Key Principles For Assessing Practice Value
- Volume 21 - Issue 12 - December 2008
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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.