Dental Practice Goodwill: How to Identify, Measure, and Value It

Goodwill is a vital asset for any dental practice. Most dental practitioners understand that goodwill is an important aspect of their practice that they should care for and maintain. However, they do not necessarily understand what constitutes goodwill and how to measure it. The practitioner cannot easily look to their books and records to find it, and when they do find this line item in their company balance sheet, it may not represent the practice’s current goodwill value.

On a day-to-day basis, goodwill measurement may not concern the practitioner. However, goodwill becomes important in circumstances where there is a need to value the practice. These circumstances might include a potential practice sale, a target acquisition, a shareholder buy-in or buy-out, divorce, litigation, or estate planning needs.

Goodwill Defined

The International Glossary of Business Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” Intangible assets are non-physical assets that can be owned and have value.

In a dental practice setting, goodwill elements comprise practice attributes such as patient loyalty, brand reputation, location, quality of care, and practitioner skill. These items can make up a substantial portion of a practice’s value. According to the Health Care Group® Goodwill Registry Database’s statistics on medical practice transactions, the average goodwill for general dentistry practice sale transactions is approximately 52% of annual gross revenue.

Valuation

Business valuators consider goodwill a residual intangible that exists to the extent that the dental practice’s overall business value exceeds its tangible asset values. There are three approaches to valuing businesses such as dental practices: asset approach, market approach, and income approach. The asset approach is based on an analysis of a business’s individual assets and liabilities and what an investor would pay to replace them. The market approach is based on analyzing actual transactions for similar businesses and comparing those transactions to the business being valued. The income approach is based on expected future cash flows of the business and converting those to a value by discounting or capitalizing them. Applying the asset approach to goodwill can be difficult as the costs of creating practice goodwill are not easily identifiable and allocable to that intangible asset. To arrive at a dental practice’s residual goodwill value under the income or market approach, a valuator would need to subtract values assigned to any tangible assets from the total business enterprise values obtained under these approaches.

Transaction considerations

Asset purchase agreements should identify goodwill separately from other practice assets for a proposed or consummated transaction to record the asset for income tax reporting. As most dental practice transactions are asset sales, where the acquirer buys specific assets rather than stock, it is essential to identify the relative fair market values of the practice’s assets, which are included as part of the total sales price. This identification process, of course, includes goodwill. For the seller, an increase in the allocation of the sales price to goodwill is beneficial, as lower capital gains tax rates may apply to the sale income. For the buyer, an increase in the allocation of the sales price to goodwill is detrimental. Goodwill is required to be amortized over 15 years for tax purposes, whereas other assets, such as dental equipment, may be eligible for immediate expensing.

Transferability of Goodwill

For goodwill to have value, it must be transferable to a prospective buyer. Goodwill of general dentistry practices is highly transferable due to the relative importance of practice location and the contribution of hygiene services to the overall practice vs. the skills and reputation of a particular dentist. Goodwill is less likely to be transferable in specialty practices. These practices tend to rely more heavily on an individual dentist’s personal reputation and skills, and these attributes can be challenging to transfer. Additionally, specialty referral sources may be more difficult for a prospective buyer to retain if the specialty practitioner is no longer continuing in the practice.

The Health Care Group® Goodwill Registry Database’s statistics on dental practice sales illustrate the difference in transferability of goodwill between general and specialty practices. The average goodwill value for Oral & Maxillofacial Surgery practice sale transactions is approximately 44% of annual gross revenue, Prosthodontics 41% of annual gross revenue, and Periodontia 39% of annual gross revenue. These percentages are lower than that of General Dentistry at 52%. However, Orthodontia transferability tends to be a higher specialty at 50% of gross revenue due to the importance of location for patients in these services.

Goodwill transferability is fostered by having the selling dentist remain on staff for a period post-sale for introductions and to instill patient and referral source confidence in the successor. This period may vary based on a general or specialty practice and could continue for up to a year. Typically, a seller signs a non-compete agreement when selling a practice. The enforceability of these non-compete agreements may also impact the value and transferability of goodwill.

Conclusion

Valuing goodwill requires a thorough understanding of both dental practices and valuation methodologies. It usually involves a combination of approaches, market comparisons, and cash flow analysis. Proper measurement and allocation of goodwill in a practice sale or purchase transaction can have significant tax consequences for both buyer and seller. Dental practice owners should consider and address goodwill transferability concerns before contemplating a transaction, as it can significantly affect value. Due to the complexity of these issues, dental practice owners should consult with valuation and tax advisors when concerns relating to practice goodwill arise.