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CDA Communiqué - November/December 1998
by Timothy A. Brown, A.L.A.
When legislation was enacted to permit incorporation of practices, many dentists chose this route. Currently, in both Prince Edward Island and Nova Scotia, Revenue Canada is disputing the value of dentists' goodwill and how it related to the transfer of the goodwill to their company. Revenue Canada has reviewed some of these incorporations and goodwill transfers because it believes the value selected by the dentists is too high, and as a result, is requiring that taxes be paid for the portion of goodwill that exceeds the value as determined by Revenue Canada valuators. Many dentists, however, believe their goodwill has been undervalued, and that the calculations used by Revenue Canada are not consistent with the numbers that are found in open-market sales and that are recommended by professional practice appraisers. So who is correct in their opinion of goodwill value?
The Market
It is important to understand that appraising dental practice goodwill is a very complex task and that many different formulas are available to attempt to determine value. However, the demand by purchasers in the open market, and their desire to purchase goodwill, is the best indicator of value. If one can determine that buyers exist, and if actual open-market sales can also be identified for similar practices in similar geographic locations, then goodwill can be appraised accurately.
Fair market value is best supported by recent or historical transactions. But when there are no previous transactions to rely on, how is value determined? The presence of the market, whether active or not, is the next best indicator and is identified by the ongoing demand from buyers to acquire a dental practice. It may not always be possible to identify an actual similar transaction, but does that mean that there is no worth to the asset? Obviously not, as the final purchaser can only be identified when the practice is put on the market for sale. Dental practices have substantial goodwill value, whether or not it can be compared to recent transactions of similar practices in similar locations.
How to Calculate Goodwill Value
There are many different formulas and approaches to determine the value of goodwill. In my organization's database, which contains more than 2,000 appraisals and more than 600 open-market sales, we have seen goodwill value range anywhere from $10,000 to $500,000. When reviewing these data, goodwill ranges from as little as 10 per cent to more than 80 per cent of the current year's gross billings or from 50 per cent to more than 200 per cent of the current year's net earnings.
Goodwill can also be determined by using approaches such as the "percentage of gross" and "net earnings" methods. The shortcoming in using these methods is that unique circumstances surrounding the practice are ignored. For example, a practice grossing $300,000 and netting the owner $100,000 in one city, may be worth much more than a practice with the same figures in another city. Why is this so? Because the fundamental law of supply and demand ultimately dictates the value. This rule of economics will influence the value of the dental practice and it cannot be ignored when arriving at value.
Who has the information required to apply this judgment? It is reasonable to say that those who are actively involved in the sale of practices have access to information on the true supply of dental practices on the open market. It is also fair to conclude that those who actually sell practices have identified the bona fide buyers and understand their expectations in terms of the price they are willing to pay based on certain factors, including geographic location.
A dental practice appraiser often uses a formula to arrive at an opinion of value, and also applies the day-to-day knowledge obtained through the course of business. That knowledge is usually reflected in the calculations arriving at a sum of money that is likely to be acceptable to both vendors and purchasers.
What Factors Influence Value
The most thorough approach involves the consideration of every meaningful measurement of value and the inclusion of all the data in the final opinion. Key factors such as philosophy of the owner, types of appointment protocols, treatments rendered and referred out, location, facility design, demographics of the community and associates or specialists retained in the practice must be considered as an integral part of the practice. These factors will have a bearing on value because ultimately, they affect the ability of the purchaser to replicate the billings and earnings of the previous owner.
The use of just one formula that only takes into account the number of patients, for example, is far too limiting a review and may not reflect a fair market value. For example, two practices, each with 1,000 patients, may generate revenues of $200,000 and $300,000 respectively. This difference may be attributable to the unique clinical philosophies of the owners who produce entirely different revenues based on their training, level of expertise and treatment planning philosophy. Valuing a practice or its goodwill based simply on patient count is probably the most unreliable method available because every practice is unique.
Another misleading calculation is the "percentage of gross" method. Let's look, for example, at two practices both grossing $250,000. One is in a highly attractive retail location with modern equipment and in a newer facility. The other is in a remote town, in an older style building with little exposure. Is it reasonable to conclude that they are worth the same just because they generate the same revenues? What if both practitioners have similar annual net incomes, are these practices worth the same amount? Actually, they are worth entirely different amounts because the buyers will view them as totally different opportunities which will, in turn, affect the price demanded for one over the other. This is another example of how value is determined by the market, not by the formula.
Another common approach is the "capitalization of earnings" method. The use of this approach basically means that the net earnings after taxes and after a reasonable owner's salary has been deducted are divided by a capitalization rate/discount factor. The result is the amount of money you would invest to achieve a specified rate of return. This is usually the way investments such as stocks or non-owner operated businesses are valued. Professional practices, however, are a personal service where the owner is well advised to be present on a daily basis. Consequently, this approach is best reserved for absentee investment vehicles.
Another concern with this approach is the selection of the capitalization rate. The higher the rate, the lower the value will be. For example, a practice that shows a "profit" of $50,000 after salary and income tax deductions could be capitalized from a low of 10 per cent to a high of 40 per cent. The results of these calculations are very different: $500,000 versus $125,000. Obviously, the selection of the rate, which is left solely to the judgement of the appraiser, is very important. The result is far too much reliability on one figure, commonly referred to as the "Cap. Rate" and does not reflect the method normally used by purchasers to make decisions. A buyer does not simply look at the "rate of return" on a dental practice they wish to purchase. They usually look for a certain level of income, not just for an "investment" in a dental practice. Therefore, the appraiser may be applying a methodology that is not understood by those who will ultimately determine fair market value. Ultimately, the final selling price is reached by means of negotiations that take place between the vendor, the purchaser and their well-informed advisors.
Conclusion
It is unreasonable to conclude that the value of goodwill in a dental practice can be determined simply by using a formula? The actual open market, whether active or not, is truly the best determining factor for fair market value. The most reliable method for determining dental practice value is to consider all meaningful aspects of each dental practice. The appraiser will then apply their professional judgement, supported by knowledge of historical, arm's-length, actual transactions, and the result will be an opinion of the fair market value of the practice. This comprehensive approach is probably the best methodology.
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