CPA.net

Observation on Reasonable Comp

A colleague and I had an exchange on reasonable compensation today and it reminded me of a point I often see missed in valuation of small businesses and professional practices: the compensation assumption in a CCF or Excess Earnings Model is PERPETUAL and increases at the growth rate used to determine the cap rate. As such, any measure of reasonable comp based on entry level salaries is likley not relevant for a capitalization model and can also lead to significant error. This is due to the fact that professionals can experience a fairly rapid increase in salary from their intial year as they "ramp up" and reach a normal level of productivity in the workplace.

For physicians, some of this difference can be gleaned from the Merritt Hawkins Annual Survey as well as the difference in reported salaries in the MGMA data using All Physicians, Partner/Shareholder Physicians and Physicians with 1-2 years experience.

Similarly, a low initial salary followed by a "low or no" buy-in and high partner income can also be explained by a combination of recruiting demand and higher-than-entry-level long-term compensation expectation. The low buy-in price reflects the new professional's high perpetual income expectation and as such a lower level of profit or excess earnings from ownerhship.

Fair Market Value and Income for Support: NOT the Same Thing

Today I am reminded again that the income of a practice in the hands of the hypothetical owner of the fair market value standard is not the same thing as the income from that practice to the existing owner for purposes of support.  For example, if industry-normal overhead is say 60% and the subject practice has overhead of only 40%, the appraiser may well need to normalize expenses to determine what the fair market value of the practice is. On the other hand, if the practice is operated by the existing owner at a low overhead because, for example, he does his own office cleaning, supply purchasing, grounds maintenance and the like and intends to continue to do so, support income will be greater than the income in the hands of a hypothetical owner - who, based on industry-normal practice, will pay someone else to clean toilets and cut grass.

Cash Equivalence

In my previous post, I raised the problem with determining the cash-equivalence required by the definition of "fair market value" when using "deal-based" market data. Besides the database that bears his name, Dr. Shannon Pratt (and his co-authors) devotes a chapter (#27) in Valuing Small Businesses and Professional Practices to the topic. Of particular interest is the comment regarding personal guarantees on page 494 (suggesting an interest rate premium over bank lending rate of 3% where there is no personal guaranty) and the example on page 500 dealing with contingent buyout payments. In that example, the cash-equivalent price is 55% of the deal price.

Nuff said.

Fair Market Value in Cash or Cash Equivalents

Caveat: I should preface my comments below by stating that this is not intended to be relied upon by others as statistical analysis –you have to do that analysis for yourself.

I have been evaluating dental transactions in the database Pratt’s Stats.  From my analysis of 230 post-1/1/2000 transactions, 102 had an answer to the question of whether or not there was a personal guaranty of a note given by the buyer in connection with the purchase. Of those, 56% had an answer of "no personal guaranty." 47 (20%) of the transactions reflected a down payment of 100% and the median down payment for the 230 transactions was 28.4%. This suggests to me that the notes given in those transactions do not represent a cash equivalent, even if secured by the underlying assets, since the seller would have to retake possession and incur the costs (e.g., legal fees!) of the repossession of assets.  This would be a difficult task, for example, for a seller who has retired and relocated. In addition, the notes are non-negotiable to begin with, negotiability is a requirement for being considered “cash-equivalent.”  Further, a bank or other lender in the business of making loans, as opposed to a seller financing the sale of his or her practice, is in a much better position to enforce collection activity.

This highlights one of the many problems with the market approach for a determination of fair market value in cash or cash equivalents – as required by the FMV definition accepted by all the major valuation and appraisal organizations and most Courts.  Converting a secured note absent a personal guaranty to a cash equivalent is a difficult task.  IF one could find empirical evidence of what a third party lender would charge for interest on a personal note lacking a guaranty but secured by equipment, then that would be a start.  Bear in mind that the majority of the value of a dental practice is typically intangible and not equipment.  Lenders generally do not loan unsecured money on intangible assets and certainly not without a personal guaranty – that is why only 44 of the transactions had down payments of 100%.  Absent a transaction involving a Dental Practice Management Company or similar operation, it is unlikely that another dentist purchasing a practice from the seller would have 100% of the purchase price lying around in cash.  Whatever the problems, you have to make some type of an adjustment to equate the underlying data to cash-equivalent.  The problem here is not with the data, which is pretty comprehensive as databases go and may well be the best, the problem is using it without studying it.