Reed Tinsley, CPA

Workforce in place as an asset of a physician's medical practice

There is a great debate going on right now in the valuation community concerning the valuation of “workforce in place” as an asset of a physician medical practice. There is a growing number of us that believe that unless the POSITIVE cash flows of the practice support it, there can be no value for workforce in place.

 

As Mark Dietrich mentioned recently (www.cpa.net), no rational investor would pay to replicate assets that result in no income. This is one of the basic underpinnings of financial theory: the value of an asset is equal to the present value of the cashflows associated with it. That in turn is the foundation of Fair Market Value. What is often missed is that the return on the assets ends up being paid out to the physicians as compensation post-transaction, rather than retained by the buyer.

 

Or as another appraiser colleague said tongue in cheek:

“Apparently some appraisers think that an incompetent, embezzling, sabotaging, shoplifting, illiterate, knuckle-dragging, drooling, high-turnover "workforce in place" that has driven (or ridden) a medical practice into a state of "bankrupt-yet-standing", still has an intangible value in the many millions of dollars despite any ability to find value by the Income Approach. Or so I read in their valuation report of a cardiology practice recently (though they didn't quite phrase it so eloquently!) ;-)”

Goodwill in Sale of Dental Practice (or physician practice)

One way to reduce double taxation on a corporate liquidation following an asset sale was highlighted in William Norwalk [ TC Memo 1998-279 (1998) ], where the Tax Court held that goodwill was not owned by the corporation because it did not have noncompete agreements with the shareholder/employees. Accordingly, the goodwill (in the form of client relationships) attached to the employees. In this recent case, the corporation did have a noncompete agreement with the shareholder/employee. Under these facts, the District Court held that "even if the goodwill had belonged to Dr. Howard personally, it likely would have little value, because Dr. Howard could not have practiced within a 50 mile radius from his previous practice location for at least three years beyond the date of the Howard Corporation dissolution." Therefore, the goodwill was an asset of Dr. Howard's corporation. Howard v. U.S. , 106 AFTR 2d 2010-XXXX (DC Wash.).

Factors of Fair Market Value: A Few Keys

One of the most problematic areas of medical practice valuation is establishing a clear understanding of the factors a valuator must assess in order to arrive at an appropriate fair market value for a medical practice. Failure by one valuator or another to understand these factors can lead to an incorrect valuation, usually an overstatement of the true value of the medical practice. The following are factors you should consider when valuing any medical practice - as a colleague once said to me, “valuation is an art and unfortunately not a science”:

 

Defining Fair Market Value

 

According to the International Glossary of Business Valuation Terms, fair market value is defined as “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” This is the definition generally accepted in the valuation community.

 

Under the Stark II regulations, the following is the definition of fair market value:

 

“Fair market value means the value in arm’s length transactions, consistent with the general market value. “General market value’’ means the price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement. Usually, the fair market price is the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition, or the compensation that has been included in bona fide service agreements with comparable terms at the time of the agreement, where the price or compensation has not been determined in any manner that takes into account the volume or value of anticipated or actual referrals.”

 

When valuing a medical practice, it is important to know therefore whether or not the Stark regulations come in to play.  Within Stark, any arrangement must be considered “commercially reasonable” in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician (or family member or group practice) of similar scope and specialty, even if there were no potential DHS referrals.

 

So what does this mean if indeed the fair market value is affected by the Stark regulations

 

• The Stark definition of fair market value may restrict and prevent the use of certain market comps since use of such comps may not be “commercially reasonable”;
• Just because a transaction may be “fair market value” does not necessarily make it “commercially reasonable”.

 

Using the Wrong Assumptions in a Fair Market Value Appraisal

All (that’s all) valuation is about future cash flow, not historical cash flow. This is why the Income Approach methodology is commonly used to value a medical practice. This method converts/discounts an anticipated benefits stream in to a single present value amount. The valuation of a medical practice therefore relies upon risk-based assumptions as to what patients, procedures or tests will occur in the future as of the valuation date.  So when projecting out in to the future, does the volume and related expected reimbursement make sense? Is the revenue assumption too aggressive? Does it make sense to increase significantly cash flow revenues in an era of declining physician reimbursement?

 

You should also look for overstated revenues as well as missing revenues. If overstated revenues are included in the calculation of practice value, the result is often on overstatement of value. To reiterate, the objective is to determine the real income stream of the practice. There are often three types of overstatement situations: (a) The commitment of fraud and abuse by the practice, (b) Utilization abuse by the practice, and (c) Upcoding of visit services normally due to a lack of coding education by the doctors.

 

In addition to revenues, take a hard look at the expense assumptions. Do anticipated expenses really match the anticipated revenue stream? You cannot significantly increase gross revenues without possibly adding personnel, increasing space, using additional supply costs, etc.

 

Finally, when making adjustments to future cash flows and expenses, you must keep in mind the difference between fair market value adjustments and investment value adjustments (which cannot be included in the valuation). Investment value represents what a medical practice might be worth to a potential investor. As such, investment value represents individual investment requirements and opportunities; it reflects the synergies that might occur after the purchase of the medical practice. Many times a person will say “If you buy or take over this practice, you can increase revenues __% because you’ll now be doing these services and I don’t currently or you can eliminate $__ of expenses because you can move the practice to your location.” These are “investment” type of adjustments and should never be included in a fair market value appraisal.

 

Relying on the Market Approach to Value

 

This approach is defined as a general way of determining a value indication of a business or business ownership interest using one or more methods that compare to similar businesses that have been sold. In other words, this approach calculates the value of the medical practice based on prices actually paid for comparable entities.  It follows the simple mathematical process of determining the sales price as a ratio to net discretionary income available for owner compensation calculated from the comparable sales data and applying these ratios to revenues of the entity being valued.

 

But can you REALLY find a “comparable” sale of a medical practice today to the one which is being valued? Is the sale transaction(s) you are looking at really “apples to apples”? If you don’t think you are, don’t use it in the valuation (REMEMBER: buyers buy cash flow – i.e. the cash flow of the target medical practice).

 

Conclusion

 

When valuing a medical practice, you will need to assess not only these factors but many, many more. A failure to do so could have a major impact on the final valuation figure. This is arguably one of the most important parts of the valuation process and one where valuators, especially inexperienced ones, usually stub their toe. So to assist you, I have included the following checklist of special issues to consider in any medical practice valuation engagement. Make sure, as you look at each one, the potential impact on the potential impact on the valuation is analyzed and assessed.

What is your practice worth?

How much is your practice worth? Often, it depends on who wants to know and why. Valuation professionals follow different methodologies tacks depending on whether a practice will be sold to another physician, valued for a divorce proceeding, or if practice partners just want to go their separate ways.

 

The traditional building blocks of practice value are:

 

• Hard assets – equipment, facilities, supplies, patient records, etc.
• Cash – what’s left after expenses, including physician compensation
• Accounts receivables – money due for professional services
• Goodwill –anything paid above the value of hard assets, cash and A/R

 

You can follow several pathways to put a value on these four items. The market value approach – what other practices in the area sold for recently – is dandy for houses but can be an exercise in uncertainty to compare medical practices in different parts of the country.

 

Another approach is to try and project future cash flow, the component most important to business investors. While it works well for many types of businesses, cash flow valuation is of little help to the typical medical practice owner since most have little cash left after paying for overhead expenses and physician compensation – in other words, medical practices do not retain earnings.

 

Physician owners tend to take whatever’s left after expenses as their compensation. If physician compensation is set at a fair market level for the same area but there’s never any cash left at the end of the year, then what’s it worth to an investor? Unless a physician earns substantially more than the fair market rate for his or her specialty and the area, that money is physician compensation, not profit. That’s why figuring in goodwill – the ability to make profits – is such a major component in determining practice value. 

 

Very Basic Valuation

 

One way to determine if goodwill might exist for your medical practice is to figure out what it would cost to hire a doctor to take your place, assuming the same level of experience and expertise that you have. The difference between your compensation and that replacement doctor might be considered goodwill.

 

To get a quick, very rough estimate of what your practice might be worth in today’s market, try a ‘back of the napkin’ valuation. This bare bones approach looks at free cash flow and the rate of return a hypothetical investor might expect for buying your practice.

 

Step one is to determine your practice’s free cash flow. That’s the amount of cash left after paying operating expenses (staff and nonphysician provider salaries, rent, leases, loans, insurance, etc.) and the fair market compensation of the physicians. Say you have a three-physician care practice that pulls in $1.5 million after contractual adjustments. Operating costs are $900,000, leaving $600,000 for the three of you to divvy up. Suppose a fair market compensation figure for your professional services is $185,000 each, thus leaving $45,000 in total free cash.

 

Step two is to propose a required rate of return on investment (ROI). While 20-year Treasury bills may pay a little less than 5 percent now, investors who take large business risks will look for returns closer to a 20 percent return annually.

 

Step three is to divide the cash flow ($45,000) by the ROI amount (0.20). The result is the “total” value of the practice ($225,000). This includes “all” assets of the practice, including accounts receivable and goodwill. Keep in mind the is an extremely ROUGH valuation calculation – impact of taxes would have to be considered, all risks to future cash flows would have to be considered, future capital needs, etc.

 

Now remember, this kind of calculation may get you in the church, but it certainly won’t get you into the right pew! Depending on the buyer, you also may have room to negotiate on other issues, such as your practice’s location, the quality of its management, patient growth rate, payer mix and other factors. However, no matter how you appraise a medical practice, you still won’t know what it will bring on the market.

 

I often run into doctors who think their practice should sell for its appraised value, but that’s not always the case. If you want to get a good deal, start thinking about life after the sale and how you’ll have the chance to get paid for what you do as opposed to what’s left on the table after all of the practice costs and contract discounts are taken out.

 

The hardest thing to convey in presenting appraisals is that it’s just business. It’s not personal, but to some people, hearing what their practice is worth is like we’re saying their baby is ugly. And for now, buyers seem to be getting the upper hand in determining what your baby – your practice – is worth.

2009 ASC Valuation Survey

The HealthCare Appraiser, Inc. 2009 ASC Valuation Survey results have been released and provide insight into the ASC acquisition market for 2008 and trends in 2009. For the past six years, HealthCare Appraisers has surveyed the "Who's Who" in the ambulatory surgery center (ASC) industry to determine trends in the value of ASC ownership interests and management fees charged to ASCs. This year's survey was the most comprehensive ever, both in terms of the number of participating ASC companies and the breadth of valuation issues addressed. Highlights of the 2009 ASC Valuation Survey include:

 

ASC acquisition activity declining but valuation multiples maintaining

While slightly over half of the respondents reported that acquisition activity in the ASC market is declining, 45% of respondents perceive that valuation multiples in 2008 have stayed consistent with the prior year.. Prevailing multiples in 2008 for controlling interests continued to be 6.0 times EBITDA or higher for the majority of respondents.

 

Actively searching for acquisitions in 2008

During 2008, respondents were actively searching for potential acquisitions. One-third of respondents performed due diligence on 16 or more ASCs, while 22% of respondents performed due diligence on 6 to 10 acquisition opportunities. One-third of respondents reported that competition for ASC investment opportunities has declined, while 22% reported that competition has increased, and 45% reported no change.

 

Most preferred specialties for ASCs

Physician-investors prefer orthopedics, ophthalmology and ENT specialties for ASCs. A strong majority of survey respondents identified cosmetic surgery as an undesirable specialty in an ASC.

 

Request a free copy of the 2009 ASC Valuation Survey 

If you would like to receive a copy of the 2009 ASC Valuation Survey, please e-mail your U.S. Mail address to HealthCare Appraisers at info@hcfmv.com or call us at (561) 330-3488. A .pdf version of the survey is available for downloading at their Web site: www.HealthCareAppraisers.com and click on the Industry Surveys tab.