Financing a Second Practice

When acquiring a 100 percent ownership interest in a practice, you should always buy “Practice Assets” and not stock of a corporation that owns the practice. Generally, an asset purchase excludes accounts receivable and cash, which remain with the seller. Asset purchases are standard in the industry and provide buyers many benefits such as limitation or termination of liability associated with the sellers practice (employment, divorce, vendors, etc.) and the ability to revalue the assets to market price and possibly take an IRS 179 deduction for a portion of the acquisition price (check with your accounting professional for advice).

Working capital for a practice acquisition should generally equal two to three months of overhead. When you acquire a second practice, you must carry overhead until the cash starts to flow. The cash flow cycle = patient appointment, bill for services, collect billings. It could take a month or more to start to collect the billings. Unless there is a significant amount of private pay in the acquired practice, you can’t live on co-pays alone. You also need a base working capital level, which is the cash in the practice used to support seasonality of revenues, fluctuations of receivable collections, and making special purchases. At Vision One Credit Union, our Private Practice Bankers will help you establish a reasonable estimation of working capital which should be customized to the tendencies of the practice you are buying.

Generally, there is not enough cash flow left over after the primary acquisition loan payments to support the additional debt and payments required to significantly improve the practice and provide a positive return to the buyer. If the practice cash flow can support some additional debt, it is best to include the improvements in the acquisition loan rather than to enter into a separate equipment loan or lease. Your Private Practice Banker at Vision One Credit Union can help you figure out how much debt the practice cash flow can support.

Sometimes practice buyers say they will just “lease” the equipment or certain improvements after the acquisition closes. Beware: Most leases have five-year terms and require higher payments, further diminishing remaining cash flow when compared to a 10-year loan.

In a lease situation, who is the customer? Have you ever felt pressured to use the vendor’s leasing company? Are you getting the best loan terms for your practice situation? Most lease companies obtain referral leads from the equipment and improvement vendors. In fact, most lease companies will pay the vendor a few percentage points for a closed loan. Loyalty develops between the lease companies and the vendors. To expedite the lease process, leasing companies rarely review the overall impact of the practice investment financing in context of practice cash flow and the owner’s salary requirements. As a result, we have seen many practices “over financed” with diminished cash flow due to the overzealous desire for vendors to sell and lenders to finance. Where is your Private Practice Banker in this scenario?

 When purchasing a practice, you are buying assets from the seller free and clear of any debt. Occasionally, a buyer will be asked to assume an existing lease agreement as requested by the seller, generally so the seller can avoid hidden prepayment penalties (see below). This is a seller problem. If this is the only way the deal can move forward, the price of the practice must be lowered by the amount of the lease assumed. This can be complex, messy and may kill your loan approval as your primary lender now has to sort out collateral priority issues and effects of increased debt service as payments are generally much higher on assumed debt. Unsophisticated sellers may not be willing to reduce the price due to debt assumption, which is a deal killer.

This is the number of months / years over which the loan will be fully paid out. It is very important to get “term” right, even more important than interest rate. Never opt for a balloon payment which requires a large loan payoff after a portion of the payments are made.

Cash flow will be thin in a second practice purchase if you fully finance the acquisition and have to hire a fulltime OD to see patients because your availability is limited (see Acquiring a Second Practice: Six Tough Questions to Ask Yourself). Therefore it is imperative to pick a loan term that balances the various considerations:

Example: A practice to be acquired has gross collected revenue of $1 million. The practice sells for $670,000 and requires $90,000 working capital, therefore the loan amount is approximately $760,000. The seller is working five days per week seeing patients and an associate three days. The practice has net cash flow of 33 percent or $330,000 before the deduction of OD costs and capital expenditures (“CapEx”). $330,000 less $166,000 (OD costs) less $20,000 (CapEx) = $144,000 cash flow available for debt service and owner return.

The following table shows how the term of the loan can dramatically affect the total amount that you pay in acquiring a practice.

Collateral is defined as the assets that will be pledged to the lender for security purposes as a second source of repayment. There are a few collateral combinations you might encounter:

Pledging the assets of both practices will generally reduce or eliminate any down payment requirement that may exist.

Some of the most onerous terms relate to leases.

Generally there is no disclosure regarding interest rate. This has allowed most lease finance companies to build in a commission payment to the equipment or practice improvement vendor. We have seen commissions range as high as 3 percent. You, the lessee (borrower), are paying for this as it is built into the payments. A quick and easy way to determine how a lease compares to a loan is to sum the payments of both and compare. Remember, any residual payment, generally ranging up to 10 percent of the lease amount must be added to the sum of the lease payments. Loans generally payout completely over the term and many leases require a final payment of 10 percent of the total be paid at the end of the term. That is why you cannot just compare loan to lease payments. Leases generally have shorter terms and higher payments than practice acquisition loans and should not be used to finance any portion of a second practice acquisition (as described above).

Many lease contracts do not disclose prepayment penalties. When you call to get a payoff, you are usually quoted “the sum of the remaining payments” which includes the full interest charge as if the lease was paid off over the full term. This may be proper lease disclosure but you can imagine the surprise from practice sellers when they call for a payoff on leases that are a few years old and the payoff may be greater than the amount financed! Simple interest loans do not have this hidden penalty as you are only charged for the time the loan balance is outstanding.

The less knowledge a lender has of optometric practice finance, often times they will try and develop comfort by inserting additional loan terms. Most ODs don’t understand them. Generally these are found in the “Default” section of the loan documents or may be called “negative loan covenants” in the lending industry. One of my favorites we found was a “call provision” that stated “the loan may be declared in default if the borrower is out of compliance with lenders global cash flow requirement” which was not specified. Other terms may preclude any additional debt on the practice. Try to operate if you have a negative debt provision coupled with a prepayment penalty, 15-year financing and the need to renovate the practice in seven years. Where is your Private Practice Banker in this scenario!

Understanding how to properly finance your acquisition and subsequent practice investments will save you time, money and surprises. The process starts by developing a relationship with the right financial institution, one that understands your practice, communicates effectively, and treats you as a valued customer.