“Reasonable Compensation” for the sole practitioner in Business Valuation

by Steve Popell on September 16, 2009

compensation_reward_strategy_pictureThe most frequent approach to valuing a sole practitioner’s private practice is the “Excess Earnings” Method.  In this method, excess earnings represent Total Practice Earnings (salary + bonus + company profit) in excess of the sum of “reasonable compensation” and a reasonable return on the practice’s Net Worth (Assets minus Liabilities.)  When the estimated value of excess earnings is multiplied by a factor (the multiple) reflecting the relative risk of the earnings stream, the result is goodwill.  Goodwill plus Net Worth equals the total value of the practice.

While the excess earnings method itself is quite straightforward, determining what constitutes reasonable compensation is anything but.  Even “experts” can draw vastly different conclusions on this topic.  Clearly, if there is no agreement on what level of compensation is reasonable, there can be no agreement on what is excess.  This post will seek to demystify this question and clarify the process.

The Excess Earnings Method is based on the principle that the vast majority of the value of a sole practitioner’s private practice is the capacity of the practice (the practitioner) to generate net income after all expenses.  This principle is common to virtually all types of businesses. The difference here is that this method requires that the earnings of the practice be compared to those of “comparable” practices.  The following scenario will help to illustrate the fundamental issue in this comparison.

You, the sole practitioner, have decided to take a year off and sail around the world on your boat.  {To simplify this example, we will assume that Net Worth = $0}  Your task as CEO is to hire a person with identical skills and experience to manage your business, and to provide all the services your clients require.  This individual would be neither an owner nor a partner in your firm.  What would you have to pay this person?

Let’s assume that you could hire an equally competent replacement for yourself for $150,000 per year.  If your Total Practice Earnings = $400,000, Excess Earnings = $250,000.  The difference between the non-owner’s compensation and your Total Practice Earnings reflects the benefits of ownership.  In other words, you compensate yourself at the $400,000 level not because that reflects market rates, but simply because you own the company, and you can.

While the concept and the basic calculation are easy to grasp and implement, the problem arises in determining precisely what constitutes market rates.  There are two ways to do so.

  1. Find at least one economically similar practice that employs a practitioner of comparable skills and experience to you.  Where such arms-length financial arrangements exist, they represent best evidence.  Unfortunately, such direct comparisons are typically few and far between.
  2. Much more common is to rely on the estimates of other sole practitioners in your field as to what such a non-owner employee would earn in their practices.

The lynchpin of both avenues of inquiry is the identification of one or more economically comparable practices.  By what standards does one determine comparability?

First, the practitioners must be practicing in the same or closely related specialty, however unusual or thinly populated.  To compare a transplant specialist with a cross section of general surgeons would be of little help.

Second, the backgrounds and credentials of the practitioners must be quite similar.  This does not mean that they went to the same medical school or had virtually identical residencies.  However, one cannot very well compare someone who is board certified in a specialty with one who is not.  Nor is one likely to find a helpful comparison between individuals whose time in practice varies by 15-20 years.

Third, economically comparable practitioners must function at about the same skill level, and be so recognized by their peers.  Fortunately, the narrower the specialty, the better known are the few leading practitioners and, therefore, the easier it is to obtain such judgments from colleagues.

It is important to keep in mind that we are not comparing the Total Practice Earnings of similar practice owners.  That would defeat the basic objective, which is to determine the incremental increase in Total Practice Earnings resulting from self-employment.  Only by making that determination can we determine the value of ownership in the private practice and, as a result, the value of the practice itself.

PhotoPopellThis article has been contributed by Steven D. Popell CMC (Certified Management Consultant.) Steve has been qualified as a business valuation expert since 1974, and has published extensively on this topic. CMC, a certification mark awarded by the Institute of Management Consultants USA, represents evidence of the highest standards of consulting and adherence to the ethical canons of the profession. Steve was a 2007 winner Collaborative Practice California Eureka Award for contributions to Collaborative Practice in this state.

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