Key Principles For Assessing Practice Value
When it comes to purchasing a podiatry practice, there are a variety of factors that one must consider in evaluating the worth of the practice. Assessing the value of a practice is fraught with potential landmines if one does not go into the process with a strong understanding of some key principles to medical practice valuation.
According to the Dictionary of Health Economics and Finance, practice valuation is the “formal process of determining the worth of healthcare or other medical business entity at a specific point in time and the act or process of determining fair market value.” Fair market value is defined as “ … the price at which a willing buyer will buy and a willing seller will sell an asset in an open free market with full disclosure.”
The Internal Revenue Service (IRS) Revenue Ruling 59-60 clearly states that fair market value “is essentially a future prophecy and must be based on facts available at the required date of appraisal.”
Unfortunately, one cannot directly observe the value of a medical or podiatry practice as there are a number of underlying issues. Obviously, the buyer and seller are pursuing oppositive objectives, and this reality is not necessarily conducive to facilitating clarity on those issues.
Accordingly, let us consider a few mistakes that are commonly made by physicians who are considering the purchase of a medical practice.
A Guide To The Myths And Realities Of Medical Practice Valuation
• Valuations are material representations providing a range of transferable worth.
• Valuations are reproducible estimates based on economic assumptions.
• Valuations are not “back of the envelope multiples” using specious benchmarks.
• Valuations are defensible and should be “signed off” by the completing firm attesting to origination guidelines and in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) and IRS formats as needed.
• Financial accounting value (book value) is not fair market value.
• Professional valuators represent only one party. The buyer or seller-owner is the client.
• Unbiased valuators do not provide financing or equity participation schemes.
Knowing The Distinctions Among Engagement Types
The Institute of Medical Business Advisors uses three levels that approximate engagement types for the industry. These levels are comprehensive valuation, limited valuation and ad-hoc valuation.
A comprehensive valuation is an extensive service designed to provide an unambiguous opinion of the value range. It is supported by all procedures that valuators deem relevant with mandatory onsite review. This gold standard is suitable for contentious situations like divorce, partnership dissolution, estate planning and gifting, etc. The written opinion of value is applicable for litigation support activities like depositions and trial. It is also useful for external reporting to bankers, investors, the public and IRS, etc.
A limited valuation lacks additional suggested USPAP procedures. It is considered to be an “agreed upon procedure,” which is used in circumstances in which the client is the only user. For example, one may use the limited valuation when updating a buy-sell agreement or when putting together a practice buy-in for a valued associate. This limited valuation would not be for external purposes. No onsite visit is needed. A formal opinion of value is not rendered.
An ad-hoc valuation is a low level engagement that provides a gross and non-specific approximation of value based on limited limited parameters or concerns by involved parties. Neither a written report nor an opinion of value is rendered.
The ad-hoc valuation is often used periodically as an internal organic growth/decline gauge.
Are You Following Industry Standards And Rules?
Specifically, when it comes to USPAP transactions involving physician practices, the following points are implied by the industry and the IRS.
• Discounted cash flow analysis is the most relevant income approach and must be done on an “after-tax” basis. It generally produces a higher value but is costly, detail-oriented and time consuming.
• One must project practice collections based on reasonable assumptions for the practice and market, etc.
• Physician compensation must be based on market rates consistent with age, experience and productivity.
• Majority (control) premiums and minority (lack of control) discounts are also to be considered. A majority premium is the amount paid to gain enough ownership to set policies, direct operations and make decisions for the practice. A minority discount for partial ownership does not allow this power. Thus, majority ownership is valuated higher than minority ownership purchase.
What About Personal Goodwill And Practice Goodwill?
Goodwill represents the difference between practice purchase price and the value of the net assets. Personal goodwill results from the charisma, skills and reputation of a specific doctor. These attributes accrue solely to the individual, are not transferable and cannot be sold. Personal goodwill has little or no economic value.
Transferable medical practice goodwill has value, may be transferred and is defined as the unidentified residual attributes that contribute to the propensity of patients and managed care contracts (and their revenue streams) to return in the future.
However, bear in mind that the Goodwill Registry, an older source used to determine the average percentage of revenue contributed to practice goodwill, has sparse to no podiatry input, may be dated for some specialties and leads to abnormally high values. We therefore prefer the more recent data, structure and representations contained in the quarterly print periodical Healthcare Organizations (Financial Management Strategies).
In addition to various multiple factors, one must also appreciate the impact of a changing environment and practice transfer in a local market, which can augment or blunt goodwill value. It is also important to determine whether patients or HMOs return because of true goodwill or are mandated to do so by contractual obligations.
Now to further confuse the issue, how each kind of goodwill is allocated in situations like divorce depends on state law. For example, some courts weigh in on the apportionment of both kinds of goodwill, other courts exclude both kinds of goodwill and other courts pursue a case-by-case approach.
Understanding ‘Excess Earnings Capitalization’ And Compensation Issues
Another way to determine goodwill value is through “excess earnings capitalization.” This economic method looks at the difference between salary and what you would have to pay a comparable doctor replacement.
As an example, when you subtract the numbers and divide the result by 20 percent, an important percentage referred to as the capitalization rate emerges. The final number gives a dollar value for practice goodwill. Courts seem to prefer this method in divorce situations because it tends to reflect a practice’s current value.
Regardless of the practice business model, physician compensation is inversely related to practice value. In other words, the more a doctor takes home in above average salary, the less the practice is generally worth and vice versa.
Emphasize Practice Specifics Over Benchmarks And Formulas
In the stable economic past, physicians may have used industry benchmarks as quick and inexpensive substitutes for professionally prepared valuations. However, this practice can be fraught with peril if challenged. The courts seem to frown on this simplistic and dated methodology. Moreover, generic benchmark formulas assume a financial statement reporting standard that just does not exist with contemporary professional valuations.
Therefore, almost every competitive issue that impacts value should be addressed with each practice engagement. This includes but is not limited to:
• contemporary dislocations by third
parties, Medicare and commercial payers;
• retail clinics and changes in supply/ demand and specialty trends;
• the rise of ambulatory surgery centers, walk-in clinics and specialty hospitals;
• outsourced care and medical tourism;
• alterations in resource based-relative value units, ambulatory payment classifications (APCs), diagnosis-related groups (DRGs) and newer Medicare-severity diagnosis-related groups (MS-DRGs); and
• the Medicare Modernization Act, HIPAA, OSHA, the EEOC and other regulations.
One must also consider the impact of current employee trends to high-deductible health care plans and private concierge medicine. Another considferation is employer shifts away from defined benefits plans to defined contribution plans.
Aggregating Or ‘Normalizing’ Financial Information: What You Should Know
In addition to possibly conducting employee interviews, one must gather appropriate financial information in order to properly value a practice. As a starting point, interested physician buyers should be able to see the following information for the most recent three-year period.
• Practice (corporate) tax returns
• Equipment/automobile leasing and/or tax depreciation schedules
• Accounts receivable aging schedule
• Consolidated financial statements (P&L, cash flow, balance sheet and retained earnings) for the practice
• Prior buy-sell and/or non-compete agreements
It is especially important to eliminate one-time, non-recurring practice expenses. These are adjusted for excessive or below normal expenses on the profit and loss statement. Such “normalization” can produce a big surprise for benchmark proponents and formula-driven advocates when a selling doctor runs personal expenditures through the practice that a buyer or court would not consider legitimate. Of course, one is less likely to encounter such shenanigans when the valuation is conducted according to professional USPAP and IRS style guidelines.
For example, we recall one doctor who painted his home and wrote it off as a valid business expense. Deleting other major expenses such as country club memberships make a practice look more profitable. This is good news if you are selling it. It is bad news if you are getting a divorce.
Conversely, you may have to defend legitimate business expenses that an appraiser may seek to normalize. For example, doctors may pay for a vehicle through their practice. If they use the vehicle to travel between multiple offices and hospitals, the expense may be legitimate.
Also realize that the appraiser may also add expenses that have not been incurred. For example, the appraiser may add an office manager’s salary if your spouse is in that role for free. This produces a lower appraised value and is common in small podiatry practices. Honorarium is another example that does not figure into value calculations.
Of course, normalization is a sophisticated and time intensive process. However, the expert earns his or her professional fee, and defends the resulting valuation range when challenged.
Keys To Selecting The Right Valuator
The most important credentials to look for are fiduciary level experience, specificity and independence. Some doctors mistakenly turn to those who may have never appraised a practice before. Just because an appraiser has initials behind his or her name, it does not mean he or she understands the peculiarities of medical specialties, especially podiatry. Agents, brokers, solicitors and other intermediaries are not fiduciaries.
We believe that physicians looking to assess a practice for possible sale/purchase should only select an independent health economist, who will be your advocate under Securities Exchange Commission (SEC), IRS or other relevant managerial accounting guidelines.
Moreover, be very wary if the valuation is not done in an independent manner or, worse, performed for both parties simultaneously.
Essential Insights On Professional Fees And What You Can Expect
Of course, it is almost impossible to answer concerns regarding fees without specific information. The cost of a valuation can range from $0 to $50,000 for an onsite team of experts for behemoth practices and ambulatory surgery centers. Keep in mind that in most cases you want to ensure the value determination will stand up to IRS scrutiny so the $0 rule of thumb approach is not an option.
However, most reputable firms use a blended fee schedule of fixed and hourly rates (plus expenses). Podiatrists should expect to spend approximately $5,000 to $10,000 for an average sized practice and a limited appraisal that is completely suitable for most internal activities.
External appraisals or poorly aggregated financial information, onsite reviews and litigation support services incur additional costs. However, most doctors find the money well spent. Expect to pay a retainer and sign a formal professional engagement letter.
Finally, once the practice price is agreed upon, sales contract terms and agreements present a plethora of financing challenges for both parties to consider. For example, one must negotiate bank loans (if they are even available), payment rates and length, personal promissory guarantees, down payment offsets, earn-out arrangements and Uniform Commercial Codes.
Do not be surprised if a sales broker does not consider the aforementioned issues as the modern health era emerges. Most agent-appraisers are predominantly concerned with earning commissions by working both transaction parties and may not represent your best interests. Also be aware that they are usually not obliged to disclose conflicts of interest and do not provide testimony as a court approved expert witness.
However, it is a fait accompli that medical practice worth is presently deteriorating. As the population ages and third-party reimbursements plummet, doctors are commoditized and traditional retail medicine is replaced by more efficient wholesale business models like workplace health clinics. The recent subprime mortgage default fiasco, credit freeze, potential tax reform law expiration and the political specter of a nationalized healthcare system only add fuel to the macroeconomic fires of uncertainty.
As a result, a good medical practice is no longer good business necessarily and retiring doctors can no longer automatically expect to extract premium sales prices. Moreover, uninformed young physicians should not be goaded to overpay.
Dr. Marcinko is a nationally known speaker and the founding partner of www.MedicalBusinessAdvisors.com. He is also the Academic Provost for www.Certified MedicalPlanner.com and is the Editor-in-Chief of www.Health CareFinancials.com.
Ms. Hetico is a Visiting Adjunct Professor in health care administration for the University of Phoenix Graduate School of Business Management in Atlanta. She is the Managing Editor for www.Health DictionarySeries.com and a Senior Educational Advisor for www.PodiatryPrep.com.
The authors acknowledge the assistance of Rachel Pentinmaki, RN, MHA,CMP and Mackenzie H. Marcinko in the preparation of this article.