7 Key factors in professional practice valuation
Does professional practice valuation differ from other business appraisals? Consider this:
Professional practices come in many types: dental and medical practices, law and accounting firms, architecture and engineering consulting companies, individual and business professional consulting firms.
While a professional practice may look like a service business, there are key differences to bear in mind that affect what a practice is worth.
Top reasons why a professional practice is valued
Remember that your choices of business valuation methods and, ultimately, the results you get will depend on the reasons for practice valuation. So, what are the typical situations calling for valuation of a professional practice? Here are the top ones:
- Ownership transfers, such as the practice sale, partner buy-in or buy-out.
- Legal disputes involving partner disagreements and divorce.
Less frequently, a professional practice may be valued for:
- Estate planning and taxation purposes.
- Bankruptcy and reorganization.
- Practice acquisition and expansion financing.
Differences between a professional practice and other service businesses
Most professional practices share a few key traits that set them apart from other service-oriented businesses. Assessing the practice in light of these traits is important to your selection of key valuation inputs: the cash flow projections, valuation factors, discount and capitalization rates.
1. Price sensitivity
Typically, professional practice clients are less cost conscious than customers of other service businesses. They look for the right expertise to address a critical need even if it costs more. Professional practices are less susceptible to abrupt pricing pressures such as deep discounts or low cost substitutions. This affects the practice cash flow projections and, in turn, what the practice is worth.
2. Professional reputation and skill
The reputation of a professional practice and demonstrated skills of its practitioners are very important to its success. This means that a large part of the practice value resides in its professional practitioner and institutional goodwill, not its tangible assets.
3. Reliance on referrals
Most clients seeking professional services get referrals from people they know – relatives, friends and other professionals. Strong referral network represents a key factor which contributes to the practice value.
4. High intangible asset base
More so than most service businesses, professional practices show a high level of intangible assets. Many of these assets do not appear on the practice’s Balance Sheet, hence have no “book value”. However, they often represent the most important and valuable assets the practice has. Consider using the business valuation methods which measure business goodwill, such as the Capitalized Excess Earnings method.
5. Licenses and protected market
Many professionals are licensed practitioners. This has two significant effects on the practice value. First, it moderates competition by limiting the number of entrants in the market. Second, it limits the pool of potential buyers that are qualified to acquire and run the practice.
Now, the practice’s fair market value is established in the competitive market place. Hence, the level of competition among the practice buyers has a major effect on what it is worth.
6. Client relationships and practice sale
Here is an important question: if the practice is offered for sale, can it be successfully transferred to the buyer? The answer often depends upon the level of professional goodwill. Some professional practices are quite challenging to sell because of the close relationship of its clients to the individual practitioner.
Uncertainty about the transfer of practitioner goodwill is one reason why you frequently see earnouts as part of a professional practice sale.
7. Professional practice life expectancy and value
A professional practice may have a shorter expected life span than other service businesses. This affects how you do income projections for the practice. And the income projections form the basis of such business valuation methods as Discounted Cash Flow. Importantly, the assumption of perpetual income stream may not be appropriate when valuing a professional practice. This reduces the practice’s residual value.