac. Orthop.

November 1992

ADJUSTED

BALANCE

.ASSETS

SHEET

GUIDELINES

HOW

DETERMINED

value value value Age accounts as follows (be r e a l i s t i c }

Cash Cash equivalents Prepaid expenses Accounts receivable

Market Market Market

up to 30 to 60 t o

30 days 60 d a y s 90 days

over 90 days

-

95% 85% 75% 65%

or less

Inventory/supplies

Unless unusual, divide previous 12 months' expenses by 6

Equipment

B o o k value (original cost minus depreciation) + h accumulated depreciation or b. O r i g i n a l cost minus 10% per year. If f u l l y d e p r e c i a t e d & An good condition, cost x 30% or c. Professional appraisal

Furniture/furnishings

B o o k v a l u e + h accumulated depreciation or b. Cost minus 20% per year c. C o s t x 3 0 % as b. above or d. Professional appraisal

a.

Leasehold

a.

improvements

Instruments/expensed

assets

C o s t m i n u s 6 . 6 7 % per year 3 0 % of original cost

a. b.

or

or

c. Professional appraisal a. 1 0 % of above equipment value

LIABILITIES

Accounts

Payable

Notes payable Taxes payable Miscellaneous

ASSETS

a. Face amounts or b. 89 of one month's normal expenses c. Face amounts d. Face amounts e. Face amounts

- LIABILITIES

= NET

value. This procedure, a modified cost approach to valuation is called capitalization of e x c e s s earnings

method. VALUATION METHODS

To apply the concepts and approaches (income, cost, market) of practice valuation, the orthodontic valuator can use many generally accepted methods. The valuator should use as many as possible, even if some are not appropriate in a specific case. Each method has applicability, advantages, and disadvantages. The capitalization of earnings method views the value of an orthodontic practice as the price that will allow an investor an adequate return on the investment. It is based on the concept that the fair market value is determined by the earnings that the practice can ge.ncrate, capitalized by a reasonable rate of retum. The primary advantages of this method are that it (a) is based on earnings, (b) that it includes both tangible and intangible assets and (c) that it is replicable and effective in all areas.

TANGIBLE

ASSET

VALUE

(NTAV)

To determine a value by this method, project a probably gross income for the year and deduct normal operating expenses. Refer to your adjusted income and expense statement. Next, subtract the amount that you would have to compensate an employed orthodontist to produce the expected income. The result should yield a reasonable pretax profit. By capitalizing this profit at a current, reasonable built-up risk rate, you will find the fair market value of your practice. a. Projected gross income $.__ b. Operating expenses ( ) c. Professional services ( ) PROFIT $ . ~ d. PROFIT+25% (Cap rate) = $ _ _ FMV h The market comparison method determines the value of an orthodontic practice by examining actual sales of other practices. This method is generally accepted by the Internal Revenue under code section 2031 (b) which considers the value of"similar" entities.

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Litigation and legislation update 485

Number 5

ADJUSTED

INCOME & EXPENSE STATEMENT

Accountant's Professional Income Less refunds Other income NET INCOME

$ 432,588 693 5,183 $ 437,078

Professional Expenses Answering service Auto Cleaning Continuing education Depreciation Dues & subscriptions Employee benefits Insurance - overhead - malpractice Laboratory Laundry Legal & accounting Miscellaneous Pension Promotion Rent - facility " - equipment R e s e r v e for r e p l a c e m e n t Salaries Supplies - dental " - office Taxes Telephone Utilities

604 2,671 4,214 6,606 9,178 3,278 3,250 2,459 1,474 5,462 1,113 8,882 5,209 16,981 7,891 38,624 4,600 0,0 84,666 34,966 10,052 13,547 4,990 4,296

TOTAL EXPENSES

275,013

PROFIT

162,065

a b c d e f

Adjustment

a

- 5,183

b

- 9,178

c

-13,461

d

-11,424

e f

+ 4,000 -18,123

f

- 2,178

- 50,364

Economic $ 432,588 693 0,0 $ 437,771

604 2,671 4,214 6,606 0,0 3,278 3,250 2,459 1,474 5,462 1,113 8,882 5,209 3,520 7,891 26,200 4,600 4,000 66,543 34,966 10,052 11,369 4,990 4,296 207,246 207,246

N o n o p e r a t i n g i n c o m e - not i n c l u d e d Subtract - non-operating expense S u b t r a c t - a m o u n t c o n t r i b u t e d to d o c t o r ' s r e t i r e m e n t S u b t r a c t - a m o u n t in e x c e s s of fair m a r k e t rent A d d - for f u t u r e r e p l a c e m e n t of e q u i p m e n t , etc. S u b t r a c t - s p o u s e ' s i n c o m e - will not be r e p l a c e d

As stated previously, there are no organized exchanges which collect data on sales of professional practices. The Institute of Business Appraisers (IBA) in Florida collects pertinent data on actual sales price to gross revenues. The Goodwill Registry compiles and publishes data on goodwill of sales as a percentage of gross revenues. The Registry, however, includes information supplied in all types of appraisals including outright sales, buy in-buy outs, buy/sells, divorce, mergers, and others. At this time the Goodwill Registry reports the mean goodwill value of orthodontic practices to be 43% of the last 12-month gross receipts. The factual percent of the IBA of sale price to gross revenues of all dental practices across the county for the most recent 3-year period is 82%. You must use this pertinent and valuable data, however, on an individual practice basis. SUMMARY

We have briefly discussed the reasons for, the three major approaches to, and specific methods of practice

account

valuation. We dissected the historical balance sheets and income and expense statements and made and transposed adjustments to derive current economic statements. We addressed goodwill, took excess earnings, capitalized them to determine goodwill value, added goodwill value to the net tangible asset value, and demonstrated fair market value. Further, we addressed and applied the capitalization of earnings and the market comparison methods and realized that they were good examples of appraisal methods. We saw that the major factors of IRS Ruling 59-60 influence and apply to the practice valuation process. The RR 59-60 clearly states that "no formula can be devised that will be generally applicable to the multitude of different valuations issues." The RR 59-60 says a great deal with "a sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance."

Determining the value of your practice.

LITIGATION AND LEGISLATION UPDATE Litigation and legislation of particular hzterest to orthodontists will be reported under this section of the AMERIC...
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