Business valuation of a veterinary practice

If you own a small animal veterinary practice, consider buying one or plan to open a new clinic, here are some interesting industry statistics.

Classified under the SIC 0742 code, there are over 37,000 vet practices in the US alone. The industry as a whole generates some $12.2B in annual revenues and employs more than 264,000 people. The average vet clinic is quite small – generating around $300,000 in annual sales with 7 professional and support staff.

Key value drivers for a veterinary practice

While each vet practice is unique, a number of common factors contribute to the practice value. Here is the short list:

• Practice size. Multi-doctor vet practices tend to be more valuable than a single practitioner clinic.
• Location. Practices located in urban areas usually command higher valuations.
• Specialty area. Small animal veterinary clinics are generally more marketable than large animal practices. As a result, small animal vet practice valuations are typically higher.
• Asset base. Most vet practices sales are asset sales. A clinic with significant furniture, fixtures and equipment assets is likely to command a higher valuation.
• Market position. Well-established clinics can create considerable business goodwill. These practices tend to be above average in client profitability and client retention. As a result, their valuations are usually above the industry norm.

Business valuation methods for veterinary practices

As with many other professional service firms, you can value a veterinary practice using a number of methods under the standard asset, income and market valuation approaches.

Successful vet practices are frequent acquisition targets. If you need to determine the market value of your clinic, comparison to recent selling prices of similar practices is a good choice.

You can calculate your business value based on the practice’s financial performance and the valuation multiples derived from comparable practice sales. These multiples are ratios that relate the actual practice selling prices to its revenues, profits, cash flows, assets or owners’ equity.

Here are the valuation multiples commonly used in valuing veterinary practices:

• Sale price to annual net sales or gross revenues.
• Sale price to EBITDA and EBIT.
• Sale price to net income.
• Sale price to seller’s discretionary earnings (SDE).

Example – valuing a private veterinary practice using valuation multiples.

Let’s consider a typical vet clinic with the following financials:

• Practice annual net sales: $300,000.
• EBITDA: $56,000.
• Net income: $33,000.
• Seller’s discretionary earnings: $110,000.

We pick a set of reasonable valuation multiples and estimate the practice value as shown in this table:

By convention, these practice value estimates include most business tangible assets and goodwill. The value of real estate, cash, and receivables is not included – a common arrangement in an asset sale of a professional practice.

Other business valuation methods you can use

Even if you need an informal business valuation check for your practice, it is always a good idea to use several valuation methods. No one method is better than the other. The combination gives you a solid coverage and much more reliable estimate of practice worth than a single calculation.

If you plan to share your practice appraisal with other business people, tax authorities or legal experts, a multi-method practice valuation is a must.

For valuing a small owner-operator managed veterinary clinic, consider using the venerable Multiple of Discretionary Earnings method. This income-based valuation technique lets you calculate your practice value based on its earnings and a number of key financial and operational performance factors.

An established clinic may have built up substantial business goodwill. You can calculate the value of goodwill using the Capitalized Excess Earnings method, known as the Treasury Method.

If you are negotiating with professional investors or lenders, the Discounted Cash Flow method should be among your choices. This formal business valuation technique is the common way to determine the value of a professional practice based on its earnings outlook and risk assessment.

Veterinary Practice Valuation using a Set of Methods

Valuing a business? Make sure your capitalization rates are positive!

Whether you are valuing an established company or a start-up, the income-based business valuation methods are a wise choice. For businesses that tend to generate a steady stream of earnings, the direct capitalization methods such as Multiple of Discretionary Earnings or Capitalization of Earnings work very well.

Using these valuation techniques you can assess the value of a business based on its ability to generate earnings at an acceptable level of risk. Direct capitalization valuation methods use the capitalization rate to capture the business risk.

Needless to say, the accuracy of your business valuation depends largely on your choice of the capitalization rate. One common problem you may have to handle is negative cap rate values.

How the capitalization rate is calculated

How can a cap rate be negative? Consider the formula used for its calculation:

C = D – G

Here C stands for the capitalization rate, D is the discount rate and G is the expected long-term growth rate in the income you are capitalizing.

If your estimate of the growth rate G exceeds your discount rate D, the calculated cap rate becomes negative.

Business risks imply a positive cap rate

While the math can produce a negative result, the economically sensible cap rates are always positive. Put differently, your business always faces certain risks.

The typical reasons for a negative cap rate calculation are:

• Underestimation of business risks that leads to a low discount rate calculation.
• Overestimation of the earnings growth the business is likely to see over the long term.

The root cause of incorrect cap rates – rosy assumptions about future business earnings and risk

When you get a negative cap rate initially, consider these factors and review your assumptions:

• Your long-term earnings growth rate estimate may not be sustainable.
• Your discount rate should capture all risks the business is likely to face.

The typical situations that can bring your long-term earnings growth rate down are:

• Additional competition enters the market. They can capture part of the market share or put a pricing pressure on your products and services.
• The initially high growth rate leads to market saturation which ultimately reduces the business sales and earnings growth.
• Current products become obsolete and need to be replaced. Product replacement can increase your expenses and reduce the earnings growth.
• As the sales grow the business needs to scale in order to continue servicing its growing customer base. The significant investments required may reduce the business cash flow.

Using what-if scenarios to refine your business appraisal

Since the income-based business valuation is forward looking, consider a number of what-if scenarios. Each can have a different set of assumptions regarding the business earnings and risk.

You can repeat your business valuation under each scenario then average the results to come up with an overall estimate of what the business is worth.

Business valuation of law firms

Private law practice ownership transfers have been on the rise in recent years. Not surprisingly, the issue of valuing a law firm has gained in importance.

In the US private law firm sales are endorsed by the American Bar Association under the Model Rule 1.17. A growing number of states now permit the sale of a privately owned law practice.

Recent sales of law practices offer you a defensible way to estimate the value of your law firm. Valuation multiples derived from comparable law firm sales are a  common way to value a law practice. Price to gross revenues is the most typical multiple used to assess the practice value.

Law practice goodwill – a large part of practice value

More than many other professional service businesses, private law firms tend to develop considerable goodwill. This is very important since the overall practice value is affected by how transferable the goodwill is. As in all professional practices, goodwill is actually made up of two parts: the personal goodwill and the practice goodwill.

Law firm value is driven by goodwill transferability

The distinction is significant because it is generally much easier to transfer the practice goodwill to the new owners. Personal goodwill, as the name implies, is created by the individual professionals.

Client loyalty translates into repeat business for an established law practice. The question is: what happens when the current owner leaves the law firm?

Client retention and earnouts

Client retention is one indication of how well the practice retains its value over time. Private law practice sales often entail earnouts. Under an earnout arrangement, a portion of the law firm’s sale price is held back for a period of time. If the client retention goals are met, the amount held back is paid to the sellers.

Law firm value depends greatly on its size

Market-based valuation multiples vary to a large extent by law firm size. It is not unusual for a law practice grossing over $1,000,000 in annual receipts to command a price to gross revenue valuation multiple greater than 1.5 times.

For smaller firms grossing under $300,000 the valuation multiples rarely exceed 0.5 times the annual revenues. Again, one reason is that the larger law firms tend to do a better job of creating the practice goodwill. In contrast, most of the goodwill in a small law firm is personal in nature.

Business valuation of hardware stores

Hardware stores, classified under SIC 5251 and NAICS 44413, are a sizable part of the retail industry. In the US alone there are over 27,000 hardware stores in operation employing just over 173,000 staff. This retail industry segment generates more than $17 billion in annual gross sales.

Hardware retail business is small business

Yet an average hardware store is typical small business – employing a staff of 6 and producing around $700,000 in annual gross revenues.

These privately owned hardware retail companies are a critical part of the industry: over 95% of hardware stores employ fewer than 25 staff and generate more than $10 billion in annual sales. That is more than 60% of the industry total!

Hardware retail business valuation – market approach

Hardware stores are sold often. If you need to determine the value of a business in this industry, consider using the market-based valuation methods. You can develop a very good idea of what a business is worth by comparison to recent sales of similar private companies.

Valuation multiples derived from hardware store sales are the tools you can apply to value your own business.

For small hardware stores, the typical valuation multiples are these:

• Business sale price to gross revenues or net sales.
• Business sale price to seller’s discretionary cash flow.
• Business sale price to furniture, fixtures and equipment (FF&E) assets.

By convention, the value of business inventory is added to the estimate you get with the above valuation multiples.

Examples – valuing a hardware store using multiples

Let’s consider a typical privately owned hardware retail operation with the following current financials:

• Annual gross sales: $700,000.
• Seller’s discretionary cash flow: $55,000.
• FF&E assets valued at: $70,000.
• Inventory of $225,000.

We pick a reasonable set of valuation multiples for 2009:

• 0.1 times the gross sales.
• 1.4 times the seller’s discretionary cash flow
• 1.5 times the FF&E assets.

Here are the valuation results for this sample business:

• Business value based on gross revenues: $295,000.
• Value based on discretionary cash flow: $302,000.
• Value based on FF&E assets: $330,000.

The average business value is then $309,000.

Hardware store valuation – effect of the economy

Much like the rest of the retail industry, hardware stores are not immune to the economic ups and downs. The business valuation results above give you a reasonable number in the current economic environment.

If we look back in the 2006 – 2007 timeframe, the business valuations were much different. In fact, our example business would be worth around $375,000 at the end of 2007. That’s a difference of some 18%!

Reasons for decline in valuations

This business value change reflects how business people currently see the earnings prospects of small hardware retailers and assess business risk. Business sales require access to large sums of acquisition capital. At the moment that capital is hard to come by.

In addition, business buyers are very careful in assessing the earnings outlook for a business they consider to buy. Having to service a large bank loan or seller’s note against unstable business earnings is not a good recipe for success.

Earnout agreements may be a good option to close a sale – and spread the risk between the business buyer and seller. You set aside a portion of the business selling price that will be paid out to the seller if the business achieves its financial objectives in the future.

For example, 50% of the contract purchase price may be held back for a year. The business seller gets this money if the revenue targets, above a baseline minimum, are reached then.

Business Valuation based on Sale Comps, Assets and Income