The Cap Rate for a Veterinary Practice is 5, Your Honor!
By George M. Lewellen, CPA, J.D.
Published in: CPA litigation service counselor / January, 1994
I recently heard of an ‘expert’ in valuing veterinary practices who testifies
that the capitalization rate for veterinary practices is always five. This concept
disturbs me. I know that the one thing on which most specialists agree is that the only
constant in the valuation formula is that the cap rate is always variable.In my
practice, many of the business litigation cases are truly small. Sales range down to a few
hundred thousand dollars, financial statement or tax return net profits range from zero to
maybe a hundred thousand dollars, and there are often short financial histories and
erratic annual profits.
All buyers are intensely sensitive to risk. Often, their life’s savings are on the
line and they view the prospective business as a coiled rattlesnake. Accordingly, any
valuation expert who proposes a certain capitalization rate with only lip service to the
inherent risks is inviting disaster. There is simply no logical way to support a two- or
three- or higher multiple. In my practice, I use various capitalization rates to calculate
some parameters and then start testing the parameters for reasonableness while wearing my
buyer’s hat. The final capitalization rate is a by-product of my final valuation. It
is never the driving element of the valuation.
Formula methodology
In any kind of small business valuation, one of the most difficult elements to
determine is the good will or "blue sky" value. Whether the valuation relates to
damages from business interruption or divorce litigation, the problem is the same: there
are never any comparable sales, and replacement cost analysis is usually not a reliable
measure of valuation. Invariably, I rely on a formula method. Typically, a formula method
is the excess earnings methodology based upon Revenue Ruling 59-60 and Revenue Ruling
68-609.
Most accountants who work in the litigation area are quite comfortable calculating
excess earnings. The format is similar to every financial statement or tax return we
prepare, with few areas open for dispute. Furthermore, the underlying theory of investment
value balancing return with risk is inherently logical. Reasonable compensation for
officers, while subjective, seems to be reasonably determinable based on hours,
experience, and ability. The compensation a company would have to pay to obtain competent
"non-owner" managers can usually be established within reasonable ranges by
reviewing the general local market and our own client base.
Capitalization rates
Where many experts, particularly accountants, can get in over their heads is in
determining an appropriate capitalization rate once the excess earnings amounts have been
calculated. While the general theory regarding when to use a high or low capitalization
rate is easily understood, the selection of an appropriate rate is virtually impossible.
Further, reference to acknowledged authorities adds little insight to the issue and, in
fact, can be downright misleading.
Revenue Ruling 59-60 provides, in part, that "among the more important aspects to
be taken into consideration in deciding upon a capitalization rate in a particular case
are (1) the nature of the business, (2) the risk involved, and (3) the stability or
irregularity of earnings."
Revenue Ruling 69-609 goes on to provide that a 15% capitalization rate is appropriate
where the risk is small and 20% where the hazards are relatively high.
| Among the more important aspects to be taken into consideration
in deciding upon a capitalization rate in a particular case are (1) the nature of the
business, (2) the risk involved, and (3) the stability or irregularity of earnings. |
Goodwill factor vs. capitalization rate
While the capitalization rates outlined in Revenue Ruling 68-609 may have been
appropriate back in 1968, I have never seen a small business change hands with the
goodwill factor being anywhere close to these capitalization rates. Why is this?
To begin with, no buyer or seller ever goes through an excess earnings calculation to
determine goodwill value. If, in the heat of an actual negotiation, you ever ask the buyer
what multiple of excess earnings he is willing to pay, you will get reactions ranging from
uncontrolled laughter, to utter disbelief, to outright dismissal.
Fair market value
I have found that the most useful approach after calculating excess earnings is to
settle back in my chair and really get into a buyer’s mind-set by asking myself,
"What would I pay for this business?" It is crucial to remember that "fair
market value" demands a price which, among other things, a willing buyer would pay.
In order for there to be the possibility of a deal, a buyer will require sufficient
cash flow to cover all operating expenses, the cost of the acquisition (i.e., notes and
other debt service), as well as his or her own family’s living expenses plus some
"cushion" for risk. While highly subjective, this analysis is extremely useful
in preparing for cross-examination because you can honestly respond with currently
existing items of risk impacting value as opposed to an abstract theory for selecting an
arbitrary capitalization rate.
Installment sale method
An extremely useful tool to apply in valuation assignments is to test the proposed
total value of the business as if it were to be paid under the installment sale method
with something in the neighborhood of 25-30% down with a fully amortized five-year 10%
note. When this is done, if the earnings are insufficient to cover these costs plus
provide a decent living for the purchaser, you can be assured that few purchasers would
enter into the transaction at the calculated price. This mechanism gives an objective
basis for ratcheting a value up or down to a value on which a buyer and seller would agree
upon. Tip: The installment sale method is also easily understood, which can be crucial in
the courtroom.
Under the installment sale method, it has been my experience that many small businesses
either have no goodwill whatsoever or it ranges upwards to a maximum of about a
three-multiple, a far cry from Rev. Rul. 68-609’s parameters.
When an appraiser reaches the conclusion that there is some amount of goodwill in a
particular going concern, he or she will be thoroughly examined as to the reasons for
those conclusions. This is where the admonishment of Revenue Ruling 59-60 must be taken to
heart:
"A sound valuation will be based on all the relevant facts but the elements of
common sense, informed judgment, and reasonableness must be taken into the
process…"
Market competition
In the current economy, competition among businesses is fierce. There is often little
customer loyalty and the market changes daily. Products and services which in past years
might have been well established are becoming obsolete. Employee loyalty can be
nonexistent. Changing neighborhood demographics can make a historically profitable
location evolve quickly into an undesirable location because of urban blight. The price
competition from discount warehouse retailers, even from neighboring communities, can be
devastating to the profitability of small local businesses.
If one acknowledges that a goodwill factor is based primarily upon the ability of the
seller to transfer profitability to the purchaser with a low level of risk, it is easy to
see why certain capitalization rates, which in the past may have been appropriate, simply
no longer apply. The seller must be able to transfer future profitability to a buyer with
some degree of certainty before goodwill can be found to exist. This is the threshold
issue, not strict determination of the cap rate. |
