The potential impact of 60 day dispensing

It is common for pharmacies to be owned in partnership between the ’Founder / long term owner’ (Founder) of the business and younger partners. This is often part of a succession plan for the Founder. Alternatively, it may be a result of a key employee retention model.

In both scenarios, the equity held by the Founder in the business is ’used’ to provide the incoming partner with the capacity to borrow funds to acquire their partnership interest.

Without this assistance, most aspiring pharmacy owners would not have capacity to acquire equity in a pharmacy business.

In this model, the incoming partner gets the opportunity to acquire their equity interest while the Founder is provided with a pathway to handing over ’operational responsibility’ while retaining an equity interest. It can prolong their access to profits of the business without maintaining the level of work intensity required to build and maintain a pharmacy business.

Banks will generally lend between 70-80% of the business value (loan to value ratio – LVR) and, because the Founder generally has plenty of equity, is provided with the capacity for the younger partner to borrow with the business as security (effectively utilising the equity of the Founder). The risk to both partners is not that extreme, provided the valuation doesn’t deteriorate, and profitability is maintained.

Typically, during the years after initial acquisition, the incoming partner is required to devote their full profit entitlement to meet loan and tax payment requirements. It usually takes a number of years to reduce the debt to a level which enables the incoming partner to obtain a lifestyle benefit from ownership.

This model works well for both parties in a financially stable environment.

However, it may result in challenges when the value of the business reduces significantly due to changes in trading conditions. The proposed 60 Day Dispensing policy is likely to result in some of these issues surfacing.

It is widely recognised that pharmacies provided the Australian community with a critical service during Covid. It also resulted in a significant improvement in trading outcomes for most pharmacies and this was reflected in the significant value increases of most businesses.

The shortage of prospective partners and the ‘burn-out impact’ of Covid brought forward the introduction of a number of new partners to the pharmacy sector.

We know that with 60 day dispensing, pharmacy revenues and profitability will be significantly impacted. In a pessimistic scenario, we may see pharmacy earnings and values reducing by 40% (or more). Even with significant reduction in labour costs, these figures are still likely to reduce by more than 20%.

This will likely result in the following:

• The bank LVR will increase. In some cases, it will increase beyond the banking covenants which are typically 70% to 80%.
• The net equity of the incoming partner will be eroded. Indeed, it may become negative.
• The profit share of the incoming partner may not be sufficient to enable that partner to service his/her bank debt on current terms.

Although the debt is the responsibility of the young partner, it has implications for the Founder too. If the younger partner has trouble servicing their debt, the bank (in a worst-case scenario) may be tempted to take action to protect its position.

This would force the other partner to underwrite the position of the younger partner to avoid the forced sale of the business.

What can be done?

In our last article, ‘Our top tips to prepare for 60 day dispensing challenges’, we looked at ways to address both costs and revenues to mitigate the impending decrease in profitability. We continue to encourage clients to commence that process.

In addition, it is important to identify and address the partnership challenges that may arise from this situation. This will require some planning as to how they are going to approach the situation in a commercial sense and best manage the partnership.

In essence, the new partner needs to be able to service their debt in the new environment. While this situation would be very concerning for the new partner, there is likely to be a workable solution.

The preferable method would be to reduce the debt amount by some means. In some circumstances, they may have means outside of the business and can manage their debt independently. Unfortunately, most won’t have that ability.

It is likely, they (with the support of the Founder) will be able to negotiate with the bank to extend the term of the loan and slow down loan repayments. This will allow them to manage debt within the limits of their profit distribution.

Alternatively, the Founder may allow the new partner to take profit distribution payments in advance, effectively borrowing from them to service the bank debt. This may require changes to the partnership agreement to reflect new arrangements.

In times of stress, it’s important to ensure that your partnership remains strong. A discussion, agreement and plan is required between the partners to reduce risk, manage debt and support business continuity. There are a lot of considerations to be tabled. These include personal circumstances, workload, retirement plans, business operations and more.

An independent facilitator may prove beneficial. That role is to talk through the options, model a range of financial scenarios and support you to make the best decisions for yourself, the partnership, the business and your wealth management.

This is one of the things we do at Holman Hodge. We look to model a range of scenarios for our clients, providing similar (deidentified) information for lobbying by the Pharmacy Guild and anticipating early insights on 60 day dispensing from our Pharmacy Benchmarking service.

We continue to have discussions with banks, who are confirming their support for the industry.  As a result, pharmacy owners having discussions with banks as early as possible could be beneficial too.

While the full impact won’t be felt until late 2024, it is important that you plan now for this challenging transition. It will be here sooner than you think – now is the time to prepare, particularly if your LVR is approaching 60%.

For a confidential discussion about your pharmacy investment or to arrange a partnership meeting, please contact us.

About the author: Frank Morgante leads the pharmacy practice at Holman Hodge. His team of specialist pharmacy accountants and advisors support pharmacy owners and businesses across Australia with accounting and compliance, tax and regulatory services, transaction, forecasting, benchmarking, planning and strategic advice.