December 1997 & January 1998

Business Valuation

Buying a Professional Practice

Professional vs. Practice Goodwill

Most individuals contemplating the purchase of a professional practice are concerned about retaining the clients of the former owner. In fact, the purchase price a buyer pays for a practice should be based on reasonable assumptions about client retention. If the seller is asking for a purchase price that exceeds the fair market value of the tangible assets of the practice, he or she is asking the buyer to purchase goodwill.

In a professional practice there are generally two types of goodwill:

Practice goodwill - The goodwill associated primarily with the entity

Professional goodwill - The goodwill associated with the individual practitioner

Practice goodwill is primarily associated with the entity and is therefore not any different than the goodwill associated with any small business. The amount of practice goodwill is determined by capitalizing projected earnings over and above a fair rate of return on the tangible assets needed to operate the business.

The practical problem for the buyer of a professional practice lies in knowing how much of the goodwill relates to practice goodwill and how much relates to the professional goodwill of the selling professional. A professional cannot typically sell or transfer his or her reputation, skills, or knowledge. This does not mean, however, that professional goodwill is not marketable. It just means it is more difficult and risky to purchase professional goodwill than practice goodwill. This additional element of risk should be reflected in a lower purchase price. There are ways to transfer professional goodwill to another well-qualified practitioner that include:

The success rate in transferring professional goodwill will depend upon how well the buyer and seller carry out the above tasks. It should also be noted that in certain type practices, professional goodwill is harder to transfer. If the goodwill of the seller depends upon professional or personal referral sources, it will be difficult for the seller to write a letter to his or her friends and referral sources that convinces them that the buyer should from now on get their referrals.

Establishing a fair purchase price for a professional practice should include an in-depth analysis of any professional and practice goodwill the buyer is being asked to pay for, along with customary due diligence of other financial and legal issues.

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