Last month I wrote about the art of negotiation in a pharmacy purchase. If you get the timing right with asking the right questions you can generally argue the price down in a sensible way. This month I want to look at the impact of paying above valuation for a pharmacy and what that means for your investment.

Current pharmacy market

Speaking at APP2016, Frank Sirianni from Medici Capital indicated that of the 5,500+ pharmacies in Australia, about 150 – 200 change hands each year. Given that we have over 1,500+ graduates each year who complete their internship and who soon enough begin thinking about ownership you can see that the pharmacy acquisition market is a crowded space. Add to those 1,500+ graduates the existing owners who might be looking for their second or third pharmacy business and you can see that the market has more than enough potential buyers competing for pharmacies for sale.

This creates pressure across the board but in particular I am seeing very high prices being paid for ‘small’ pharmacies. What is a small pharmacy? I would say one with turnover less than $2m. In this market, there is a pool of buyers who have been looking for a pharmacy to buy for some time, anything up to 2 or 3 years and there comes a time when they simply want to buy a particular pharmacy they are looking at. This can greatly distort the ‘market value’ of the business by really pushing the price up.

It’s not unheard of where a small pharmacy which might be ‘valued’ at $800,000 will sell for $1m or more. In such a case, the buyer has to kick in the $200,000 extra PLUS the 25% of $800,000 which the bank won’t lend for the deal – so that is a capital contribution of $400,000 to make the deal happen.

Why pay 25% over the odds?

The comment I receive from buyers is that they have been looking and looking and looking for a pharmacy to buy but can’t seem to get the inside running on one. So the big offer is made in order to knock out the competition. The reasoning is that the offer needs to be high because ‘that is what everyone else will pay so I need to do the same and a little more’. And because everyone else is paying the money it must be worth it, or so the saying goes!

But what then is the outcome? Let’s assume the business is making $140,000 and this generated a value of $800,000. This is a return of 17.5%. Now that we have paid $1m for it, our expected return is $140,000/$1m – a return now of 14%.  If we take into account transaction costs such as stamp duty and other expenses, the full total cost might be $1,050,000. Then our return falls to 13.3%.

Is 14% an acceptable return for the risks being taken? What if profit drops before it gets better? What if, when I go to sell the pharmacy, I can only get $800,000 for it?

Can I ‘build’ my return up?

Of course you can – you can work hard to improve the profits and this will lead to a higher selling price. But remember in this example you could improve profits by 25%, from $140,000 to $175,000, and potentially if the heat comes out of the market at the time you sell, the business is still only worth what you paid for it. This would happen when, for example, at the time you sell it the market for selling pharmacies has changed and the competition for the business has reduced and so the premium payments start to disappear.

The point is that a lot of hard work might yet result in no capital gain on the sale of the business because you have paid too much for it in the first place. Effectively you have paid the previous owner the goodwill that is generated by your hard work after you take over.

The impact of paying too much

There are a couple of possible implications if buyers continue to invest at such low returns on investment, i.e. pushing the price up.

  1. Hopefully the additional $400,000 came from cash resources. By this I mean, money that is not a loan from somewhere else on which you have to pay interest. If it is an interest-bearing loan, this means the business will be under pressure from day 1 because it will be paying interest on all loans and owners’ ‘equity’ – on 100%+ of the value of the business. 
  2. Currently interest rates are low – very low. If they begin to rise, this will chew into the rate of return being obtained and reduce it even more. It will also exacerbate the issue outlined at point 1.
  3. It ties up more capital on individual risks. In the example given, an extra $200,000 has been required to obtain the business and for the same fixed return of $140,000, i.e. the premium produced no additional or better outcome. That money could be used elsewhere or even put towards improving the business by buying more stock or contributing towards a new fitout – things which would in turn improve the profit.

 

Many times too I see that the extra capital needed to top up the purchase price comes from other family members. Paying too much for any asset is not good practice. But then tying up other people’s money until such time as the business grows and risking their capital on the punt that the market will continue to support the higher price paid is not exciting for them either.

Unless you have a business strategy that can change the outcomes of the pharmacy that you have just bought so that the profit can increase to match the price paid, you are better off staying out of the market until you can find something that represents value. Once you buy a pharmacy, paying rent and repaying a bank loan over say 10 years, is a long time to spend regretting having paid too much for the business.