Today’s business community is characterized by mergers and acquisitions.
The pharmacy market place is no exception. Pharmaceutical companies are buying
other pharmaceuticals companies; retail pharmacy chains are buying other chains
and independent community pharmacies. Independent pharmacy owners are being
approved nationwide by chains interested in buying out their independent pharmacy.
The proliferation of managed care; decreasing profit margins and uncertainty
of the future have caused may independent owners to consider selling their
pharmacies. Because many pharmacy chains are making offers to purchase independent
pharmacies, it is very important for the owner to be able to determine what
the pharmacy is worth. This will assist the owner in making the appropriate
decisions to sell or to assure that a fair price is paid for the private decision
to sell or to assure that a fair price is paid for the pharmacy should the
owner decide to sell.
The determination of an equitable selling price for a community pharmacy is
difficult for most pharmacy owners. For many, is a once in a lifetime experience
for which they have received little or now formal education or training. Moreover
the pharmacy owner may be placed in the situation of negotiating with representatives
from a chain pharmacy whose primary function is negotiating the purchase e
of pharmacies, an activity which, they may so several times a week. Therefore
because of a lack of experience, the pharmacy owner may find himself in a difficult
situation and at a disadvantage. It behooves the pharmacy owner to be as knowledgeable
as possible regarding the factors associated with the determination of an equitable
selling price.
Further exacerbating the situation is the fact that many pharmacy owners tend
to set an unrealistically high selling price for their pharmacy. This comes
about because most owners let emotion play too much of a role in the selling
price determination. This is somewhat understandable when one considers that
for many owners the pharmacy is not unlike a member of the family. It was ‘created’ by
the owner and has been part of the owner’s life for decades.
Another confounding factor is associated with the fact that many business owners
tend to sell their business at the wrong time. Few businesses are offered for
sale at a time when the businesses in profitable and economic trends are optimistic.
Most decisions to sell occur when the profit margins of the business are poor
or decreasing and future economic projects are less than favorable. Consequently,
many businesses, including pharmacies are sold for less than optimal prices.
Financial Analysis
The fiscal condition of the business is an important consideration in the determination
of an equitable selling price. Although there are formulas, which will be
discussed later, which can provide one with a goods indications of the selling
price for an “average” pharmacy, the value must be adjusted up
or down depending on the financial condition of the business. The situation
is similar to the determination of the value of a used car. We are all familiar
with the used of the ‘Blue book’ value for used automobiles.
This book contains value for the ‘average’ used car. However,
the value listed in the ‘blue book’ would be adjusted up or sown
depending on the physical condition of the auto. Included in this determination
would be such things as the condition of the interior and exterior, mileage
condition of the motor, etc. In a similar manner, the fiscal condition of
a business would affect its selling price. Therefore, a complete financial
analysis should always be performed in conjunction with formulas to determine
and equitable selling price. How to conduct a financial analysis is described
in another issue of Pharmacy Management Advisor (Vol 1, No. 1).
In addition to providing information related to the valuation of the pharmacy, a favorable financial analysis will assist the seller in the negotiation process. By pointing out those aspects of the business, such as profitability, solvency, efficiency, etc. The seller may be able to negotiate a better selling price. To be certain and astute purchaser would be quick to point out negative financial static’s in an attempt would be quick to point out negative financial statistics in an attempt to negotiate a lower purchase price.
Other Factors Affecting the Value
In addition to the financial analysis, there are several subjective factors,
which would affect the value of a business. An assessment of each of the
following would be important in adjusting the valuation of a pharmacy as
determined by various formulas described later in this monograph. Important
factors include:
1. Physical Appearance and Conditions of the Pharmacy (Are certain fixed assets in need for repair or replacement?)
2. Cash Flow (Examine past cash flow and make future projections)
3. Competition (How aggressive are pharmacy and other non-drug outlets and is expansion planned?)
4. Inventory Composition and Condition (Does inventory reflect needs and demands of physicians and customers and is its saleable or shopworn?)
5. Economic Trends in the Community (Is the community stable with high employment?)
6. Future Projections for Retail Pharmacy (Are other pharmacies stable?)
7. Managed Care (What percentage of prescriptions is third party and what is the outlook for the future?)
8. Lease Terms
9. Locations
10. Image of the Pharmacy in the Community
11. Terms of Sale
Valuation Formulas
The value of a business is usually determined through a process of negotiation
between the buyer and the seller. It goes with out saying that the eventual
selling price will lies somewhere between the initial price asked by the
seller (usually too high) and the price the purchaser is willing to initially
pay (usually too low). The valuation of a business is not an exact science.
It is based on the assessment of facts about the business informed judgment
and some aspects of common sense. In the final analysis, the valuation is
subjective, however, several formulas have been developed to estimate the
equitable selling price of a business. The valuations derived from these
formulas may then be adjusted according to the financial analysis and those
subjective factors described above to arrive at a valuation that is equitable.
There is no single formula that is best for all pharmacies. Many formulas should
be used providing for a range of valuations. Each formulas provides for an
assessment of the valuation of the business from different perspectives. e.g.
profitability net worth, sales, etc. The use of the formulas provides the range
of values that serves as a valid indication of the value of the pharmacy. Based
upon the financial analysis and other factors described above, one may more
precisely assess the value of the pharmacy. To illustrate the use of these
formulas, a pharmacy with approximately $700,000 in annual sales will be used.
The income statement and balance sheet for this example pharmacy appear in
Figures 1 and 2.
Inasmuch as space is limited, a complete financial analysis is not provided
in this monograph. The financial analysis of the pharmacy reveals the pharmacy
to be approximately “average” thereby not necessitating any significant
adjustment in the values provided by the formulas.
It should be pointed out that some adjustments may be need to be made in the
data provided on the financial statements before being utilized in the valuation
formulas. For example, some of the formulas used net profit in their calculation.
In some situations, an owner may be taking an unusually large salary thereby
resulting in an inordinately small net profit. In this case the owner’s
salary would need to be adjusted to a more ‘realistic’ figure and
the net profit adjusted upward for use in the valuation formulas. Other adjustments
from ‘book values’ to move realistic figures may be necessary.
In addition, since depreciation is not an ‘out of pocket’ expense,
it is usually added to the net profit in those formulas wherein net profit
is used in calculation of the selling price.
The following valuations using formulas do not include accounts receivable
or long-term debt, which may be negotiated separately by the buyer and seller.
Figure 1
Sales Projection Methods
1. Two methods that relate to sales should be mentioned since they were used for many years to estimate the value of a pharmacy. Due to changes in the community pharmacy marketplace affecting profit margins, these methods involving sales should be used with caution because they may tend to overstate the value of the pharmacy.
The first of these involves dividing the annual sales by three, which yields an estimated value of the pharmacy of approximately $225,000.
{$673,922/3} = $224,641
The second method involves multiplying the average sales by 100. Dividing the annual sales by 365 and multiplying by 100 gives a value of approximately $185,000.
{$673,922/365}*{$100} = $184,636
However if the number of days open is considered to be 310, (assuming the pharmacy is closed on Sunday) we get a value of approximately $217,000.
{$673,922/310} = $217,394
2. Return (Net Profit) on Investment (Purchase Price)
Another method uses the return on investment as an indicator of the value of
the pharmacy. The return is the net profit per year and the investment is
the selling price of the pharmacy. If a return on investment of 15 percent
is acceptable, the selling price would be $200,000.00. (0.15) (Selling Price)
= Net Profit or $30,000.00
Selling Price = $200,000.00
3. Summation of Relevant Factors
A third method of valuation involves selection of “relevant factors” from
the balance sheet. These factors include assets, liabilities, and net worth
as well as “goodwill” to assess the purchase price.
In addition to assets, liabilities, and net worth, the fourth component in
the summation of relevant factors is “goodwill.” Goodwill is the
intangible asset associated with positive reputation that the pharmacy enjoys.
An estimation of the value of goodwill is approximately one year’s net
profit for an “average” pharmacy and two net profit for an “above
average” pharmacy. In the example “average” pharmacy, the
net profit before tax is $30,000. Using the data from Figures 1 and 2, the
value of the pharmacy is estimated to be approximately $180,000.
(Assets Table 3.1)
4. Direct Assessment (Bank of America)
A fourth method involves an assessment that has been established by the Bank
of America. It is outlined in Figure 3. In the example, the inventory investment
is $90,587.00 and fixtures and equipment are $20,062, which totals $101,549.
This is the value of the tangible assets of the business. Before using these
figures in the valuation calculation, it may be necessary to adjust them. The
value of the inventory on the balance sheet may not be accurate figure. The
inventory may contain unsalable items or outdated items that have not been
removed from stock. It is best to have an outside inventory service do a complete
inventory, the cost of which should be shared by the buyer and the seller.
The value of fixtures and equipment should be determined by a disinterested
third party such as an individual who sells fixtures and equipment who could
give an accurate appraisal of how much new fixtures of a similar condition
would cost.
The next item, earning power represents the amount that might be earned by
investing the $101,649 in something other than the purchase of a pharmacy.
Assuming a 10 percent return, this means that the earning power of $101,649,
if not invested in this pharmacy, would be $10,164.
The next item lists the salary that the prospective owner might make if he
or she were manager elsewhere. This is estimated to be about $50,000. Therefore,
if instead of purchasing the pharmacy the prospective owner invested the $101,649
and went to work as a manager somewhere else; he or she could expect to have
a total income of $60,164.
The total income that could be expected if the prospective purchaser actually purchased the pharmacy would be expected if the prospective purchaser actually purchased the pharmacy would be $30,000 in met profit from the pharmacy plus the owner’s salary of $49,075 which totals $79,075. (Item IV).
The next item, the extra earning power, is calculated by subtracting the earning
power and salary if employed elsewhere ($60,164) from the income of the pharmacist
if he or she were to purchase the pharmacy. This would be $18,911 in the example.
The next line, in Figure 3, intangible assets is calculated by multiplying
the extra earning power times an item that is known as the years of profit
factor. The years of profit is a number varying from one to five that indicated
the approximate number of years it would take a newly opened pharmacy to get
the financial position of the pharmacy consideration. A value of 1 would be
used for a pharmacy that was not very profitable and a value of 5 would be
used for a pharmacy that was extremely profitable and stable. If we assume
that our pharmacy is average, we would use a years of profit factor of three.
Multiplying this factor times the extra earning power yields a value of $56,733.
The final calculation of the purchase price involves adding the tangible and
intangible assets together. The total for this example is $158,382.
5. Percentage of Sales Plus Inventory
The fifth method involves taking 12.5% of sales adding that to inventory giving
a value of $165,827.
(0.125) (Sales) + Inventory
(0.125) ($673,922) + $81,587 = $165,827
6. Net Income Approach
The net income approach involves doubling the net profit and owner’s
salary and adding the value of the inventory. This yields a value of approximately
$240,000.
(Net Income Table 6.1)
7. Asset Approach
The asset approach simply involves adding two times the net profit to the net
worth. This yields a value of approximately $210,000.
Net worth +2(Net Profit)
$149,199+2($30,000) = $209,199
8. Owner’s Equity Approach
The owner’s equity method is arrived at by multiplying the net worth
by 1.5 yielding a value of $223,799.
1.5 (Networth)
1.5(149,1999)=$223,799.00
9. Net Profit Approach
The net profit approach involves multiplying the net profit by 7 providing
a value of $210,000.
7(Net Profit)
7($30,000) = $210,000
10. Owner’s Cash Flow Method
This formula involves multiplying net profit by a factor between 2 and 4 depending
on the financial condition of the business. The better the condition, the higher
is the number with an average pharmacy assigned a value of 3. To this added
current assets and liabilities are subtracted. This mathematical manipulation
yields a value of approximately $210,000.
2-4(Net Profit) + Current Assets – Liabilities
Use 3: 3($30,000) + $159,899 - $39,375 - $210,524
11. Owner’s Cash Flow Intangible Method
This formula is similar to the previous one. Net profit is multiplies by a
factor between 1 and 2.5 depending on the condition of the business with
1.75 being the average. The formula is as follows and yields a valuation
of $193,086.
The estimated range of the value of the pharmacy varies between approximately $158,000 to $239,000 with an average of $199,877. The financial analyses will indicate whether the price should be at the upper, middle or lower range of the valuations provided by the formulas. Further, certain intangible, subjective factors described above such as the economy, competition, and the physical facility will provide insights as to whether the values should be adjusted upward or downward.
The selling price for this “average: example pharmacy would be approximately $200,000.
Establishment of a Junior Partnership
The establishment of a partnership or a “junior partnership” is an alternative to a direct and immediate sale. In this situation, the sale of the pharmacy occurs over several years, with the new owner acquiring a gradually increasing percentage of ownership in the pharmacy while increasing his or her share of the management.
For many owners the transfer of ownership to an individual rather than a chain is difficult because other prospective buyer may lack the necessary capital to make the purchase. It is the problem that causes many independent owners to sell to a chain rather than an individual. The junior partnership example described in this monograph provides the owner or potential buyer with practical guide as to how to transfer ownership of a community pharmacy may be accomplished in situation wherein the buyer has little or no capital. Adjustments in the example such as the time frame, percentage of purchase per year and amount paid may be adjusted to meet special needs of the owner or purchaser.
To explain the establishment of a junior partnership, a case study has been
developed in which the first 50 percent of the pharmacy is purchased over a
six-year period at approximately 10 percent per year. After the sixth year,
the junior partner could purchase the other 50 percent using a bank loan, owner
financing, or the same procedure as for the first 50 percent. In our example,
the junior partner pays for and receives the first 10 percent of the pharmacy
after the second year of the agreement, which gives him two years to save for
the purchase of the initial 10 percent. After years three through six of the
agreement 10 percent is purchased per year based on the valuation of the pharmacy
at that time.
All provisions of the junior partnership should be agreed upon in writing by
both the owner and junior partner. This agreement may be drawn up by and attorney.
The description of the current example may serve as a guide particular attention
should be given to provisions that would allow the owner or the junior partner
to terminate the agreement should particular situations develop. In the event
a portion of the pharmacy had been purchased by a junior partner at the time
of termination, provisions should be delineated to describe the disposition
of the junior partner’s share, i.e. would be sold back to the owner and
if so how would the purchase price be determined?
We will use the Jones Professional Pharmacy for this case study. The incomes statement and balance sheet for the pharmacy may be examined in Figures 1 and 3. I may be noted that the pharmacy has annual sales for approximately $700,000. For the purpose of this example, it shall be assumed that the purchase price has been determined to be $200,000. Adjustments will be made each year to reflect an increase in the value has been assumed to be six percent. In terms of salary for the junior partner the agreement calls for him to receive and annual salary of $46,000 plus a $4,000 bonus each year. This bonus is used as an incentive for the junior partner to remain with the pharmacy and continue to participate in the junior partnership. Salary increases would be provided each year as allowed for in the junior partnership agreement.
Ten percent of the ownership in the pharmacy will be transferred to the junior partner beginning at the end of the second year and continuing through the end of year six. Therefore, the junior partner will obtain 50 of the ownership of the pharmacy in six years. In this agreement, the junior partner will actually pay for the only five percent of the pharmacy at the end of each year in which a payment is due. An additional five percent is provided by the owner at no charge as an extra invective for the junior partner.
During the first six years of the junior partnership when the junior partnership purchase 50 percent of the pharmacy, the owner receives compensation in the form of his share of the net profit of the pharmacy and the payment from the junior partner for the incremental 10 percent of the business beginning at the end of year two. The income of the owner from net profit and purchase payments is provided in Figure 4. The net profit and value (See top line of Figure 4) of the business are projected to increase at six percent per year. Line 2, which is the payment fro the junior partner, is determined as follows: the initial value of the pharmacy was established to be $200,000. By the end of the second year the value of the pharmacy has been projected to increase to $224,720 based on a 6 percent increase each year. The actual value may be recalculated each year. It should be remembered that the junior partner purchased the first 10 percent of the business, 10 percent of the value ($224,720) is $22,472, but the junior partner only pays for 5% of the business or approximately $11,200.
By summing Line 2, it can be determined that the owner will receive $63,301 in payments from the junior partner over six years for the purchase of 50% of the business at 10% per year after years two through six of the agreement.
The net profit of the pharmacy is estimated to increase 6aa5 per year (See Line 3). The owner’s share of the net profit decreases 10 percent each year after the second year (See Figure 4). In years one and two of the agreement he still owns 100% of the business so all of the net profit accrues to him. In year three, the junior partner owns 10% of the business so the junior partner receives 10% of the profits and the owner 90% or $32,157 (See Line 5). The total received by the owner from his share of the net profit over the six years of the junior partnership agreement is $181,598 (the sum of line 5).
Assuming that the value of the pharmacy increases six percent per year, the remaining 50 percent of the pharmacy will be valued at approximately $141,851 at the end of the six-year period (50% of $283,703). The junior partner may then agree to pay the remainder to the owner over a period of years through owner financing. He may choose to go to a lending institution and obtain a loan to purchase the remaining 50%. He would have 50% of the pharmacy to then use as collateral. Of course, the remaining 50% may be purchased by simply continuing the purchase agreement used in the first 50% in the years seven to eleven.
As may be determined from Figure 4, the total income for the owner at the end of six years, in terms of annual payments for the junior partner and his share of the net profit, would be approximately $244,899 (The sum of the line 6). The purchase of the remaining 50% is the $141,951. Assuming the junior partner obtained a loan from a lending institution at the end of 6 years and paid the $141,951, the total amount received by the owner for the purchase of the entire pharmacy would be $386,750. Which is the sum of $244,899 from payments from the junior partner and the owner’s share of the net profit and $141,851 from the purchase of the remaining 50% of the business.
By comparison, let’s consider the income to the owner if the pharmacy
were sold outright for $200,000 instead of entering into the junior partnership
described above. If invested at six percent interest, this would yield about
$68,019 interest or a total of about $268,019 for the six years of the junior
partnership agreement example. The junior partnership example provided the
owner with $386,750 or an $118,731 difference ($386,750 -$268,019). Considering
that the owner’s share of profits and payments from the junior partnership
could be even larger. Therefore, it may be seen that the partnership yields
a significantly greater financial dividend for the owner.
Figure 5 provides information concerning the junior partnership from the perspective
of the junior partner. The income from net profit (column 2) is based on the
junior partner’s share of the net profit, which increases each year beginning
at the end of the second year. The last column represents the payments that
the junior partner make to the owner each year based on the purchase of 10%
for which he pays only 5%. These numbers correspond to the figures in line
2 of Figure 4. From Figure 5, it is obvious that the junior partner would have
to use little of his or her personal funds to make payments to the owner because
payments are made primarily from the junior partner’s share of the net
profit and bonus. By the time the junior partner make the first payment, he
or she would have received two bonus payments. Using these bonus payments plus
saving $270 per month from salary in the fist year the junior partner could
make the payment. In years three and four $360 and $90 per month, respectively,
would have to be saved from the junior partner’s salary plus the bonuses
to make the payments. None of these among are unreasonable for a practicing
pharmacist.
For this example it bay be determined that it is possible through he establishment
of a junior partnership for an independent owner to transfer ownership to the
prospective purchaser who may not have the necessary capital to purchase the
pharmacy outright. The procedure is financially beneficial for both owner and
junior partner. Most importantly for most independent owners, it provides a
mechanism to transfer the ownership of the pharmacy and keep independent pharmacies
independent.