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Practice Management

Veterinary Practice Financing—Understanding the Options

by Jeramie Eimers
    Loan form

    Astute buyers know, or quickly learn, that there is more to a well-structured financing package than simply the interest rate. Thorough preparation, lender selection, and offer analysis are the critical components of a smooth buying experience and well-structured loan.

    Purchasing a practice requires—at minimum—knowledge in law, accounting, human resources, banking, and business. Veterinarians, while experts in their industry, may not possess all the detailed knowledge needed in these other fields to be comfortable and confident when making the decision to purchase a practice. Successful practice buyers surround themselves with experts who can serve them well—accountants and attorneys; veterinary practice agents who can help find, evaluate, and assist with the purchase; business associates who know human resources, real estate, and practice management; and lenders who have expertise in practice finance.

    Buyers can avoid many problems or surprises by asking the right questions at the right time and fully understanding the nature of the business relationships forged during a practice purchase.

    Preparation

    Building a Team

    Outlined below are some of the main team members and considerations that should be addressed when preparing for practice ownership:

    Veterinary-focused certified public accountants (CPAs). CPAs analyze, assess tax impacts of, and make recommendations on the buyer’s financial options from a tax perspective. They are responsible for the overall financial analysis and tax planning for the practice and can complete the payroll and tax returns for the new buyer.

    Buyer Due Diligence

    Often, one or more parties to a sale offers to refer the buyer to another party and subsequently may be compensated for the referral, including when the buyer is being referred to a lender. Buyers should perform their own due diligence on each member of their team and, since there may be no disclosure requirements, should directly ask each team member how/if they are being compensated for any referral. Getting this information in writing can help you in making an informed decision about who to include in your team. Very few lenders require full disclosure to the borrower of any compensation being made to the referring party.

    Lenders. A lender finances the purchase. Once a location has been identified and an offer has been made, the lender evaluates both buyer and seller information to make the final lending decision. Not all lenders offer the same financing terms and conditions, and different lenders have different underwriting guidelines, so it is important to evaluate lenders and offers before securing financing.

    Practice Acquisition Credit Requirements

    The following checklist will assist buyers and sellers in compiling the credit information required to begin the review process.
     
    Buyer Requirements
    • Credit application and personal financial statement
    • Resume
    • Bank statement showing account balances
    • Last 3 years of personal federal tax returns (full returns)
    • Year-to-date pay stub(s) from current associate position(s)

    Seller Requirements
    • Year-to-date income/profit and loss statement and balance sheet
    • Last 3 years of business federal tax returns (full returns)
    • Practice information report/summary

    Additional Factors to Consider

    Lease/purchase details. The number-one reason that acquisition transactions fall apart is the inability to secure space. Land purchases and lease negotiations are normally done simultaneously with the practice purchase. In the case of a lease, problems can arise if a landlord wants to increase the rent or is not willing to assign the lease or write a new lease for the new owner. If the space cannot be secured, the practice purchase cannot be completed. For this reason, it is wise for the buyer to ask if the landlord is aware of the sale and is open to new terms. If lease terms can be negotiated on the front end, buyers and sellers avoid undue costs and time spent on a deal that might fall through.

    Risk tolerance. Similar to making investments, risk tolerance comes into play when making financing decisions. The buyer’s feelings about factors such as interest rate variability will help drive a loan structure best suited to the buyer.

    Cash flow comfort. Will the cash flow of the practice support the borrower’s living needs, tax liability, practice debt, and expenses? Sometimes, retaining an outside associate position may be necessary to support personal and business overhead needs (this should be determined on a case-by-case basis). To avoid a conflict of interest, be sure to disclose your plans to each party. Practices should have adequate cash flow and pay the debt off over a 7-year term.

    Accounts receivable (A/R). Should the outstanding A/R be included in the sale? If not, the buyer may benefit from including some working capital in the financing. In most cases, buyers do not purchase A/R, which is work that the previous owner performed, is taxable as income, and may not even be collected. Working capital, on the other hand, is available on the first day and is not taxable, but will be assessed interest. In most cases, the buying veterinarian collects A/R on behalf of the seller and may or may not be reimbursed for the time spent to do so. It is rare to purchase A/R, but if you do, the transaction is negotiable.  

    Choosing a Lender

    Buyers have two main options when looking for practice financing. They can use a lender that specializes in veterinary practice financing, or they can go to a commercial lender at their local financial institution. A third option, using a seller’s note, may be considered for all or part of the financing package.

    Using a specialist in veterinary practice financing. This type of lender has a deep understanding of practice finance and will use the assets of the veterinary practice for collateral. These lenders have experience that enables them to more easily identify strengths and weaknesses in a potential practice and, usually, to render quicker decisions and close a loan faster than a standard commercial lender. They typically are able to finance 100% of the purchase price, plus working capital needs that may arise.  A specialized lender can assist with financing veterinary acquisitions, start-ups, expansions, relocations, equipment, and practice debt refinancing.

    Obtaining a commercial loan through a financial institution. A commercial loan financed through a local bank will use the overall practice as collateral. In addition, loans of this nature usually require money down and alternative collateral, such as a personal residence.

    Financing with a seller’s note. A seller’s note can be used in conjunction with one of the other methods of financing to provide further security or eliminate some risk. A seller’s note is a loan between the seller and buyer at the same interest rate and term that the bank is offering. This option can be of benefit when the buyer feels that a practice is overpriced but still wants to purchase the practice. In this case, the seller carries an unsecured note for a percentage of the financing. For example, if a practice is being sold for $1 million, the buyer may wish to finance $800,000 through the bank and $200,000 through the seller. The buyer will then make monthly loan payments to both the seller and the bank. In another example, due diligence might uncover information that causes the buyer to have reservations about the purchase. In this case, the seller can carry a note to guarantee what they are representing. Since the buyer has no leverage after the fact, this is a way to minimize the buyer’s risk.

    Offer Analysis

    Because there are so many factors to consider when obtaining financing, what works for one buyer might not be the best approach for another. Buyers need to educate themselves on the financing process, know what questions to ask, and know what is important to them and their unique situation. It is prudent to interview lenders and receive terms, credit guideline standards, and finance quotes before submitting credit applications. This minimizes the number of credit inquiries that will be reflected on the buyer’s credit history.

    Interest Rate

    “What’s the interest rate?” is usually the first, and sometimes the only, question the buyer asks when selecting a lender. In most cases, interest rates are fixed and are not based on the prime rate, but occasionally, a commercial lender offers a variable interest rate tied to prime. Interest rates are usually tied to long-term treasury bills, swap rates that are set by the Federal Reserve, or other cost-of-funds indexes set by the lender. These indexes provide a baseline for the lender’s interest rates.

    Buyer Due Diligence

    Always ask for an amortization schedule. When comparing offers, compare the true annual percentage rate, monthly payment, and total out-of-pocket expenses to fully understand the true cost of the loan.

    Term

    Standard loan terms of 5 to 10 years are common, but if the transaction has strong cash flow, a shorter term can be offered. Some lenders offer a buyer only one term choice in their financing proposal, while others lay out multiple term options and allow the buyer to choose the term length that is best suited to his or her needs. Before deciding on a term length, make sure to discuss the options with an accountant who can help evaluate the accounting and tax implications. While short terms generally have lower interest rates and interest expense, there may be other factors to consider, including depreciation and whether it would be beneficial to have the interest rate write-off or increased cash flow for a longer period of time. Buyers should compare total loan costs over the entire term period.

    Payment Types and Terms

    While interest rate and term length are important, understanding the payment types and payment terms is crucial when making a decision. Often overlooked, payment and prepayment penalties can have a huge effect on the overall cost of a loan.

    Buyers may encounter the following types of payments:

    Equal payments. When a standard amortization is used, the buyer makes equal payments over the term of the loan.

    Step plans. In a step plan, the buyer makes lower or no payments for an initial period of time. This payment approach can be used by buyers who want to finance less working capital, need time to build up income, or want to have a cushion while they settle into all aspects of practice ownership. Interest-only payments help ensure that the loan does not become negatively amortized, but when using a step plan, it is a good rule of thumb to make sure that payments are structured to get back to the principal balance by month 6 of the loan.

    Reprice loan. Buyers are able to request a repricing of their loan interest rate after 3 to 5 years. Requesting a reprice reduces the interest rate compared with a fully amortized loan. In a reprice loan, the interest rate of the loan may be fixed for 3 to 5 years, with the payments amortized over 10 years. After year 3 or 5, the interest rate resets based on an index or cost of funds set by the bank and is fixed for another 3, 5, or 7 years. Some of the potential benefits are (1) having a lower interest rate and payment for the first 3 to 5 years, (2) basing the repriced loan on a lower cost of funds due to the shorter remaining term, (3) realizing interest savings in the first 3 to 5 years, and (4) usually avoiding credit review at the time of repricing (TABLE 1).

    Balloon payments. In this type of loan, the buyer receives a very low rate for (on average) 7 years, at which point the loan “balloons” and must be refinanced at the current rate. This type of payment not only brings interest rate risk into the equation but also requires the buyer to take the time to refinance the loan, raising the question of whether that time would be better spent with patients rather than requalifying for financing.

    Payment Terms

    Payment terms are a huge differentiating factor between lenders and are crucial to understand. Poor terms can cost a buyer thousands of dollars over the course of a loan.

    Principal reduction. Understand how soon extra payments can be made to reduce principal without a penalty. Some lenders offer this option starting on the first day of the loan, while others may not allow principal reduction payments until after the first year or beyond. The ability to apply additional payments to principal without incurring a penalty can shorten the term and overall interest costs for the buyer (FIGURE 1).


    Figure 1. Impact of additional principal payments on term length and interest costs if one extra principal payment is made each year.

    Early payoff. Similar to principal reduction, early payoffs often carry a penalty and vary greatly between lenders. Banks may have no prepayment penalties, a penalty in the first year equal to the sum of all remaining payments, or a penalty for part or all of the term.

    Buyer Due Diligence

    When comparing lenders, specifically ask what the prepayment penalty is and how it is calculated. It is prudent to request the answer in writing, along with an example that covers, at minimum, 1-, 2-, and 5-year scenarios. In certain cases, a loan could cost $200,000 more than it would with more advantageous payment terms. When evaluating options, the question to ask is, “Would the practice be worth paying another $200,000 in the market?” Most times, the answer to that question is no. This same question should be asked when deciding between a shorter or longer term.

    Collateral

    The collateral that will be taken to secure the loan also varies based on the lender. Generally speaking, specialized veterinary practice lenders will take the practice as collateral by establishing a first lien against the practice’s assets. Traditional commercial lenders are more likely to use the practice assets and to require additional collateral such as the buyer’s home, bank accounts, and other assets.

    Some lenders may require assignment of the buyer’s life and disability insurance policies to protect themselves in the event of the veterinarian’s death or disability. This generally depends on the lender and the transaction size. It is always good to think ahead and have a plan for either of these scenarios.

    Service

    Often, buyers don’t take into consideration the level of service they will get from their lender—both during the actual purchase as well as throughout the term of the loan. One of the main differentiating factors between lenders is how well they know the veterinary practice finance business. Lenders who are well versed in this area will be able to ask the right questions to ensure all of the alternatives are considered before finalizing the financing. Usually, they can also help align the buyer with knowledgeable team members who can focus on the business, help protect the practice, and allow the veterinarian to focus on his or her patients.

    Conclusion

    Buying a veterinary practice can be very exciting. It can also be overwhelming. That is why it is important not only to be educated on the process but also to be surrounded by a team of experts, including specialized accountants, attorneys, practice agents, business associates, and lenders. Using a team of specialists who know the veterinary industry well will help you ensure success.

    Author Jeramie Eimers (jeramie.eimers@usbank.com) is a practice finance sales representative with US Bank in Sioux Falls, South Dakota.

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