Anatomy of a Bad Deal: Buyer Beware

By Mark Wright, OD, FCOVD,
and Carole Burns, OD, FCOVD
ROB Professional Editors

Oct. 18, 2017

Before we can look at what happens in a bad deal, we must first understand the three central components of a good deal: Both the buyer and seller agree the price is fair, the terms are fair to both sides, the buyer is able to pay the price, and there are no hidden time bombs in the practice. If any of these components break down, then the deal devolves into a bad deal, and will eventually fall apart.

With that understanding, let’s consider the three central components as they would be found in a bad deal from the buyer’s perspective.

Often the price is not fair to the buyer. Let’s look at how practice valuation formulas based on gross revenue and those based on goodwill can lead to an unfair price.

When gross revenue is used to calculate practice valuation often the price is not fair. A common way this happens is when the seller has a friend who just sold a practice that is close to the gross revenue of the seller’s practice, so the assumption is that both practices should be priced the same. Other times this happens is when the practice valuation formula simply considers gross revenue.

To show how this is unfair, let’s consider two practices that both have a gross revenue (i.e.: dollars collected, not dollars billed) of $500,000. The first practice has a net revenue before the doctors or the owners are paid of $100,000.

The second practice has a net revenue before the doctors or the owners are paid of $200,000. Should both of these practices be valued the same? The second practice has twice the net revenue of the first. Should the second practice be valued higher than the first? The answer is yes. So, clearly, considering only the gross revenue does not result in a fair value for a practice.

A healthy way to think about buying a business–any business–is that you are buying an engine that produces a net income. The optometry practice can be considered to be an engine that produces a net income. Some engines are more efficient and effective than others and, therefore, are more valuable even though the gross revenue may be exactly the same. The opposite is also true, which is an engine that is less efficient and less effective is less valuable.

Another common way that a practice is not fairly priced is when the seller consults a financial advisor about their retirement. The financial advisor tells the seller that they need a certain amount of money in order to retire comfortably. The seller determines the market value of all of the assets of practice and then adds in the amount of money the financial advisor told them they needed for retirement to determine the price for the practice. That additional money added in is called “goodwill.”

Goodwill is an arbitrary number. Practice valuation formulas utilizing goodwill often end up with an unfair price. When a practice value is determined by the amount of money the seller needs to retire comfortably, the price of the practice is not being determined fairly.

In a bad deal the terms are not fair to the buyer. The seller may say to a potential buyer, “Come work for me for five years and then we’ll determine the value of the practice and you can buy in.” What happens to the value of the practice over the five years that the associate is working for the owner? In most scenarios, the value of the practice is increasing. In other words, the associate is being penalized for working hard to increase the value of the practice. The harder the associate works, the more the associate is going to have to pay for the practice.

Sometimes the seller keeps putting off the buyer. The seller says to the buyer, “Work for me for a few years and then we’ll sit down and work out how you can buy in.” So, after a couple of years the associate approaches the owner about the practice. The owner lets the associate know that they’re not ready to sell yet, so let’s work together for a few more years and then we’ll revisit this. This scenario keeps repeating itself over the years until the associate either gets frustrated and leaves the practice, or just resigns themselves to waiting until the owner is ready to sell.

Another way the terms of the deal may not be fair to the buyer is when the seller wants to continue working in the practice after the sale as an employee of the practice. Consider a practice that supports one doctor working five days a week. The extreme situation would be if the seller of that practice wants to sell the practice, but then continue working five days a week. That leaves no time for the buyer to work in the practice from day one of ownership. There is no other way to look at that situation than that it is a bad deal.

Another variation of this problem is when the seller wants to continue working in the practice as an employee, but at an exorbitant fee. The seller only wants to work two days a week after the sale, but wants $850 per day.

If the new buyer needs someone to work two days a week in the practice, and could hire an associate optometrist at the going rate in that area of $425 per day, which is the better way to go? Sometimes it might be a good idea to hire the seller at the higher rate, but most of the time it is not. It all comes down to cash flow and need. Can the practice afford the higher rate, and does the practice need the seller to continue?

It can be the best deal in the world, but if the buyer cannot afford to pay the price, then the deal will not work. A common misunderstanding by buyers is that they may have a large amount of school debt and personal debt and, therefore, believe that they need to try to find the smallest practice possible to purchase. The exact opposite may be true. Because of the amount of previous debt, and the new debt that will occur as a result of a practice purchase, the buyer may need a larger practice to have adequate cash flow to best manage the buyer’s entire debt. A bank like Vision One Credit Union can help a buyer to understand what that number would be.

It’s a waste of both the buyer and the seller’s time when the buyer cannot purchase the practice because the buyer cannot obtain financing. Neither side wants to waste time. Both sides want to move forward productively, so it’s important the buyer completely understands their financial situation.

The business term is called due diligence. It is important to do the appropriate due diligence before the practice purchase occurs. We’ve seen everything. We saw a practice where every patient was identified as a glaucoma suspect. What are the odds that every single patient in the practice is a glaucoma suspect? Obviously, this was a fraudulent third-party billing scheme.

A partial list of things to look for is: HIPAA compliance, up-to-date equipment, inventory sell downs, up-to-date practice management and billing software that is government approved, patient portal usage, social media like Yelp reviews of the practice, chart auditing, staff payroll and retention, history of previous audits, and participation in local medical networks.

When these are not present, the practice is at risk. One of the issues the buyer has to consider is how much work is necessary to bring the practice up to speed.

The goal of a good deal is that both sides believe the price is fair, the terms are fair, the buyer is able to pay the price, and there are no hidden time bombs in the practice. The goal of a good deal is that in the future when both the seller and the buyer walk into a room and see the other person they smile, walk across the room and are genuinely happy to see each other. The key mark of a bad deal is that in the future when the seller and the buyer walk into a room, and see the other person, they avoid each other. In a bad deal, one side or both feels that the other side took advantage of them, resulting in resentment.

Understanding the common problems that can occur should help people avoid bad deals and work toward producing only good deals. There are ways to avoid every problem talked about in this article. This is what we do at the Practice Management Center everyday. We are here to help make your practice transition as easy and smooth as possible.