• Eric J. Yetter

Getting to EBITDA – The Importance of Normalized Compensation in Private Equity Transactions

EBITDA is a key component to the accelerating consolidation trend within specialty physician practices. It is the single biggest determinant in valuing practices, and subsequently the purchase price paid by private equity firms. But what does it mean? EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is intended to represent the firm’s adjusted cash flow. Essentially, it is the cash flow that an acquirer is “buying” from the practice’s current owners.

There is an important twist to EBITDA when applied to professional services firms, including physician practices. Because the owners of the practice are also contributors to its revenue and profitability, as opposed to wholly passive owners like investors in the stock market, "Normalized Compensation" must also be considered.

Normalized Compensation represents the cost of compensating the current owners or their replacements for professional services after a sale is complete. It is essentially what owners will continue to be paid after the practice is sold. In most cases, it should also represent the “replacement cost” of the owners. For example, if a physician-owner sells her practice and then remains an employee for three years before retiring, Normalized Compensation should be the cost to pay her in the inteim and then replace her with a new physician.

Like most things in medicine, Normalized Compensation is location-specific and varies by practice. As an example, normalized compensation is generally 30-35 percent of net professional collections for general ophthalmologists.

Importantly, physicians interested in selling their practices can negotiate the post-sale compensation package that best fits their needs. Sellers should keep in mind that the more they are paid after the sale, the less they will typically receive on the front end. That’s because the buyer is essentially acquiring less “cash flow” as more is being retained by the previous owners as post-sale compensation. For that reason, and because of the importance of replacement cost, we recommend that physicians stay somewhere close to the benchmark.

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