Real Life Experience in Practice Combinations
I. SPACE SHARING ARRANGEMENTS STRUCTURED AS A DISGUISED SALE
Dr. A is rapidly approaching the golden years and would like to sell his veterinary practice, which is currently grossing $400,000 annually and has been appraised at $280,000. Dr. A owns the free-standing building where his practice is located and also desires to sell the real property which has been appraised at $350,000. Dr. A enjoys being a veterinarian and would be interested in continuing to work on a part-time basis after the sale. The practice and real property have been listed with a broker for 9 months and not a single offer has been forthcoming. The listing agreement expires tomorrow and Dr. A does not intend to renew the listing. Dr. A recently spoke with Mr. Yasgoor who advised Dr. A to contact local veterinarians to see if any practice owners would be interested in some type of space sharing arrangement, merger or outright purchase. To Dr. A's surprise, Dr. B is very interested in exploring the possibility of "relocating" Dr. A's practice into Dr. B's practice facility by way of a space sharing arrangement disguised as a sale. What are the potential benefits of this arrangement to Dr. A and Dr. B?
B. Overview :
1. Benefits to Dr. A.
a. Receives money for an otherwise unsaleable practice.
b. Continues to service his clients at Dr. B's hospital facility.
c. Eliminates headaches of ownership and overhead.
d. Sale of unused equipment and the return of unused inventory creates instant cash.
e. Sale of real property or lease for non-veterinary use creates instant cash.
f. Note : If Dr. A is leasing the real property from a third party (e.g., a shopping center), the rent payments would be eliminated.
2. Benefits to Dr. B.
a. Acquires Dr. A's practice with little, if any, financial risk.
b. Acquires Dr. A's practice by using "soft" dollars, which are fully deductible when paid.
c. Acquires Dr. A's practice without assuming any liabilities.
d. Creates new profit center.
e. Adds veterinarian, possible AHT and other employees to staff.
C. Specific Issues to be Addressed:
1. How is Dr. A's practice valued?
a. Based on appraised value of the intangible assets only (e.g., trade name, client files and goodwill) and not on the tangible assets (e.g., furniture, fixtures, equipment, medical instruments, drugs and supplies).
b. Query whether Dr. B desires to purchase any of the tangible assets separately? If so, how will the purchase be structured (e.g., cash, note or combination of both)?
2. How is the agreed to "purchase price" to be paid to Dr. A?
a. Earn-out with an "agreed to" cap.
b. Earn-out with no cap.
c. The earn-out concept is based on percentage of production revenues produced by Dr. A on Dr. A's clients (and possibly revenues produced by Dr. B's veterinarians on Dr. A's clients) to be applied toward the purchase price. This percentage of production revenues is paid to Dr. A over time until the payment of the "purchase price" is satisfied.
(i) Assume that Dr. A's practice is valued at $240,000 (i.e., 60% of annual gross revenues). Dr. A will receive a salary equal to 20% of his production. In addition, he will receive an extra 20% of his production to be applied toward payment of the purchase price for the first 3 years of employment. In a perfect world, Dr. A would receive the entire $240,000 purchase price within 3 years ($400,000 x 20% x 3 years).
(ii) In the above example, Dr. B is receiving 60% of the revenues generated from Dr. A's production.
3. What happens if Dr. A's employment relationship is terminated (whether voluntary or involuntary) prior to full payment of the "purchase price?" How can both Dr. A and Dr. B protect their respective investments?
a. For Dr. A's protection, create a promissory note equal to the difference of the "agreed to" purchase price and the percentage of production revenue payments paid to Dr. A prior to date of termination. Need to address term of note, interest rate, security and right to prepay.
(i) Assume that Dr. A's practice is valued at $240,000 and he terminates employment after he has received $160,000 of the purchase price from the extra 20% of production payments. Dr. A would receive a promissory note from Dr. B in the amount of $80,000 ($240,000 - $160,000).
b. For Dr. B's protection, a penalty (i.e., discount) for early withdrawal could be built into the "agreed to" purchase price to prevent Dr. A from possibly receiving an economic windfall.
c. From a tax standpoint, how will the parties treat the note payments?
(i) Query whether they can be classified as severance payments fully deductible by Dr. B and taxed as ordinary income to Dr. A?
4. Define employment relationship.
a. Employee or independent contractor.
(i) Does it matter whether Dr. A operates his practice as a sole proprietorship, "S" corporation or "C" corporation?
b. Term of work arrangement.
c. Work schedule.
d. Compensation payable to Dr. A usually based on percentage of veterinary services production.
(i) 20%-25% for services rendered by Dr. A to his clients.
(ii) 20%-25% for services rendered by Dr. A to Dr. B's clients.
(iii)20%-25% for direct referrals made by Dr. A to Dr. B (e.g., surgical procedure).
(iv) 10% for services rendered by Dr. B's veterinarians to Dr. A's clients when Dr. A is unavailable (e.g., vacation or illness).
e. Fringe benefits (e.g., medical health insurance, vacation, CE, membership dues, malpractice insurance, retirement plan, etc.).
5. Representations and warranties of both parties.
6. Dr. A's covenant not to compete.
a. Can it be enforced?
7. Dr. A's death or disability.
8. Miscellaneous issues.
a. Staffing (including receptionist).
b. Telephone lines.
c. Mailing of announcements to Dr. A's clients.
9. What does Dr. A do with the real property where his practice is located?
10. When all is said and done, strive to create a "win-win" result for both parties.
II. SPACE SHARING ARRANGEMENTS STRUCTURED AS A SUBLEASE
• Dr. A has been winding down her practice and currently grosses $200,000 annually. Her shopping center lease will expire in 6 months and she does not plan to exercise her option to renew the lease. Dr. A would like to continue working as a veterinarian on a part-time basis. Dr. B owns a nearby practice and has offered Dr. A the opportunity to relocate her practice to Dr. A's hospital facility.
• Dr. A has been practicing in a shopping center for 10 years. The landlord has decided not to renew her lease. Dr. B, whose veterinary practice is located 1 mile away, has offered Dr. A the opportunity to conduct her practice out of Dr. B's hospital facility.
• Dr. A owns a veterinary practice grossing $500,000 annually and would like to increase the gross revenues by creating a new profit center. Dr. B specializes in the treatment of birds and exotic animals and has been working as a relief veterinarian at several practices within a 10 mile area of Dr. A's practice. Dr. B would like to work solely at Dr. A's hospital so that she can more rapidly develop her client base and have more stability in her life.
• Dr. A sold a satellite shopping center practice to Dr. B a few years ago and took back a large promissory note. Over time, Dr. B's business has declined to a point where she can no longer meet her financial obligations to her creditors, including the promissory note payments owed to Dr. A. Dr. A suggests that Dr. B attempt to extricate herself from the shopping center lease and move what's left of her practice to Dr. A's hospital facility.
• A specialty animal clinic would like to add an ophthalmologist to its practice. Dr. A, a board certified ophthalmologist, would very much like to join the specialty practice by subleasing space and starting her referral practice.
1. Benefits to practice owner.
a. New profit center.
b. Additional veterinarian in the hospital.
2. Benefits to non-owner veterinarian.
a. Reduced overhead. Rent payments to practice owner for use of space are built into split of revenues produced by non-owner veterinarian.
b. Increased revenue.
c. Fewer employee headaches since support staff provided by practice owner.
C. Specific Issues to be Addressed:
1. Term of space sharing arrangement.
2. Termination provisions if space sharing arrangement does not work out.
3. Non-owner veterinarian relocation expenses (e.g., moving, telephone transfer and installation fees, yellow page advertising, etc.).
4. Allocation of revenues between practice owner and non-owner veterinarian.
a. 40% of the fees "produced by" non-owner veterinarian for veterinary services performed on his or her clients are paid to non-owner veterinarian; remaining 60% are retained by practice owner as the "rent."
b. 20%-25% of the fees "produced by" non-owner veterinarian for veterinary services performed on owner's clients are paid to non-owner veterinarian; remaining 75%-80% are retained by practice owner.
c. Services are deemed "produced by" non-owner veterinarian if such veterinary services are performed by non-owner veterinarian on either non-owner veterinarian's or practice owner's clients. Veterinary services may include certain ancillary services (e.g., laboratory, pharmacy sales and imaging services rendered at non-owner veterinarian's direction) and usually excludes revenues from pet food and other retail products sold at practice owner's hospital.
d. Non-owner veterinarian's percentage of production is paid on revenues collected by practice owner and not on fees billed.
5. All billing done by practice owner's staff. Practice owner provides non-owner veterinarian with a full and complete accounting each month of fees billed and collected, as well as itemized breakdown of all monies due non-owner veterinarian based on the percentage of production formula.
a. Non-owner veterinarian is paid bi-monthly on the 15th and last business day of each calendar month.
6. Non-owner veterinarian is considered an employee; however, under limited circumstances, may be classified as an independent contractor.
a. If non-owner veterinarian is an employee, practice owner is responsible for employment and withholding taxes.
b. If non-owner veterinarian is an independent contractor, practice owner does not withhold any state and federal taxes. Non-owner veterinarian must agree to indemnify, defend and hold practice owner harmless from any liabilities resulting from non-owner veterinarian's failure to make the required tax payments.
7. Practice owner provides non-owner veterinarian with full use of equipment, veterinary instruments, drugs, supplies and incidental administrative support services (e.g., receptionist and phone answering).
8. Practice owner pays for all costs and expenses pertaining to proper maintenance and repair of the hospital facility, other than any costs related to non-owner veterinarian's intentional, reckless or negligent acts.
9. Practice owner pays for all utilities supplied to hospital facility.
10. If non-owner veterinarian is classified as an employee, practice owner should maintain malpractice insurance coverage for non-owner veterinarian. If independent contractor status is utilized, the result may be different.
11. Non-owner veterinarian may or may not be permitted to participate in the medical health insurance plan or retirement plan maintained by practice owner for practice owner's other employees.
12. Non-owner veterinarian's covenant not to compete following termination of space sharing arrangement.
a. In California, there is no prohibition against competition so long as non-owner veterinarian competes fairly. Non-owner veterinarian may take his or her client files and medical records and may practice veterinary medicine anywhere.
b. Non-owner veterinarian agrees not to solicit or take away any of practice owner's clients.
c. Non-owner veterinarian agrees not to induce any of practice owner's employees to terminate their employment with practice owner.
d. Practice owner agrees not to solicit or take away any of non-owner veterinarian's clients.
13. Walk-in clients.
14. Arbitration of disputes.
15. Option to purchase practice owner's veterinary practice.
a. What percentage of practice owner's interest will be acquired?
b. Determination of purchase price.
(i) Peg the price currently.
(ii) Compute the purchase price when option is exercised using an agreed to formula.
c. Terms of purchase.
(ii) Promissory note.
d. What will secure the payment if a promissory note is used?
e. Determine fair market rent if practice owner owns the real property where hospital facility is located.
f. Option to purchase real property if owned by practice owner.
1. The Straightforward Merger of Two Practices
Dr. Isadore Lip, age 55, owns and operates a veterinary hospital as an "S" corporation which generates annual net revenues of $700,000. Dr. Lip owns the real property where his practice is located. Dr. Ida Bell, age 48, also owns and operates a veterinary hospital as an "S" corporation and her hospital generates annual net revenues of $650,000. Dr. Bell owns the real property where her hospital is located, which is approximately 2 miles from Dr. Lip's hospital.
Dr. Lip's hospital was averaging approximately $1,000,000 in annual revenues 3 years ago; however, the loss of his long-time associate veterinarian and increased competition in the area has caused the revenues to drop by 30% over the past 3 years.
Drs. Lip and Bell have been friendly competitors for several years and are members of the same rotary club. Although Dr. Bell's gross revenues are lower than Dr. Lip's, she runs a more efficient operation and has a higher "net income" than Dr. Lip. Dr. Bell recently has begun to do dentistry work and believes that her net revenues will increase significantly over time.
At the suggestion of Dr. Lip's practice management consultant, he phones Dr. Bell to see whether she has any interest in bringing the practices together under Dr. Lip's roof. Dr. Bell is intrigued by the concept and agrees to meet with Dr. Lip over a cup of coffee to explore the possibility of merging the practices.
2. The Merger With a Twist
Assume the same facts as set forth in Hypothetical No. 1, except that Drs. Lip and Bell each lease the real property where their respective practices are conducted. The doctors would like to pool their resources and acquire a parcel of real estate, build a new hospital and then relocate the combined practices into the state-of-the-art facility.
1. Why consider a merger of two or more practices into a single veterinary hospital facility?
c. Is the labyrinth of complexities worth the effort?
d. Economics of scale. Is bigger more profitable?
2. Analyze geographical area and demographics.
3. Similar clientele.
4. Compatible practice culture, philosophy and protocols.
5. Staffing (query whether the spouse of either veterinarian works at the practice?
6. Pricing of veterinary services.
7. Formation of entity to run and operate the combined practice.
a. Type of business structure (e.g., partnership, corporation or LLC).
(i) In California, a limited liability company (LLC) and limited liability partnership (LLP) cannot be utilized to operate a veterinary practice.
b. The value of each practice should be "pegged" in order to establish capital accounts. How will the respective practices be valued?
c. Business name.
e. Phone system.
h. Employee policies and procedures manual (specific job descriptions needed).
i. Distribution of profits.
j. Retirement plan.
9. Real property issues.
a. Leasehold vs. fee ownership.
b. What will abandoned practice real property be used for?
c. Determination of rent for the combined veterinary practice facility.
10. Location, visibility, personnel and practitioner reputations will all have bearing on success of the combined veterinary practice.
C. Specific Issues to be Addressed:
1. Formation of new entity evidenced by appropriate business agreements addressing a potpourri of issues.
2. Each practice must be valued (e.g., appraisal method based on traditional valuation factors, including analysis of the assets and liabilities being transferred to new entity as the initial capital contribution).
a. Excluded assets.
b. Excluded liabilities.
3. The initial capital account of each practice owner is a critical component to the overall merger and is significant in determining the percentage of cash distributions to each owner.
4. Establish guidelines for salaries, cash distributions and guaranteed payments to each owner.
5. Establish guidelines for additional capital contributions to the combined veterinary practice if needed for working capital purposes.
6. Establish rent if combined veterinary practice is located in free standing building owned by one of the owner veterinarians.
7. Define what events will trigger a future buy-out of the other owner (e.g., withdrawal, retirement, bankruptcy, permanent disability, death, dispute, etc.).
a. In the event of a dispute between the owners, the agreement must set forth the right of the disputant to give notice to the other to either sell his or her ownership interest to the other or buy the other owner's interest at specific price and terms.
b. Mandatory or optional buy-out?
8. Determine purchase price formula to establish fair market value of owner's interest if a buy-out event occurs.
9. Determine method of paying purchase price.
10. Establish a covenant not to compete for exiting owner if the triggering event is other than permanent disability or death.
11. Arbitration of disputes.