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When Is an ‘Appraisal’ Not an Appraisal? Buyers Need to Know the Terminology

The question of “do I need an appraisal?” often comes up when working with clients, whether buyers, sellers, clients entering into partnerships, mergers or litigation, or for estate planning.

First let’s define what an appraisal is. An appraisal is a formal opinion of value based on all the pertinent information available about the subject–in our case, a dental practice. There are many factors that go into “all the pertinent information,” including gross income, net income, fee schedule, staff information, PPO, HMO and Medicaid insurance participation, total number of patients, number of new patients, specialties and procedures, demographics, market issues, etc. Appraisals can be oral or written, but must be based on all of the pertinent information.

Some practice brokers and consultants often offer a “Free Appraisal” of a practice when seeking to represent a seller. Unless specifically indicated, it is most likely that this will be an “Opinion of Value” based on a Rule of Thumb approach, not an “Appraisal.” So what’s the difference?

Using a Rule of Thumb
A Rule of Thumb uses some information and then usually applies an arbitrary multiplier to that information to arrive at a value. The most common Rule of Thumb we hear is, “The practice is worth 70% of gross revenue,” or “The practice is worth one times net income.” Neither of these Rules of Thumb is an accurate representation of the practice value.

An example: Two practices each collecting $1,000,000. One has an overhead of 50% and the other an overhead of 70%. Using the “70% of gross revenue” Rule of Thumb, each practice would be worth $700,000. In reality, the first practice is significantly more valuable than the second because of the larger profit. Similarly, if one practice has state-of-the-art equipment and technology and a second has 20-year-old, non-digital, out-of-date equipment, it is obvious the first practice is worth more.

A Formal Appraisal
A Formal Appraisal includes all the pertinent information and provides a formal written report. The report can be a Comprehensive Report, usually from 50 to 70 pages of information plus supporting documentation; or a Letter Appraisal Report, usually from 2 to 4 pages plus supporting documentation. Both reports have completed the same analysis, the difference being that significantly more data and discussion is included in the Comprehensive Report, where the Letter Appraisal report is a summary of the information without much in-depth discussion of the data or findings. Both formal reports must be signed and dated by the appraiser.

For the purchaser of a practice, one very important piece of information in an appraisal is a “Cash Flow Analysis.” This is the most important tool a buyer can have in determining if he/she can afford to purchase the practice and how much earnings will be available to take home after the debt service. The value of the practice is irrelevant if there is not enough money to take home! (A Rule of Thumb will not provide this important information.)

Brokers Use Different Methods
Unfortunately, there are brokers and consultants who will tell a seller what he or she wants to hear in order to engage a client. If the seller thinks the practice is worth $500,000 but an official appraisal suggests it is really worth $350,000, the seller is going to be more inclined to engage the broker who tells him the practice is worth $500,000, even if the broker knows the practice will end up selling for $350,000. AND, the broker has a contractual period, usually a year, during which the seller will be obligated to work with the broker.

An honest broker is going to tell the seller what the market for the practice is and, by doing an appraisal analysis, give the seller a realistic value. The appraisal does not have to be in the form of a written report, either Comprehensive or a Letter Appraisal, but the analysis that the broker does comprises all of the pertinent information that would go into a formal written report.

Some buyers will request or require a written appraisal report, and the banks that finance the transaction will certainly want the same information that the broker or consultant has used to arrive at a sale price as a requirement for financing. In the case of litigation, partnerships, mergers or estate planning it is probable that a comprehensive written appraisal report would be required.

Since purchasing a practice is probably one of your most valuable decisions, doesn’t it make sense that you would want to know its real value? Knowing the difference between “appraisals,” and the information and terminology the use, can make all the difference. Looking ahead, we encourage all dentists to periodically have their dental practice appraised as an element of their net worth, their exit strategy planning and for estate planning purposes.

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