The legal 40% return on investment when buying a practice

March 5, 2010

The U.S. economy is in turmoil, real estate values are generally down, the stock market has not fully recovered, and T-bill returns are miserly. Investors are looking for alternative, advantageous opportunities.

Key Points

Investors are looking for alternative, advantageous opportunities. This is the type of situation that brings out the hucksters and scam artists offering physician investors all kinds of opportunities, such as oil exploration shares, commodities futures, offshore investments, and other high-risk and questionable ventures.

One perfectly legal, long-established investment opportunity - limited to only physicians in most states - can provide extraordinary financial returns in both good and bad economic times. That opportunity exists in buying excellent physician practices and operating them yourself or staffing them with employed physicians and midlevel providers.

There is a lot of scuttlebutt in physician lounges at hospitals about the demise of goodwill value and the worthlessness of the value of medical practices. In a lot of individual cases involving low or average incomes, that is true, but not always.

DIVIDENDS ARE KEY

"Dividend-paying capacity" is the primary underlying concept to the value of investments, even more so in a climate of falling or stagnant equity inflation. Dividend-paying capacity is determined through the use of the net cash-and-benefit flow to ownership after subtracting the equivalent market-rate compensation of one owner as if the owner were employed and the remaining cash flow were available to shareholders/investors.

In the case of a physician owning a practice wherein other providers are employed to provide medical services, dividend-paying capacity is the cash flow to the owner above payment for work performed - with the work being up to a few hours per week of management at the medical director pay level rather than the work being a full patient schedule and the physician-owner being paid for seeing patients. With an "owner-operator" physician working full time in the practice seeing patients, dividend-paying capacity is the income in excess of compensation for that work.

Think about this example. A family physician with two midlevel providers wishes to retire. She has taken plenty of practice-management courses at the American Academy of Family Physicians annual meetings and has a smooth, well-run, well-managed practice with a stable, well-trained staff. A lab, echocardiogram capabilities, and on-site dispensing add further profits. Her annual net pre-tax income is $250,000 for a 36-hour workweek.

In this example, you are a new physician - or an established one unhappy with your employer - living in the same town and looking at job opportunities. Without relocating, the only jobs available to you pay $150,000. Buying the seller's practice and working there full time as the seller's replacement would earn you $100,000 more per year than taking a job elsewhere. There is logically some value to the extra $100,000 per year in "dividends," whether you buy the practice and work there or buy it as the practice-next-door and employ someone else to be the working physician at $150,000.

Determining how much the annual extra $100,000 is worth to you is where the "40 percent return on investment" (ROI) comes in. A valuation concept called the build-up rate of risk finds that riskier investments need to provide higher returns. So you build up the required ROI from low risk to high, from 20-year treasury certificates to the long term Standard and Poor's 500 rate, to smaller public company rates, to the risks of small, owner-operated professional-service businesses.

It is common to see rates of return of 20 to 35 percent for pretax earnings after owner's compensation for professional practices not subject to Medicare or insurance company reimbursement or clinical malpractice - ones such as accounting, law, architecture, and engineering practices. Private medical practice ownership, therefore, logically should provide a return to ownership in excess of 20 to 35 percent for its greater risk, that is, a 40 percent or more return.

Another way to look at the investment is that the purchase of a practice - 100-percent financed - should pay for itself with extra earnings over no more than five years. You can borrow the money to buy the practice at around seven to nine percent, then earn 40 percent on the bank's money.

At the time of the writing of this article, some specialty divisions of banks still are eager to lend practice-purchase money to physicians during the recession and banking crisis.