Key Principles For Assessing Practice Value

Author(s): 
By David Edward Marcinko, MBA, CMP, and Hope Rachel Hetico, RN, MHA, CMP

   • 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:

Comments

As a healthcare practice appraiser and broker myself, I agree with much of what Dr. Marcinko states, but not all of it. I expect this would not be surprising to him since he acknowledges that appraisers often disagree.

Many of us healthcare appraisers believe that the Discounted Cash Flow method is no longer the most relevant income approach in small professional practices, due to the impossible requirement to predict future reimbursement in healthcare, year-by-year, for years in advance. To quote Gary Trugman, CPA, a leading author on the topic and faculty for the course for appraisers Valuing the Very Small Business: “Attempting to use a discounting model for a very small business would be like throwing darts at a target from six miles away. There is no way you can hit the target.”

I also dislike the Excess Earnings Method for small professional practices, even though some courts still require it so I then have to include it. Judges don’t always make the right decision. That’s why we have higher courts. The IRS now appears to agree per IBA News, Jan 2011: “The IRS disapproves of the use of the EEM in its Appellate Conferee Valuation Training Program. Moreover, RR68-609 approves of the EEM ‘only if there is not a better basis available’ ”.

Personally, I prefer the Single Period Capitalization Method espoused and taught by the Institute of Business Appraisers. I also prefer to calculate capitalization rates rather than using rules of thumb like “divide by 20%”. I think 20% is too low a risk number for calculating cap rates in today’s healthcare market, resulting in an inflated value.

I disagree that the age of the doctor has impact in determining the “market rate of compensation." I believe that skills, services-mix, productivity and the market are what count, irrespective of one’s age.

I think that the Goodwill Registry does have some worth in calculating the value of a podiatry practice. It is not an “older source” in that its data is not current. It is older in that it has been around longer. Its data is added to annually. True, podiatry is underrepresented therein but it does provide perspective of the overall trends in the U.S. market of values of insurance-based surgical and non-surgical practices. It can be easily misused by the uninformed reader, for example, limiting consideration to its one component of value as a percentage of revenues. Obtaining the underlying database provides many more insights into sales prices as ratios of earnings, regionalization, currency and size. I wish more podiatrists and their advisors would submit transaction data to make the registry more robust in podiatry.

I am a licensed broker and appraiser. I disagree with Dr Marcinko that brokers cannot be fiduciaries. I also think that they often should not and cannot be fiduciaries, and that they should be entirely independent in their opinions, such that they have no bias to either the buyer or seller. In those cases, then one can perform an appraisal for both the buyer and seller together, even if they are a broker. A good example of this is when I am selected by a court mediator or arbitrator, and my opinion is for the court, not for the parties involved, even if I am also engaged to broker the practice.

Expressing bias for the buyer or seller, or parties to litigation, is an ethics violation in a Fair Market Value appraisal. When I perform a valuation, I find the same number no matter who pays me. I get paid in advance to eliminate any possibility that the client can influence my opinion by withholding payment. When I broker a practice, I am usually on an hourly fee rate rather than a commission, I never negotiate on behalf of the parties, and always have both parties represented by independent healthcare transaction specialist attorneys for individual advocacy, and state and federal compliance of documentation. That said, I agree that not all appraiser-brokers practice the way I do, and every profession has its share of scoundrels, and conflicts of interest can occur.

I caution readers to not confuse “value” with “price." A practice can have value without having a buyer, for example, in divorce or a location undesirable to the current crop of candidates. Value is an opinion based on a set of assumptions. Price is the result of negotiation between two specific parties, each with their own needs.

Best wishes.

Keith C. Borglum
Certified Healthcare Business Consultant
Licensed and Certified Business Broker specializing in healthcare since 1983
Author and Faculty to many medical associations and publications

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