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Cap of Excess Earnings vs. DCF

The Cap of Excess Earnings is the lazy way to value a business,

but does that make it the wrong way?  I rarely use the method since I’m a believer that you should attempt to forecast the business you are appraising for at least a few years before you just assume that the business will grow at a constant rate into perpetuity.  Plus why be lazy?

Let’s start with why I decided to write about these two methods.  First, I’m a nerd, I’ll admit it.  This means that my nightmares are very detailed and force me to jump out of bed and do math.  Yeah, strange right?  No, I’m not chased by clowns or “bad guys” as my 3 year old would call them.

Rather, I’m harassed by attorneys in my nightmares.  Last night in my dream an attorney asked me questions about things that I take for granted.  My answer of, “that’s finance 101, everyone knows that the cap of excess earnings method yields the same results as the DCF method when growth is held constant”,  just doesn’t fly.  Attorneys are smart people, but they know how to play dumb when they want to trip you up or get you frustrated.  So in my nightmare, I start to explain it to him and the jury.  I shrug to the judge “do I really need to explain something that everyone knows?  Just look it up on google, crack open any how to value a business book, or open up your Finance text book.”

The Judge looks at me and says, “we don’t have any of those here today” so he points to the white board.  I walk over there and I’m start to describe the Gordon growth method, which is used in the cap of excess earnings method.  I draw up the formula

Value=Cash Flow1/(Discount Rate-growth) or V=CF1/(Dr-G)

The DCF method is more complex you need to Sum up a stream of Cash Flows

So your value= Cashflow1/(1+Discount Rate) + CF2/(1+(Dr)(Dr))+CF3/(1+(Dr)(Dr)Dr))+ etc.

Then I go through an example, and I try to make it easy since there is no way I have lost my audience with these boring formulas.  So, I assume the following:

CF0=100

Discount rate = .1

Growth =1%

I then wake up and run to my computer, no pit stop for the restroom.  Didn’t stop at the fridge for some water, right to Excel.  I couldn’t do the math in my head during my nightmare, but I know that I have proven it before.  Had I forgotten how to do the math?  Could I answer my own nightmare question?

I know that the cap of excess earnings = DCF when growth is held constant, but could I prove it to the judge and jury in real life?

So as I cracked open excel I took on the cap of excess earnings method first.  I used my givens from my nightmare.

If CF0=100 and growth is 1% that means that CF1=101.  So that’s my first input.

Value=101/

Next the Dr is plugged in and the growth is subtracted.

Value=101/(.1-.01) or Value = $1,122.22222

Easy right?  Well I couldn’t do it in my head so that’s what drug me out of bed.  Can you visualize why an appraiser is likely to default to this method?  Think, all I need to come up with a value for your business is: an estimate of cash flow for next year, a discount rate (which is an art to take all of the information available and apply it to your subject company) and an assumed rate of growth.  For argument’s sake let’s just assume the discount rate is given to the appraiser.

Now let’s look at the DCF method given the same assumptions.

Value= Sum(Cashflow1/Discount Rate + CF2/(1+(Dr)(Dr))+CF3/(1+(Dr)(Dr)Dr))+ etc)

Value = Sum(101/1.1+102.01/1.21+103.03/1.331 + CF4……CF200/(Dr)^200)  I took this out to 200 periods rather than to infinity.  Since, we get 99.98% of the expected answer after 100 time periods and 99.999996% of the way to the Gordon growth method after 200 periods.

It took me about 5 minutes to write the formula in Excel to get me to $1,122.00 after 100 time periods.  Then I got $1,122.22218 after 200 time periods.

Did you notice that as we approach infinity we get the same value as we calculated in the Cap of Excess Earnings method?  We are 99% of the way to the correct answer after 54 time periods, but Ross this is taking way too long!  There has to be a short cut…

Welcome to the multistage DCF method.

What we do now is we assume that at some point the business we are appraising will achieve a steady rate of growth.  Here we can assume that at any point on the CF stream we could substitute the Gordon growth formula for our CFx through CFx to CF200.

Let me introduce you to the magic of mathematics.  Were I to sum my results from CF1-CF20 and then for CF21+ substitute in the Gordon growth method.  I would then calculate $1,122.22.  Go ahead I’ll wait for you to calculate it.  Did you get $918.68 for the CF1-CF20?  Did you then add in your Gordon Growth result of $203.54?  Well, you made it to $1,122.22 didn’t you!

Let’s try that with a different time period lets cut it off after CF5.  After 5 years you are only 35% of the way to proving the math.  You don’t really want to do the math another 95 times to get 99.98% of the correct answer do you?  So after 5 years you have $389.87 and you add that to your Gordon growth of $732.35, you get $1,122.22 again right?  Imagine taking it after say CF2, what do you get, $1,122.22.  So if we cut it off at CF1 we get $1,122.22.  Therefore, we have proven that if you have the same growth rate into perpetuity the DCF method will yield the same results as the cap of excess earnings method.

Did I win my case?  Does the jury applaud?  Do I get to go back to sleep?  Will I be haunted by more lawyers in my dreams?

So why do I use the DCF Method in 99% of my Appraisals?

As you can see by the math, taking the capitalization of excess earnings is the easy way out.  Am I trying to impress my clients by doing more work?  No, although I have to admit my reports are a lot thicker than they would be were I to use the cap of excess earnings method.

I just don’t believe that all businesses have hit their steady state growth rate.  I mainly deal with doctors who are in the transition process.  This generally means, that an older doctor is on the way out and a new one is on the way in.  Is it reasonable to assume that there won’t be any disruptions in the practice?  In my opinion, no.  If they overlap will there be a temporary boost in revenue and with that an increase in expenses.  My bet is yes.  Will the new doctor be as productive as the old one?  Well, there is the art part in forecasting.

Nobody has a crystal ball, so an appraiser needs to either rely on assumptions/forecasts/or budgets provided by the client, or make their own judgement.  Many people will argue that they aren’t experts so they can’t be relied upon to forecast the cash flow of the business that they are appraising.  Typically, when confronted with that response, I ask myself: do my clients have more financial training and expertise than I?  If, the answer is yes, I ask them for guidance and their upcoming forecast or budget.

However, the majority of the time my clients aren’t going to be experts on the field of finance.  So, I feel duty bound to show them how I believe their practice will preform given the history of the practice and my experience with similar practices or situations.  Given my attempts, my crystal ball has NEVER been exact it couldn’t possibly be, or else I would be a world famous sports gambler, who has been banned by all Casinos.  I do smile a bit when my previous clients come back to me years later and say the projections I made were pretty close to where they are this year.  Of course, I pull out the frowny face when I find out that I have over projected revenue due to something like a lost associate doctor or a hygienist who left the practice.  Generally, those things are out of my control and just don’t get thrown into my crystal ball.

Although I admire the cap of excess earnings for its simplicity and mathematical beauty.  I just don’t feel like it serves the best interest of my clients to take the short cut and assume that things will continue on forever exactly as they are today.

About the Author

Ross Landreth is an appraiser and owner of Medical Valuations Inc.  His firm appraises medical and dental practices throughout the US.  He is an Accredited Senior Appraiser with the American Society of Appraisers.  Ross holds a BS degree from the University of California at Berkeley and a MBA from California State University East Bay.  Although he has nightmares about lawyers he gladly accepts cases to provide expert witness testimony for divorces, injury claims and partnership dissolutions.

Trump’s Estate Tax Plan, Should You Be Worried?

Part of Trump’s tax plan is to eliminate the Estate Tax, otherwise known as the Death Tax

As an appraiser this has a small impact on my business, as I do a few estate tax valuations each year.  If this goes through I stand to lose a bit of work, but I’m excited for the prospect that there may be changes.

Why is that?  Well, I think that the estate tax valuations that we do are complete BS.  Seriously, let me walk you through the process and you can decide if what we do is actually something that is needed by society.  The first step in sheltering assets from the Estate tax is for a lawyer or estate planner to set up the assets in a complex legal entity, such as a Family Limited Partnership (FLP).

What’s an FLP?

The estate planner will move assets into a company which will have ridiculous rules that aren’t designed to manage the assets properly, they are purely there to set up the opportunity to lower the estate tax.  Here’s an example of how it would be set up:

Let’s assume that the father has a piece of land worth $10 million and that is the only asset.  This exceeds the 2017 limit of $5.49 million, so $4.51 million of the land is subject to the estate tax.  To make the math easy we will assume a tax of 50%.

Assume there is a father who owns the land and his son.  Assume that the land is rented as a parking lot with no expenses and generates revenue and profit each year.

The asset is placed into the FLP, and that FLP’s rules are going to be governed by the partnership agreement drawn up.  This agreement is written purely as an exercise to lower the potential tax burden of the estate tax.  The father will be declared a 1% owner of the FLP, while the son will own 99% of it.  The rules will state that the 1% owner has full control of the business.  With full control of this business the 1% owner chooses to take all of the profit personally.  The 99% owner receives nothing.  The son has no control and no income in this FLP agreement.

The next step is that they hand this FLP agreement to an appraiser and say we would like you to appraise a 1% undivided interest in the land given the draconian rules set up under the FLP agreement.  The appraiser’s job is to come up with a value that represents any 1% of this property.  Well, what if there is only one entrance to the parking lot?  Which 1% is that?  If we assume that the 1% doesn’t have control what is the level of profit that they will receive?  Is it zero or is there some potential that the controlling interest won’t squander all of the profit and will distribute it to the other owner?

The appraiser then uses these reasons to formulate a discount to the property.  Let’s assume that the discount calculated is 50%.  Magically this piece of property is now worth $5 million.  What’s that?  That’s below the estate tax threshold?

Now the CPA fills out the estate tax form and says that the decedent’s assets were under $5.49 million and therefore no tax is due.

The IRS is out $2.25 million in taxes, and all they had to do was pay for a new entity to be formed by the estate planner/lawyer, hire an appraiser, and have their CPA fill out a form.  Clearly those costs would be a tiny fraction of what they would have handed over to the IRS.

Does the Estate tax work as planned?

You know what else is BS?  You pay taxes on everything you earn in your life, does it make sense that the IRS gets to tax it again upon your death?  Some people take the stance that it’s necessary to pry the hard earned money out of the hands of those that earned it.  Others use another tactic to avoid the estate tax, but they are so sneaky about it that they fool the common folk.

Take the case of Bill Gates and Warren Buffet.  These guys have pledged to, and have already started, the process of giving away their vast fortunes.  That sounds so awesome in the headlines right?  What a bunch of true heroes.  Well, are they truly altruistic?

If they give away all of their money to “charity, or education” how much does the government get when they die?  What’s that?  Is it $0?  Yep, they have chosen to not allow the government to tax their money twice by giving it away.  Are they true patriots?  Or do they just see a government scam and have a way to sneak around it?

Let’s go through an example of what should happen if Bill Gates or Warren Buffet play by the rules and pay the estate tax upon their deaths.

Assume that my fortune totals $1 Billion to make the math easy.  Assume that I have one son who would inherit my fortune.  Again, for the math let’s assume no exemption and that the estate tax is 50%.

Upon my death, my son becomes the owner of $1 Billion.  He then fills out the estate tax and writes a check to the IRS for $500 Million.  He’s still a happy kid as he has $500 million left.  He enjoys a nice life has a daughter and upon his passing he leaves her with $500 million.  She then writes a check to the IRS for $250 Million.  She lives a nice life an passes her $250 million on to her son, who writes a check to the IRS for $125 Million.   After about 5 generations the IRS will have confiscated almost all of the original fortune.  In fact, after three generations the IRS has $875 Million of it (87.5%) of the original fortune.  Not bad for them huh?

Now are Bill Gates and Warren Buffet dumb enough to allow the IRS to steal their fortune?

No, they are going to decide how they give it away rather than just handing it to the government.  Have you ever been to a college campus?  Do you find it odd that every building has someone’s last name on it?  Well how did those names get there?

Rather than just give my money to the IRS I’m going to donate it to my undergrad.  I’ll tell UC Berkeley that I want them to build a building called the Landreth School of Finance.  The name will never be allowed to change, and the funds to upkeep and eventually replace it will be in the endowment I leave them of $1 Billion.  In addition, my family members will be in charge of the endowment perpetually.

Do you see what I have done?  I just set up a perpetual legacy for my family that includes income for all of my descendants.  How do I guarantee all of my descendants will receive income?  They will serve on my endowment board and get paid for handling the duties associated with the management of this responsibility.  They will determine how much each member needs to be paid and they will determine their raises into perpetuity.  If inflation goes up my great grandson will just give himself a big raise that year.  Oh did I mention that that building and all future ones from my endowment will be called the Landreth School of Finance?  A thousand years from now that will still be there.

In my “altruistic” donation example, I established a legacy and allowed my descendants to keep a huge portion of the money, whereas in the IRS example the government ends up with almost all of the money.

Conclusion

Even though I, as an appraiser, would potentially lose income from a world with out an estate tax.  I am 100% for the president’s plan to take it out of the tax code.  We as a society want to punish the super rich for being so successful.  I get that jealous feeling that we have, but the estate tax isn’t the way to do it.  In fact, the super rich have outsmarted the media and common folk by so much that we think that they are our heroes for being so “generous” and giving away their fortune.  Will you be surprised when you find out that there are going to be a lot of Gate’s buildings and endowment funds that will keep his legacy going forever?

Health Care Costs Going Up

No Surprise Health care Costs are going up

What is a shock is that in the 80s health care costs per person went down.  What was going on in the 80s that made this possible?

Either it was a odd time in American demography or we were doing something right.  If it turns out that we, as a country, were doing something right, then it is time to do something about it before this problem gets even more out of control.  Now if it turns out it was just demography, then we won’t have any control over that.

American Demography in the 80s

Government Health Care Regulations in the 80s

Insurance Companies in the 80s

I’m going to do some research and then finish this up.

 

Share an Office

Creative Way to Share an Office

SSK Plastic Surgery moved into their new location in Newport Beach, CA.  Dr. Kelshadi had his open house a couple of weeks ago so we got to go on the grand tour.  The office has two treatment rooms, a consultation room, Dr. Kelshadi’s office, and an admin area.  However, that’s just what’s behind the door.  The office sharing of the waiting room is where the real magic happens.  The third floor of the building is set up into office “pods”, where the tenants share a huge waiting room that is set up kind of like the terminal in an airport.  When you are flying you would try to sit near your departure gate.  However, there is nothing stopping you from sitting in a different section.  The Hoag center is set up the same way.

Hoag Second Floor

As you walk towards the waiting area of Dr. Kelshadi’s office you pass by several offices that can lead to natural referrals.  He specializes in mommy makeovers so it makes sense that he would be surrounded by four other offices that women need to visit.  Each of the offices has an admin desk in the waiting room, which would be a nice work area as there is so much open space.  Usually the front desk person is crammed into a small area.  I rarely run into medical practices that have the sliding window at their front desk, this is the complete opposite extreme.  This set up provides for a much friendlier introduction, and many times the first impression that your front desk gives is the most important.

SSK Sign at his office

This is a nice model to share an office and cut some costs.  If you want to know more about his office click the link below to open a tab to his website.

SSK Plastic and Reconstructive Surgery

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Where Does My Money Go? A Review of Overhead

Where does my money go? 

Credit Card

Is my dental practice overhead too high?

Have you asked colleagues how much their overhead is?  Have you received answers from 40% all the way up to 90%?  Don’t worry, most of the confusion is due to how they define their overhead.  Some doctors may view their overhead as everything that doesn’t show as profit on their tax return.  Meaning, that they didn’t factor in personal expenses, nor their own salary.  Industry standard is to take all of your expenses and add back the following:

  • Personal Expenses
  • All Doctor Salaries
  • Interest Expenses
  • Loan Fees
  • Depreciation
  • Amortization

A look at Overhead

Let’s start the process of adding back to the profit of the practice.  You have probably never stroked a check with the name of Depreciation, yet it shows on your tax return.  Depreciation and Amortization help to reduce your tax liability, but aren’t factored in overhead calculations.  We also need to take out all of the fees associated with practice debt.  All personal expenses need to be removed or adjusted.  All dentists need continuing education credits, but do they need to be acquired in Hawaii?  Rather than removal we need to adjust the CE expenses to a normalized amount of expenses for the CE, around $3,000 per doctor.  What about a family member on the payroll, who has a “no show job”?  Their pay needs to be removed.  However, if you have an unpaid family member working in the practice, you need to make an adjustment to pay them a fair salary.  After we have made all of the adjustments, it is time to compare your practice to those of your peers.

Staff Overhead

We want to group all of the costs associated with the staff.  Salaries, payroll taxes, uniforms, health care, and payroll processing fees need to be in this category.  We then divide this cost by your revenue to get an overhead ratio.  The following targets are for general dentists:

  • 25%-30% Perfect!
  • 30-35% Keep an Eye on this
  • 35%+ you may need to consider cutting hours or employees

Facility Overhead

Make sure that depreciation costs have been removed.  If you own the building we may need to make an adjustment.  Ask a local commercial real estate broker how much your space should rent for on a triple net basis.  They will give you a per square foot number which when applied to your useable square footage will be the rent you should charge yourself.  The target for this category is 5%-7%.  If you live in a big city, like Los Angeles or New York, it will likely be a struggle to keep this category under 10%.

General Overhead

This is a category devoted to all of the other expenses in the practice that aren’t going to be associated with doing the clinical work.  Examples of these expenses are:

  • License
  • Dues and Memberships
  • Malpractice Insurance
  • Overhead Insurance
  • Marketing and Promotion
  • Meals
  • Travel
  • Continuing Education

Typically this category will be between 5%-7%, unless the practice is doing heavy marketing.  As a rule of thumb, you should be willing to accept up to 5% of your revenue for marketing costs is the practice is seeking growth.

Variable Overhead

The more dentistry that you do the more these costs will go up.  This is where you should put:

  • Clinical Supplies
  • Lab Costs
  • Postage
  • Credit Card Fees
  • Office Supplies

This category is usually in the 15%-18% range for general practitioners.

Total Overhead

If a practice were to hit the low end of each of these categories the total overhead would be 50%.  Meaning that the owner is 50% profitable, so for every dollar that comes through the door one would expect to be able to keep $0.50.  Were the practice to find themselves on the high end of each of these categories, they would be at about 67% overhead.  So for every dollar they bring in they would expect to make about $0.33.

I just ran a query through Pratt’s Stats which when filtered down to look at gp dental practices yields a median overhead of 59.1%.  If your practice overhead is lower than this, you are doing better than half of your peers.

Please respond if you want to know what category an expense goes into.

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Start a Business

How to Start a Business

I have focused my career to help medical professionals create partnerships, retire, or start a business.  As an entrepreneur, I have had to figure out what is necessary to start a business.  I had to learn how to do things the hard way.  I made many mistakes, but have managed to run my business for six years.This year I decided to retool my process and document the journey from start up to an established business.  To do this, I decided to start a business using what I know and researching what I still need to learn.  My goal is to create a lean business that is easy to get up and running.The business that I chose to start has nothing to do with Valuation.  For this series I am going to pretend that I’m starting a scratch dental practice as I speak with about 100 dentists a year on the subject.Please note: I am not an attorney nor a tax advisor.  The process below documents my personal decisions in 2017, tax rules and regulations change often so please consult with an attorney or tax advisor when starting your business.

If you already have your business up and running you may want to skip through to some other sections.  Here is a navigation menu:

Part 2: Start a Business Entity
Part 3: We now have our Entity
Part 4: Takes Money to Make Money
Part 5: Your Office
Part 6: Advertising
Part 7: Time to Get Paid
Part 8: Staying Organized

Part 1: Entity Selection Process

Below is a chart highlighting the different entities that are available.

Entity Liability Protection Tax Status Benefit
Sole Proprietor No Pass Through Easy to use
LLC Yes Pass Through Limited Paperwork

Possible to limit your Medicare taxes
S-Corp Yes Pass Through Possible to limit your Medicare taxes
C-Corp Yes Double Tax Can have more than 100 owners
Partnership No Pass Through Worse than Limited Partnership
Limited Partnership Yes (for the limited partners) Pass Through Protection for some partners

We are looking at starting a scratch dental practice, so we know that we can eliminate two options right away.  Your odds of being the target of a malpractice suit are lower than 9% per year.  Odds are at some point in your career you will face at least one case.  Therefore, liability protection is a must.  So, a sole prop and forming a simple partnership are out.  Additionally, if there are two people in a Limited Partnership, odds are both would be considered general partners.  Therefore, they wouldn’t get the needed liability protection anyway.

So that leaves us with three choices:

          • S-Corp
          • C-Corp
          • LLC

You can see that both the S-Corp and the LLC have pass through tax status.  These are taxed once by the IRS.

Unfortunately, a C-Corp is taxed twice.  The IRS requires payment for the C-Corp’s profit, and then taxes from the shareholders on their dividends from the company.  So, unless you feel some duty to pay the government twice every year the C-Corp should be eliminated.

If you choose to file your LLC taxes on a 1120s form, the two companies will essentially be taxed the same.  Both enjoy one level of pass through taxation and have a quirky tax advantage.  This advantage is relatively complicated so bare with me as I lay out the framework and then I’ll provide an example.

          • Social Security tax rate is 6.2% for you and 6.2% for your company (which you own), up to $127,200 in 2017.
          • Medicare tax is 1.45% for you and 1.45% for your company with no limit.

As long as you believe that you will be able to collect SS when you retire, it is in your interest to pay yourself a W-2 wage of $127,200 this year.  Let’s assume that your profits for this year are going to be $227,200.  If you take a W-2 wage (you have to take a reasonable W-2 salary with a S-Corp) of $127,200 then that leaves a profit of $100,000.  You pay 12.4% SS tax on the $127,200 and you pay 2.9% Medicare tax on the $127,200.  The profit of $100,000 is not taxable for SS, and you found the tax advantage which allows you to take that $100,000 in profit without paying the 2.9% Medicare tax on it.  This structure may have just saved you $2,900.

Both of these entities share a nice tax treatment perk, so we can’t use that to eliminate either one.  A S-Corp has a limit of 100 shareholders, which shouldn’t be considered a huge drawback unless you are thinking about really expanding your business.

The only remaining difference is in the paperwork necessary to keep each entity running.  To put this short, S-Corps have a lot of rules and regulations that need to be followed, whereas, LLCs have minimal paperwork requirements.

The logical thought is that if it is going to save us some time why not just pick the LLC?  My thought is that the extra paperwork may protect the owner a bit more if they find themselves as the target of a malpractice suit.  So, my ultimate selection would be a S-Corp.  For medical practices, some states may require you to form a professional corporation, or a PC.

Part 2: Start a Business Entity

In part 1 we picked out our ideal entity structure.  Now it is time to select a name and file for our company.  This is a two step process and I’ll start with making sure that the name is available in your state.  I live in Arizona so I need to go to the Arizona Corporation Commission’s website located at:

          • ACC

All states are different so you will need to search for your state’s commission if you don’t live in AZ.  There is a search tool that allows the user to verify that the name that they picked isn’t currently being used.  I’m going with Cool Family Dentistry, Inc. as it isn’t taken here in Arizona.  By the way, you need to attach a corp, or inc, or ltd. to your name when you file.

The second step in the name picking process is getting a .com address that is close to the name/branding that you want to use.  I’m going with coolfamilydentistry.com as it fits my corporation name and is available.  So how do I know it is available?  You need to go to a vendor of domain sites to figure out if your desired domain is available.  I went to the following three companies to see how they were priced.

Each one is around $1-$10 so the decision on which one to go to isn’t really important at this stage.  In theory you would like the place you register your domain to also be the place you use to host your website.  We will cover setting up a website in part 6.

At this stage we have our:

          1. Ideal corporate structure
          2. Trade name available through our state
          3. Available .com name

If you are an attorney you can skip this section.

I pulled some coupon codes to Swift filings, BizFilings, and Corpnet.  Each company can guide you through the paperwork needed to file for your entity.

If you decide to do this stage without help, let me give one more piece of advice.  You probably won’t find the option to start a C-Corp or a S-Corp.  There is a minor catch here, all corporations start as C-Corps.  You have to file additional paperwork with the IRS to become a S-Corp.  You can find the form and the instructions on how to fill out the form on the link below.

You have about 75 days from the time you start your business to file this form.  If you don’t file it in time, you will be a C-Corp for the tax year.  As noted above that subjects you to double taxation for the year!

Part 3: We now have our Entity

After a week or two you should receive approval from your state corporation commission.  I paid an expedited fee, of $35, on 1/5/17 and received my approval on the 9th.  My approval letter came with some other good news.  Arizona now publishes new corporations for you if you live in the populated counties.

In the past, it was necessary to publish my articles of incorporation with a newspaper to inform the world of my new company.  This saved me a little bit of hassle and about $50, so thanks Arizona.  Your state may not have this time saving step.

This next step should be really easy, but the government give’s the irs.gov website office hours, because computers need to rest too???  Your business needs an employer identification number (EIN).  Below is the link to obtaining your EIN, just be sure that you are on government hours before doing this step.

Depending on your state you may need to repeat this step to obtain a state identification number as well.

Depending on your state/city you will probably need a business license.  Figure that this should cost around $20-$50 per year.

If you selected a corporation then you will need a shareholder’s agreement.  I have searched a couple of sites and what I was looking for on the link below for $20.

It Takes Money to Make Money

For the first three steps of this process, if you have spent less than $500 you are doing great.  Part 5-8 are going to cost a lot more so you are probably going to need to obtain financing to keep pushing forward to get your practice up and running.

Banks need a way of measuring how risky your business is so that they can determine the proper rate structure for the risk.  They will assess your fico credit score, your profession, and seek to have their funds collateralized by your property, or equipment.  They then find profitable niches and actively target those low risk pools.  If you have a medical license and a fico score in the 700+ range they are going to be pleased to do business with you.  If not things get a little more difficult.  let’s start with the low risk high reward pool of loan seekers.

Low risk (700+ FICO, and a medical license)

This group of loan seekers is going to have a fast-track experience as long as they go to companies who are actively seeking your business.  Some banks will have divisions set up to make the process as smooth as possible, while others may lump you into the SBA loan category.  SBA loans take longer and have many government required rules to navigate.  SBA loans should be avoided when possible (I’ll cover that more later in the series).

I know of a few places that will directly fund rather than making you jump the hoops required by a SBA loan, so contact me and I’ll get you directly to the division leaders at Wells Fargo’s healthcare division or Bank of America’s practice solutions division.

Full disclosure, these banks will probably compensate me for the referral.  It may be a trip to a baseball game, or lunch, or even a check.  I assure you that I am mentioning them as my client’s feedback from the process has always been positive.

Medium risk (Under 700 FICO, with a medical license)

This group will probably be rejected by the specialty units of Wells and BofA.  Don’t stress too much, your medical license will still make you an attractive candidate for a loan, but now you either have to jump some hoops, or pay a higher rate.  This group is likely headed for a combination of the two…

When I first started working for banks appraising businesses so that they could meet the guidelines, known as the SBA SOP, I had to read countless pages of rules to make sure that every appraisal that I do for a bank meets all of their criteria.  My first SBA assignment blew my mind, here is a summary of what my client and I had to go through to get an SBA approval.

I had done a practice appraisal for both the buyer and seller.  When working in the low risk category (not SBA) the buyer can submit my appraisal to the bank who then puts it in their file and the appraisal process is complete.  Well, in the medium risk area my appraisal defines the doctors as my clients, so that didn’t meet the SBA’s SOP.  So, the bank had to hire me, or another qualified appraiser, as defined by the SOP, to redo the analysis and write a new report with the bank as the client.

This may sound simple,  couldn’t I just replace my client’s name with the banks name?  If so, I would be violating rules of both the appraisal foundation (USPAP) and the SBA’s SOP.  Long story short, I had to do another report using more updated data.  The fees to do the additional work were then wrapped into the loan funding process.

Why take you through that example?  To show that is just one of the extra hoops you will need to jump through to get SBA funding.  There will be many more.  So let’s talk about another way to obtain funding outside of the SBA.

About two months ago a client of mine fell into this category after being rejected by the low risk group for having a short sale on his record.  I referred him to a boutique lending group that I had been working with for years and they gave him an auto decline.  So, I can’t in good faith send people there as I wouldn’t want my clients to spend time on a likely declined application.

I decided to start the search to get him financing through other means.  I ended up finding a company that was willing to take on the additional risk, but as expected with a higher rate.  Fortunately, they didn’t have the SBA paperwork requirements so the end result worked for my client.  They basically have two products that should fit the needs of people in this category.

          1. Unsecured Loans based on a percentage of the existing company’s revenue.  So if you are looking to purchase some equipment or a smaller satellite office, this could be a quick way to obtain some funding.
          2. Traditional purchase loans.

Follow the link below to National Business Capital to learn more about their programs if you fall into this category.

Part 5: Your Office

This is going to be the most expensive step to start a business.

Contact a commercial real estate broker

Hopefully they will have experience in finding locations for medical practice locations.  You need to decide if you want to buy or rent your office.  I suggest that you start looking at both types of properties as you may miss out on the perfect location by restricting your search.

Your real estate broker will help guide you through the negotiation phase.  Here are some of the most important things that will be negotiated were you to lease space.

          • Term of the contract, it’s pretty standard to sign a 5 year lease with 2-3 options to extend by 5 more years
          • Price per square foot
          • Leasehold Improvement allowance.  Expect to pay at least $100 per square foot to set up a dental practice.  Many times you will be able to have the landlord cover a part of this cost.

If you end up buying the property, you can think of it as the same process of buying a home with a few different terms.

With a lease signed or a purchase contract in hand it is time to order the services, utilities, stationary, cards and set up a merchant banking account.

It is also time to purchase the equipment and software you will need to run your practice.

At this time you need to start thinking about which positions you need to hire day one and which positions can wait a few weeks or months.  You will need pay your employees, and eventually yourself.  The most common payroll reports that I see come from:

Part 6: Advertising

How many years in a row have you instantly thrown away the yellow pages that show up at your doorstep?  I’m probably at around ten years now.  Don’t bother to pay $100 per year for this.  The first day you open your doors you probably won’t have a patient sit in the chair so you are going to need to do something to fill up your schedule.

The ultimate goal of a dental practice should be to operate fee for service model.  Unfortunately, you may need to take some insurance plans during the start up phase.  When your practice is profitable you can always choose to cut these plans.

You will need to set up a google account and a bing account to drive traffic to your location.  Of course, they are going to ask for your web address so it is time to get that set up as well.

Many firms will host the website that you want to represent your practice.  You should expect to pay a set up fee around $5,000, or more depending on the complexity of your site.  You should also expect monthly fees in the $200-$1,000 range.

If you are a do-it-yourselfer you will see incredible savings, but it is going to drain a lot of time from your schedule.  The following cater to this group:

Part 7: Time to Get Paid

The CRM software that you probably purchased with your computer system should contain all of the forms needed.  Unfortunately, it probably doesn’t gather your data in a tax friendly way.  For your bookkeeping you have two basic paths.  First, you could hire a bookkeeper, and expect to pay around $1,000 per month for that service.  Typically a CPA firm would offer that service.  Your other option is the do-it-yourself route of using one of the three most known products in the industry for small businesses:

Both of those programs will allow you to do your invoicing and track your spending and income.  At the end of the month, quarter, year you can provide all of the information to your accountant so that they can prepare your taxes.  That is, unless you are really bold and want to take a crack at doing your own taxes for the business.  You will need to spend about $250 each year to purchase the software necessary to do your taxes through TurboTax.  It is hard to find an accounting firm that will file the 1120s return required for running a S-corp or an LLC for less than $2,500.  So, if you trust in your skills with tax software and are willing to commit about 40 hours, you can save a bundle.  Of course, if your business is doing well you could probably make up the difference by working.

Credit Card Servicing

Your bank will probably offer a credit card service and terminal.  Expect to pay around 2%-3% of what you bill your client in fees to the credit card company.  Your servicer will take a fee for the transaction (less than a dollar) and a monthly fee of around $30.  If you expect to do less than $30,000 a year in credit card volume, then you may want to use the service provider that I use.  I use Square for my credit card processing as they don’t have a monthly fee.  However, they charge between 2.75%-3.5% of each transaction.  So, as long as you do less than $30,000 in volume you will likely pay less than you would if you were paying your bank that $30 per month fee.

I just started accepting Bitcoin as more and more of my clients are also in the tech realm.  It’s a bit of a conundrum to accept it.  Do you view it as an investment or do you hurry and cash it out as quickly as you can?

If you are in the medical field you will probably want to offer your clients CareCredit services.  Giving your patients an additional way to pay is probably worth the hassle of setting up the program for your practice.

Let’s make sure that you don’t lose everything in the process.  Here are the types of insurance that you will likely need.

            • Malpractice
            • Health
            • Disability
            • Life/Buy-out insurance if you have business partners
            • Office Overhead
            • PUP (personal umbrella policy)

        Part 8: Staying Organized

        It will be necessary to hold an annual shareholder’s meeting.  Notes from the meeting along with a small fee will go to your state corporation commission each year.  It won’t be terribly expensive nor will it take up a lot of time, but it needs to be on the to do list.

        Tax time will come, and when it does try to have all of your paperwork and bookkeeping information ready for your accountant in early February.  This will give your accountant a chance to complete it by March 15th.  That’s not a typo, companies need to file their returns a month before you send in your personal, 1040, return.  So by 3/15/17 you will have to file your 1120s for your corporation or file an extension by that date.  If the corporate deadline is missed, odds are you will also need to file an extension for your personal return.  The IRS will require interest on unpaid takes after the deadline.  You can pay an estimated amount of taxes before sending in your extended return to help lower interest costs.

        I sincerely hope that this guide helps you start a business the right way.

        Thanks,

        Ross Landreth, MBA, ASA

        A few people have asked me what business I started up on the side (for this article I was just going through the steps as if I started a dental practice).  So I thought I would provide a couple of quick details.  As an appraiser I am bound to be non-biased in all of my duties, so I basically live by that code.  I have helped my wife start up a business called non-biased reviews as I am sick of seeing 5 star reviews for every product I research online.  Clearly, some of those reviewers are getting paid, or maybe even work for the company that they are reviewing.

How to Split Profits With a Partner

Thinking about adding a new partner into your medical practice?  How are you going to split profits?

Depending on your entity status you probably have been taking your salary/draw in a tax efficient way.  Also, many of you have been using the practice as your personal check book in an effort to lower your taxes.  By running your car lease and family vacations through the practice you will reduce your tax burden, but you are distorting the profitability of the practice.  You will need to stop the majority of this behavior when you bring on a partner.

Before you add a partner, you need to think of your salary as a competitive salary rather than just minimizing taxes.  Imagine that you and your partner were not doctors; instead you were both investors that are going to go out and hire two new doctors with your qualifications and experience.  How much would you be willing to pay those doctors to do your job?  Wouldn’t you expect something in return for investing in the practice and managing these two employees and the practice?

Split Profits: 50-50

Let’s start with the easiest method, to split profits right down the middle.  What if we do the same amount of clinical work, but I am always the go to person when it comes to staff issues?  What if I do all of the free work for friends and family?  Or, if I am the one who is bringing all of the new business through the door?  What if I am the one that spends all weekend going through the books and paying the bills?  How about if my partner decides that he or she will be going on a 3-month vacation, how happy will I be to cut a check for my partner’s share of the profits during that time?  What if my partner decides that he or she is only willing to work one day per week? 

As one can see, this method has some serious draw backs, but in an ideal situation it can work great.  For example, let’s say that I am great at bringing in new business and my partner is great at the office management aspects.  I may do a bit more production on the clinical side but recognize that my partner’s office management tasks free me up to do more production and marketing.  To use this method both partners need to feel equal value for their partner’s contributions to the practice.  That feeling is hard to put in a legal document so these partnerships can experience problems.

If we were to set up a deal with a 50-50 split, we would probably want to put in a clause in our partnership agreement that would reevaluate our profit sharing agreement every couple of years in case some of the balance is no longer possible.  I tend to see this method after problems arise and partners are going through messy partnership disputes.

Split Profits: Pro-Rata

This method looks at the production that you do vs. what your partner does.  In this method, let’s assume the following income and expense for a general dentistry practice:

  • Dr. 1: $400,000 in collections
  • Dr. 2: $200,000 in collections

Hygiene department $200,000 in collections

Wages for the team (no salary or draw for the two doctors) all other bills: $480,000

This leaves us with a profit margin of 40% before paying the doctors.

In this method, Dr. 1 and Dr. 2 are in a direct competition for clinical production.  In this case, the total amount of doctor collections is $600,000.  Dr. 1 did 2/3 of the production so Dr. 1 will take 2/3 of the profit ($213,000) and Dr. 2 will take the remaining 1/3 ($107,000) sounds fair, right? 

What if I changed a couple of facts?  What if Dr. 1 tells the front desk that he gets all of the new patients?  What if Dr. 1 has more chairs?  Do we really want the staff to take sides on where the patients go?  If I am busy managing the practice doesn’t that mean that you are working out of your chair doing more production than I am?  If I spend a day out of the office and bring in ten new clients, but you do the work on them am I not hurting myself?  As one can see this leads to fighting over patients and an anti-motivational method for managing and promoting the business.

 For fun, imagine what happens if we hire three associates and pay them a salary of 35% of their collections.  The numbers now look like this.

  • Dr. 1: $1,000
  • Dr. 2: $500
  • Total Associate Production $1,500,000 (3 X $500,000)
  • Hygiene: $200,000

Let’s leave the expenses the same and now include a salary for the associates of $525,000 or 35% of $1.5M

This gives us revenue of $1,701,500 and expenses of $1,095,000.  That leaves Dr. 1 and Dr. 2 a profit of $606,500 to split between the two of them.

In this method, they are in competition against each other not their associates.  Dr. 1 and Dr. 2 have been able to bring in other people to do the work for them while they sit back and manage/invest in the practice.  This method would have Dr. 1 take 2/3 of the profits or $404,333, while Dr. 2 would take only 1/3 or $202,167.  This is an extreme example, but it highlights the point that this method is a little quirky.  It should only be attempted if the doctors feast on competition.  Consequently, multiple highly competitive clinicians can make this system flourish.

Corporate Split Method

In this method, each owner will be given two hats to wear.  The first we will call their clinical hat, and the second their investor hat.  What we are going to do is pay each other a salary based on a percentage of each doctor’s clinical work (typically between 35%-40%).  We are going to pool all of the revenue (even from hygiene) pay both doctors their salaries and then pay off all of the bills.  All of the remaining profit will then be split 50-50.  

In this case, the better producer is going to get a higher salary, but what about the management/investment incentives?  If we both know that bringing in new business or taking care of that staff issue before it gets out of hand will increase the profitability.  Both of us have incentive to grow the practice profit as we are splitting it 50-50, after our salary of course. 

If the production is the same amount wouldn’t we be able to just split everything 50-50?  Yes, if you and your partner were equal producers you would probably be indifferent between this method and the first method we looked at.  However, keep in mind that this method will protect each doctor during times of vacation or short time illness.  The partner who is in the office will be compensated for the work that they will do.  Both partners will still be splitting the profits with the person who is out.  Both parties will see a drop off in profits and that month’s split of profits, but each will have a consistent flow of cash coming from the practice.  It is important to put in expectations for each partner duties when doing the contracts.  These expectations would balance the management/marketing duties and ensure a minimum amount of clinical participation.

Which Method Should You Choose to Split Profits?

I tend to find that the Corporate Split method tends to work for most deals that I touch.  This is due to having dual incentives to keep the partners in check. 

I tend to not recommend people use the equal split of profits method.  On occasion, I’ll run into an all for one practice that can thrive, but it is pretty rare.  Unfortunately,  I mainly see the equal profit split method when they are in the process of breaking up the partnership.

I don’t think that Pro-Rata split of profits is flawed, but it takes highly motivated partners to make it work.  Therefore, I rarely encourage people to go with it.

Medical Practice Valuation

Medical Practice Valuation: Within the Rules Established by the Uniform Standards of Appraisal Practice (USPAP)

The USPAP rules have been adopted to ensure minimum standards for appraisal reports. The valuation process described herein complies with the rules followed by the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA).
Here are the four most important rules for appraisers:

  1. The appraiser has no present or prospective interest in the property.
  2. The appraiser has no bias with respect to the property or to the parties involved with the valuation assignment.
  3. The assignment is not contingent upon developing or reporting predetermined results.
  4. The compensation for completing the assignment is not contingent upon the amount of the value opinion.

The data collection process is both the most important and intimidating part of the valuation process. The data request will include:

  • Practice tax returns for the previous three years
  • Profit and loss statements for the previous three years
  • Balance sheets for the end of each of the previous years
  • Practice depreciation report
  • Payroll report for the last year
  • Practice production reports by provider
  • List of discretionary items to account for quasi-business expenses that would not transfer to a new owner.
  • Description of the practice (How many ops? How large is it? Do you own the building?)
  • Patient counts (How many new patients per month? What is the active client base?)

It will take some time to gather all of the information, but the seller’s diligence during this part of the process will save time and money in the long run. Typically, appraisers won’t start working on a project until all of the data collection pieces are in place. After the data is collected it can take anywhere from a week to a few weeks to complete the valuation report.
When the data has been collected it needs to be cleaned up to remove discretionary items. For example, the practice’s automobile lease may need to be removed. That is, of course, unless the vehicle is actually used to make house calls. Another example of an adjustment that we may need to make would be to the owner doctor’s salary. Some owners will take a salary while some will not. The salary decision is generally determined by the way the business is set up. To put all of the practices that we see on a level playing field an adjustment to the owner salary may be necessary.

Methods Used in Medical Practice Valuation

Asset Approach

This method values a practice’s equipment and leasehold improvements at today’s fair market value. Imagine this method as a fire sale method. It is generally not utilized when the company being valued is a service-oriented business.

Market Approach

This is a method is similar to the one used in real estate. In real estate, appraisers utilize comparable house sales (comps). A business valuation appraiser will use data from sources such as the Goodwill Registry, Pratt’s Stats, Bizcomps, and Midmarket Comps to compare to the subject business. Consequently, this method provides an appraiser with a good idea of the range of which the majority of similar business sold.

Income Approach

This approach examines the practice’s ability to generate profits above and beyond the owner doctor’s fair market salary.
The Capitalization of Excess Earnings (CEE) method looks at the extra profits of the practice and assumes that they will continue growing at a stable rate into perpetuity. Then, a measure of risk is applied, known as a capitalization rate, to the earnings to yield a value.
The Discounted Cash Flow (DCF) method relies on a forecast of the practice’s potential earnings. It then uses the capitalization rate plus growth, discount rate, to value the future stream of cash flows to an investor today. Most noteworthy, the two methods would yield the exact value if the DCF growth was the exact same. The DCF method would be preferred, if a company is likely to experience short term changes.
Reporting options:
USPAP allows for two types of business valuation reports they are; an Appraisal Report and a Restricted Use Appraisal Report.
The Appraisal Report option will provide all of the details necessary for a person to make an informed decision about the business. I think of this report as the one that I want to use to help settle a partnership dispute or divorce. Since this report covers all of the details it is typically around 70 pages or so.
A Restricted Use Appraisal Report will omit certain sections of the full report. An appraiser will do all the necessary research for the assignment, but the report will be smaller, typically around 40 pages. I think of this report as one that has all the math, it just doesn’t tell the full story.

I also offer a non USPAP compliant calculation report for clients who want a ballpark estimate of their practice value, but don’t anticipate selling the business or settling a dispute.

First
Last

Should You Use a Broker?

Are Brokers Unbiased?

Business brokers put a selling party and a buying party together, and they help the parties arrive at a purchase price and generally draw up some, or all, of the contracts necessary to complete the deal.  Business brokers are paid on commission, which is usually 10% of the purchase price.  As a result, they have an incentive come up with the highest transaction price possible.

In addition, some brokers will claim that they are experts in valuation.  However, very few of them will be members of these recognized appraisal organizations:

American Society of Appraisers
American Institute of Certified Public Accountants
Institute of Business Appraisers
National Association of Certified Valuation Analysts

These organizations abide by the Uniform Standards of Appraisal Practice or USPAP.    The USPAP ethics rule states the following:
It is unethical for an appraiser to accept an assignment, or to have a compensation arrangement for an assignment, that is contingent on any of the following:

  1. the reporting of a predetermined result
  2. a direction in assignment results that favors the cause of the client
  3. the amount of a value opinion
  4. the attainment of a stipulated result; or
  5. The occurrence of a subsequent event directly related to the appraiser’s opinions and specific to the assignment’s purpose.

If a broker takes a commission based on the amount of a value opinion it would be a direct violation of USPAP’s ethics rule.  Therefore, a business broker taking a commission would not meet the generally accepted standards of valuation.  It is hard to claim that you have a non-biased opinion when, you are incentivized by high prices.

Furthermore, many brokers will claim that they work for both parties.  Of course, it is easy to see how a selling doctor could see the broker as representing his or her interests.  Furthermore, the are both interested in seeing the highest transaction price possible.  Is the buying doctor also interested in paying the highest price possible?  Clearly the broker is not motivated to represent the best interests of the buying doctor.

How does a business valuation specialist do business?

A BV specialist will represent the deal that they are forming.  Part of the specialist’s job is to remain unbiased so that the deal is as fair as possible.  The most important thing that they need to balance is the purchase price.  The only way to create an equitable purchase price is to abide by the rules established by the Uniform Standards of Professional Appraisal Practice.  Fee based valuations are necessary for transparent and non-biased results.

How much would it cost to sell my practice?

Below are estimates of the cost of hiring a broker to sell your practice vs. the cost of getting an appraisal and some consulting support through the sales process.
Large business ($3 Million in revenue) Assume a value of $1,500,000

Broker cost: $150,000

Direct option $6,500:

Medium sized business ($1.5 Million in revenue) Assume a value of $750,000

Broker cost: $75,000

Total for the direct option: $6,500

Small business ($750,000 in revenue) Assume a value of $375,000

Broker cost: $37,500

Total for the direct option: $6,500

In conclusion, a BV specialist, will be competitive across all sizes of practices.  Therefore, if you can attract a buyer on your own going without a broker will save you a small fortune.

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