The perfect profit sharing arrangement - Best Practice News Alert 112

HEALTH & LIFE’S BEST PRACTICE NEWS ALERT Current circulation:

6918

DATE: ISSUE NO:

8 August 2005 112

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Writer in charge: Mr David Dahm CPA, BA Acc, FTIA, ASIA, FAAPM

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The perfect profit sharing arrangement - there is a better way and you can sell your practice!

Problem – Growing discontentment with profit sharing arrangements For owners of group practices, the biggest area we are asked to consult on is what is the best way to share profits or costs in a practice and what is a sustainable arrangement?

At the end of the day the best arrangement is one everyone “perceives” as fair. In this issue we are going to show you an arrangement we have developed that is very popular by practitioners which is commercially sustainable.

For over 14 years we have seen many arguments and court cases fought on this issue, predominately from retiring doctors or deceased estates, as practice valuations are brought into dispute due to ambiguous or unrealistic profit sharing arrangements.

The White Elephant is in the room!

There is always a “white elephant in the room” that nobody wants to talk about and usually this is about money and how practices reward their doctors.

The reality is unless the practice addresses the problem it will continue to fester and the practice cannot make clear and sound financial decisions for the future. This can stall practice growth and future practice investment.

We have an ageing workforce, where 10,000 out of 14,000 full time GP’s are over the age of 45 and are looking at full to semi-retirement over the next 5 to 10 years.

What are Doctors and Practices saying?

In recent years the following comments have been made by practices to us: 1. I can’t sell or give away my practice!

Senior owner doctors say “My practice is worth something. How much goodwill should some one pay when neighbouring practices are being given away for free”.

2. I am doing all the hard work!

Junior owner doctors say “the senior doctors are slowing down and we are doing all the hard work and not being rewarded for our efforts”. Senior doctors have said the same with junior doctors pursing other interests outside the practice;

3. There is no money left!

The practice manager say “there is not enough money to pay for new magazines. Forget about a new computer system, we need another doctor!”

4. “Why spend good money on a bad investment” Owner doctors say “why should I invest more money in my practice or give personal bank guarantees for new plant and equipment loans and sign a 10 year property lease if nobody will buy my practice or will work in it”.

“Why am I creating a bigger noose around my neck? What happens to these practice debts if I suddenly fall ill or want to retire or slow down? They won’t go away”.

The larger concern is what increased risk will occur if I do not further invest in my practice. Will standards and quality of care begin to decline, and what additional risks will occur for not keeping up to date. rd

A case in point is the recently announced 3 edition Royal Australian College of General Practice Standards that addresses the recalling of patients with “significant test results”.

Practices are now responsible for missed results, not just treating practitioners.

This has highlighted a plethora of medico-legal and operational issues that require practices to revise their written recall protocols, computer systems and legal agreements they have with doctors and their insurers. More financial resources are required to meet these needs and standards.

Solution - So what is the best way to share profits?

The best arrangement should demonstrate via written practice agreement (contact us to purchase a template agreement) the following: 1. Reward doctors for effort regardless of ownership interest; 2. Reward and encourage doctors to invest in the practices infrastructure e.g. systems, branding, staff, property and plant and equipment; 3. Provide a clear practice valuation if there is a change in ownership; and 4. Ideally be tax effective.

1. Establish commercially sustainable and simple profit sharing principles Focus on Profits, not Costs, and treat it like any other investment!

When you invest in BHP you want to know how much profit i.e. Revenue less Expenses (practice overheads) it makes, not how much it spends.

Revenue growth should equally be part of practices key focus. Practices can cut costs only so far.

Cutting costs will eventually affect quality at some point in time. Only liquidators focus on costs, successful practices and businesses focus on profits.

Treat your practice in the same way as your BHP shares. Ask yourself how much money does it make for me without having to go to work?

Decide to Make a Practice Profit on Infrastructure Acknowledge the practice, such as your service trust, must make a profit for providing infrastructure such as branding, systems plant and equipment and staff support to treating doctors.

Profit margins will range from 20% to 30% of a practices total overheads. See example below: The practice below has 2 owner doctors and generates the following annual profit: Practice Revenue

$200

Less Expense (Practice Overheads)

$100

Practice Profit

$100

Less Practice Profit Margin 20% (practice overheads $100 x profit margin 20%)

$20 p.a.

Profit available to pay doctors

$80 p.a.

In the example the practice profit of $20 guarantees anyone seeking to buy your practice a minimum profit distribution regardless of effort of $20 p.a. Clearly this would apply to group practices only.

This is an income stream that be can sold. To receive a 30% Return on Investment (“ROI”)or 3 year pay back on such an investment a person would have to invest $66 ($20 divided by ROI 30%).

Clearly any potential doctor can borrow at 8% p.a. to purchase an investment returning 30% p.a.

It is more important to keep the bankers and accountants happy. They will always have the final say. This becomes quite an attractive investment. With the use of a service trust, it is a very tax effective investment as well.

Step 2 Share any remaining profit based on effort!

The most popular profit sharing arrangement is sharing the profits based on a doctors percentage of gross billings or revenue to the group’s billings or revenue.

The remaining profit is shared after practice overheads and the practices profit margin have been paid first and the doctors are paid what is left over.

Using the following example from above illustrates this point.

Dr A & B have an equal ownership (50/50) in the practice). Let’s assume Dr A bills $120 and Dr B $80, total practice revenue is $200.

Therefore Dr A generates 60% (Dr A revenue $120/200 total practice revenue).

Dr A

Dr B

Total

Revenue

$120

$80

$200

% of Revenue

60% (1)

40%(2)

100%

Profit Share based on Revenue (A)

$48(1)x (3)

$32(2)x (3)

$80(3)

Practice Profit Margin (B)

$10

$10

$20

Total Payment to the Doctor(A)+ (B)

$58

$42

$100

From the example above the practice rewards each doctor based on their work load and they are paid $10 p.a.regardless of how many patients are seen for investing and taking on the risks in the practices infrastructure.

2. Put All Agreements in writing After deciding what is the appropriate profit sharing arrangement it is critical to put it in writing. All group practices must have a practice agreement. Contact us about purchasing a template agreement.

Why? 1. A professional approach improves recruitment of owners A practice that can professionally present itself to outside doctors, gives confidence to a joining doctor that the practice understands its business and is organized. It helps them and their

advisers understand the value of the business and how decisions are made and profits are shared. It becomes the practices living will.

2. Outgoing doctors can sue for their share of practice profits Chia v Nicholson 2001 which is about 4 GP’s in South Australia who had a service trust and called themselves an Associateship. A female owner wished to leave the practice and she could not sell her interest externally.

She turned to the remaining owners and requested they buy out her 25% interest in the practice.

As no formal agreements (although there were many discussions) were signed she successfully sued the remaining owners for $125,000.

The moral of the story is unless you have a written practice agreement with a pre-agreed valuation, be prepared to buy out your senior doctors who may suddenly fall ill or retire!

This becomes more complex when dealing with deceased estates. We have dealt with a th deceased estate Court case in Queensland where a 1/5 interest was valued at $350,000. Who said General Practice is worth nothing. The Courts have a different position!

The good news is all of these issues are avoidable and can be solved while everyone is alive and still friends if you can put everything in writing. Time is your only enemy.

Where to from here?

1. Do Profit Sharing Scenarios and show your colleagues Try and do some calculations to see if this system can work in your practice. Show the results to your partners and see if they agree. There are variations of this theme that are possible.

If you do not want to do the numbers or want to know more contact us on 1800 077 222 to discuss what profit sharing scenarios you could implement in your practice. We can provide spreadsheet calculations demonstrating before and after tax benefits arising from such arrangements.

2. Check your legal arrangements Before you implement any changes ensure your legal and taxation structure will not prevent such an arrangement from being implemented. Service trusts that are a Discretionary and/or Fixed Unit trusts may cause a problem. Call us for further information about solution to this problem.

3. Complete a Practice Agreement Formalise all arrangements in writing by using a practice agreement. Contact us on 1800 077 222 about purchasing a template agreement.

These are practice owner template agreements. Key features include internal practice valuations that do not require external valuations to value your practice in the event of a

retiring partner leaving the practice due to sickness or ill health. The agreements cover profit sharing, decision making and succession planning issues. The agreement plays a devils advocate to key issues that affect the daily operations of the practice.

The areas covered include: 1.

2.

3.

4.

5.

6.

Entry and Exit Terms and Conditions Pre-agreed Practice Valuation Profit Sharing Death and Disability Decision making Working conditions e.g. after hours and on call etc.

David Dahm Phone: 1800 077 222 Mobile: 0407 620 120 Email: pa@healthandlife.com.au Office Manager – April Myles Phone: 1800 077 222 Direct: 0413 675 633 Email: aprilm@healthandlife.com.au

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*** End of Issue 112 ***

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