Valuations of Professional Physician Medical Practices in an Acquisition Setting

By Douglas R. Ayres, CPA/ABV; Stephen J. Diagostino, CPA and Thomas J. Thieme, CPA/ABV, CMA

The valuation of physician medical practices typically presents a difficult valuation dilemma. Under traditional business valuation theory, the value of a business or asset is often a direct function of its cash flow generating potential, which can be estimated or at least assessed. However, in the realm of physician medical practices, the cash flow potential is zero, since most physician medical practices pay these cash flows out in the form of bonus compensation to the physician owners. As a result, the valuation of physician medical practices, at least at first glance, appears to contradict general valuation theory in regard to cash flows.

However, history is also full of businesses that have carried high values, though not necessarily that carried parallel levels of cash flows. These types of businesses typically either held valuable individual assets or had rights to proprietary assets, which had the potential to produce significant cash flows in the future. In a valuation context, physician medical practices are likely to be classified as holding valuable individual assets.

The typical buyer for a physician medical practice is another physician(s), a hospital/health system, a subsidiary of an insurance company, a privately-owned investment company or a publicly-traded company (such as Mednax, Inc.). Buyers such as hospitals and health systems that receive funds from and participate in federally-funded programs, such as Medicare, must conduct these acquisitions at fair market value, and the transaction must be commercially reasonable. As a result, these transactions are held to a higher standard than transactions that occurs with other parties or within other industries. The remainder of this article discusses some valuation approaches and techniques that are available to appraise such transactions and still fall within the guidelines of fair market value and commercial reasonableness. However, it should be emphasized that the universe of hypothetical buyers of medical practices should not be limited to hospitals and health systems.

Valuation Techniques for Medical Practices

Once the definitions of fair market value and commercial reasonableness are assessed, a valuation practitioner must employ theoretically sound valuation techniques and still fall within these definitions. Paramount to this approach is valuing the practice in question from the standpoint of a hypothetical buyer and seller. This involves looking at the transaction from an arm's length point of view, not taking into account any post-merger synergies (such as increases in reimbursement rates, changes in referral patterns or the favorable tax structure of one entity over the other). This is different from the way in which the respective parties contemplate almost all other mergers and acquisitions. Typically, synergies (operational or financial) are a basis of the bargain, and such synergies are valued and considered during the negotiations. However, such an approach (which is indicative of investment value, another valuation premise of value) is discouraged under current health care law and falls outside the scope of fair market value.

A practitioner must, therefore, employ valuation methodologies appropriate within the statutory restrictions of the federal health care and tax laws. As part of this assessment, the practitioner should consider the three basic approaches to the valuation process: the income approach, the market approach and the asset approach.

The Income Approach.

This approach, in its simplest form, is based upon the assumption that the value of any business or asset is a function of both its inherent level of risk and the potential cash flows that can be garnered from such an investment. Future cash flows are discounted using an appropriate discount rate to determine the current value of any business or asset. This approach is best for cash flow rich businesses or businesses that are expected to become cash generators in the near-term. Factors such as the industry, current cash flow levels, underlying business risk, growth potential and interest rates all affect the value derived from this approach.

The practical application of the Income Approach is typically difficult in the valuation of a medical practice. The reason is that, in most practice settings, physician compensation is increased to a level in which there is no remaining cash flow for which a hypothetical investor could earn a return on their investment. As a result, the assessment of the feasibility of an Income Approach typically ends upon review of the income statements for the practice being valued.

Opportunities do exist to employ the Income Approach to value certain aspects or assets of a medical practice. This typically takes place in valuing certain ancillary sources of income, such as research, MRI, nuclear testing, etc., and income earned from mid-level providers. The Income Approach for these specific revenue streams should be carefully applied, especially in their potential impact to overall historical and future physician compensation.

In summary, the application of the Income Approach is not typically feasible in the valuation of a medical practice; however, opportunities may exist to value certain segments of the practice, so long as the proper post-transaction compensation structure is in place. In addition, particular scrutiny should be employed to the cash flows being measured, the assets being valued under an Income Approach and the effect of taxes.

The Market Approach.

The Market Approach is premised on the notion that the value of any business is essentially the same or similar to the value being given to other similar businesses. This method is theoretically similar to the methods employed in real estate appraisals; properties are assessed using several metrics (such as acreage or square footage) and these metrics are compared to a database of recent transactions of similar properties. This method is typically easy to employ and easy to understand. Databases of both publicly-traded companies and private-company transactions can also be employed, once proper considerations are given to the marketability of the asset being valued.

Despite its relative ease of use and understanding, the Market Approach has practical limitations. For example, finding appropriate comparable transactions can be extremely difficult. Oftentimes, the valuator will struggle to find an appropriate number of transactions, transactions within the same geographic environment (which is very important in health care valuations) or transactions of businesses of a similar size, etc. In addition, the underlying structure of the deal for the database transaction is often difficult to know or assess, and the deal structure can have valuation implications. Examples of deal metrics in a medical practice purchase that would affect valuation would include the presence of a non-compete agreement, the structure of future physician compensation and whether certain assets or liabilities were carved out of the deal.

Due to these limitations, the Market Approach is typically not useful in the valuation of a medical practice. Such an approach standing alone would warrant a high number of truly comparable transactions. In practice, this rarely happens. However, for each medical practice valuation that is to be conducted, the Market Approach should be considered and explored. The Market Approach can serve as a useful proxy of the results of another method, such as the Income Approach or the Asset Approach. It can be a meaningful yardstick with which to test the reasonableness of these results, even if its results are not being employed in the ultimate determination of value.

On a side note, it can be observed that the vast majority of transactions within the valuation databases, contain some element of goodwill, meaning actual buyers and sellers are giving value above of the net tangible assets involved. This is an important observation, as some valuation professionals and attorneys have contended that any payment to a physician practice for intangible value or goodwill would be a potential payment for referrals. Based upon the data contained within the valuation databases, it appears as if the universe of market participants has consistently found goodwill to be a factor in the transactions and something of value to the acquirer. Our discussion of the Asset Approach will outline some theoretical support for why goodwill can be an asset to be acquired in a physician medical practice, while never considering referrals.

The Asset Approach.

The Asset Approach, in its simplest sense, is the fair market value of all individual assets to be acquired, less any assumed liabilities, to produce a finite value for a business enterprise, such as a physician practice. All individual assets of a physician practice would include tangible assets such as equipment, financial assets such as cash and receivables and various intangible assets attributable to the practice. Any assumed liabilities should also be valued at fair market value, which is typically at cost, with the exception of certain long-term liabilities, deferred compensation and tax liabilities.

The strength of the Asset Approach is in valuing companies that 1) do not cash flow or are financially distressed, 2) have large holdings of assets that are better valued separately or 3) are in their initial development stage and the cash flow potential cannot be reasonably estimated at this point in time. As a result, this approach is an excellent tool for the valuation of medical practices, since these entities do not produce cash flow that would be available to a hypothetical investor, but do possess assets (both tangible and intangible) that would be of value to the purchaser. As a result, the Asset Approach is almost universally applicable to the valuation of a physician practice.

In viewing the potential purchase of an existing physician medical practice, a potential purchaser is faced with a choice: either it can purchase the physician practice outright and assume these assets in a single transaction, or it can attempt to re-create the assets, often times at greater risk, decreased market share and increased time lag to fully develop these assets. In essence, the valuation of tangible and intangible assets, in its purest form, represents the opportunity cost for a potential acquirer and, oftentimes, the outright acquisition of an existing physician practice is the less costly alternative, rather than trying to construct a physician practice from inception.

The motivations for acquisitions range from defensive and offensive strategic acquisitions, succession planning, market consolidation, the opportunity to decrease one's own business risk (thus increasing the value of the acquirer) through vertical and horizontal integration and, in the case of an individual physician, the opportunity to purchase or increase one's source of future income. All of these motivations for buying and selling physician practices constitute the market for such activities, aggregate the supply and demand for such endeavors and ultimately set the fair market value for such transactions.

To begin an asset-based approach, the valuator should begin with the most recent balance sheet of the practice. Care should be taken to obtain an accrual basis balance sheet, as most practices keep their internal records on the cash basis. The most obvious adjustments to a cash basis balance sheet would be for accounts receivable, accruals, payables, etc. When accounting for these items, the practitioner should carefully consider whether these accrual basis items should be revised since they may have no tax basis due to the cash-based method of accounting for the taxpayer. The transaction's structure will weigh heavily on this decision (whether the deal is being contemplated as a stock transaction or an asset transaction). Any purchaser of these assets also may be purchasing an offsetting tax liability or asset and, if so, the balance sheet should be adjusted accordingly.

Once the tangible assets and liabilities on the balance sheet have been assessed, a valuator must then focus on the value of any intangible assets associated with a practice. These could include, but are not limited to, the value of the workforce in place, the value of the patient records, the value of the practice's telephone number, and the value of a trade name among others. The valuation of intangible assets is typically achieved through one of two means, a relief from royalty method or a Cost Approach.

However, in practice, the value of a trade name or telephone number is oftentimes not applicable to the valuation of a physician practice. In the case of a trade name, the consideration of value would likely increase exponentially in direct relationship to the size of the practice. Obviously, world-renowned institutions such as the Mayo Clinic and the Cleveland Clinic have trade names or brands that can bring patients in without any further aid from other marketing channels. In such cases, there is obvious trade name value. However, in the case of most medical practices, their trade name does not warrant the same command of the market as these examples. In many practices, the bulk of referrals still come to specific physicians employed by the practice, not to the practice itself. In addition, most practices that do receive referrals to the practice, receive these more as a direct function of the geographical placement of the practice or its hospital relationships, as opposed to its overall "brand." Many do not receive a high degree of out-of-market referrals based upon brand recognition. A true test to whether a practice's brand has value is whether it could be licensed to other physicians within the market to practice under, in exchange for a prescribed fee. Telephone numbers are typically of negligible value, given our increasingly electronic world, the nature of how people currently search for businesses and the advent of search engines to seek out such data. The valuation of these assets, when employed, typically involves a relief from royalty income-based methodology.

The bulk of a practice's intangible value involves the patient charts and the workforce in place. An acquirer of a practice would be motivated to purchase these assets, in excess of the tangible assets of the business, because of the immense amount of time, effort and money that would be saved in a direct acquisition as opposed to trying to reconstruct these assets from scratch. As a result, both of these assets are valued using a Cost Approach.

In the case of the patient charts, these should be valued at the estimated cost to reconstruct the patient record. Special consideration should be given to whether the records are in paper form or electronic form. Electronic records typically obtain a higher value for a number of reasons. First, the implementation of an electronic medical records system is a costly endeavor, requires enormous investment in various hard costs (equipment and software) and soft costs (training of employees and physicians on how to use the system). In addition, CMS has in essence placed a premium on electronic medical records systems by introducing a set of financial incentives to motivate physicians to convert to these type systems. For practices that already have an eligible system in place, this could represent a receivable to the practice that a similar practice with paper records would not have.

The valuation of the workforce in place typically represents two elements or types of costs. These would be the same costs borne by a potential acquirer, should they forgo the acquisition decision and attempt to build a practice from the ground up. The first of these is an estimate of the one-time, hard and soft costs needed to market to, attract and hire each employee. Such costs would include advertising, fees paid to recruiters, sign-on and relocation bonuses, fellowship stipends and the internal soft costs to administer these activities and interview the whole host of eligible candidates for the said position. When aggregated, these costs can be very substantial, especially when considering the recruitment of highly-skilled positions, such as physicians, mid-level providers, administrators and technologists. The second component of the workforce in place is the value attributable to training time. To any businessperson, the value of an in-place, trained workforce is typically much higher than the value of an untrained workforce. This is especially true for an industry that requires a high degree of specialization and skill, such as the health care industry. The time required to train each employee represents an investment period in which the value of an employee's outputs do not typically exceed the value of compensation paid to the employee during this period. All businesses essentially make this investment decision when assessing a potential future employee in their hiring decision. Thus, the value of a trained employee is the cost of the training period, in which the employer is not necessarily receiving commensurate value for the employee's wages and benefits being paid during that time span. For most medical practices, these training time horizons are typically between one month and one year, depending on the complexity of the underlying position to be trained. Some reasonable level of efficiency should also be assessed during this time frame, as the business does typically receive some value from the employee's labor during this time, but does not typically receive full value.

Combined, the Cost Approach would capture the associated costs with hiring and training an employee. A potential acquirer of a business with a trained workforce in place would be, in theory, willing to pay a premium for these intangible assets. Otherwise, the acquirer would have to inefficiently reconstruct these assets from scratch, often with considerably higher levels of risk, and with potentially decreased market share and disruption to their existing business.

Common Misconceptions Concerning the Asset and, Specifically, the Cost Approach

Many valuation practitioners are reluctant to fully utilize an asset-based approach. Specifically, these practitioners limit the value of a practice to its tangible asset value and nothing more. They typically cite a multitude of reasons for this approach, but the main reason typically boils down to the belief that in the absence of cash flows no investment should hold any value beyond its tangible asset value. Thus, any payment beyond the tangible asset value should automatically be construed as a payment for referrals, especially in the case of a hospital acquirer. This appears to be a connotative meaning placed, by some practitioners, on the term "hypothetical buyer." This term has never been fully defined by any of the governing authorities, but the most common example of its use may be "the absence of the facts of a specific buyer."

This logic is flawed and self-contradictory to a certain extent. First, these practitioners believe that the value other than tangible assets, and giving the physician owners credit for these assets, is markedly different from the valuation of intangible assets. Obviously, the value of receivables and cash are pretty clear, and easy to determine. However, under this logical construct, the value of fixed assets is less clear, yet these practitioners typically "give" value to fixed assets but do not give value for intangible assets. Fixed assets are crucial because, even though they are tangible and can be readily valued on the open market, the fact of the matter is that under a hypothetical buyer premise as strictly interpreted by these practitioners, the buyer (the hospital) of these assets does not receive a financial return on them (ignoring any financial synergies or economies of scale). In fact, the buyer pays a large sum of money for them, only for them to depreciate and continue to lose value and, assuming a typical physician compensation arrangement, the physicians continue to reap the financial benefits of these assets even though they no longer own them.

As a result, we have a few practitioners who, due to the arbitrary difference between both real tangible and intangible assets, choose to use two valuation philosophies for each of them. This logic appears to be self-contradictory and self-defeating at the same time. Either a practice should not receive any value for fixed assets and intangible assets, or it should receive full value for both. To hedge valuation philosophy based on the ability to physically touch certain assets appears to be suspect logic at best.

Another basis for this treatment is that the valuation of intangible assets by the Cost Approach is not congruent with the hypothetical buyer premise. Essentially, these practitioners cite that, in the absence of cash flow returns, any investment is essentially worthless. However, this belief may be false on several fronts, especially in consideration of the acquisition of a medical practice, as the hypothetical buyers for a medical practice have numerous reasons to purchase a practice outside of considerations of cash flow. Again, under this strict interpretation, the value of fixed assets would also likely be minimal if not zero.

What these practitioners fail to recognize, is that value may be created by the transaction even in the absence of cash flows, or referrals for that matter. Businesses acquire and integrate other businesses, either horizontally or vertically, sometimes in the absence of cash flows, in order to increase their own value. A theoretical substantiation of this, in the absence of any true operational or even financial synergies, is for the acquiring health system to increase its own value through diversification of risk or simple reduction in risk. In essence, the acquiring health system, through either horizontal or vertical integration, has eliminated some element of risk from its business model. In theory, any reduction in risk would in turn thereby reduce the cost of capital, which would in turn increase the value of the acquiring health system, even in the total absence of cash flows from the investment. A horizontal integration may build a wall to prevent further competition from entering the marketplace, which reduces the overall risk of both the health system and physician medical practice in the transaction. A vertical integration may reduce potential market disruptions in supply or level peaks and valleys in margins. Both situations ultimately could result in an increased value for the acquiring firm, even in the absence of cash flows. Such a health system, with rational management acting to increase overall health system value (regardless of whether the health system is a non-profit or for profit, all rational business models seek to reduce risk and increase value (grow) over time) would even consider, in the course of negotiations, paying the owners of the physician medical practice to be acquired at least a part of this theoretically increased value in order to complete the transaction and increase the value of their own health system. This logic would apply to the full universe of hypothetical buyers, as all buyers, whether they are individuals, corporations or non-profits, are bound by the laws of economics and rational choice.

To analogize, consider the situation of a hypothetical manufacturing concern. The manufacturing concern is profitable, yet its valuation is low because it relies upon a tenuous supply chain that is subject to possible disruption and operates in a market low barriers to entry. Management decides to increase the value of its manufacturing concern by doing two separate transactions, neither of which will add to the cash flow potential of the firm. The first transaction is targeted at a similar manufacturing concern that is marginally profitable. The second transaction is aimed at acquiring a marginally profitable supplier of raw materials. Through acquisition of these firms, the acquirer reduces its risk of future competition, perhaps reduces its geographic risk, perhaps reduces management depth risk and is likely to prevent or limit future supply disruptions. As a result, the acquirer is likely to raise its own value through the acquisitions, so long as it pays somewhere between the value of the tangible assets of the firms to be acquired and value of these plus its own incremental increase to value. As a result, management, in order to close the deal and increase the value of its firm, may be willing to pay more than the tangible book value of the firms to be acquired. All of this increased value is obtained through effectively reducing its own cost of capital.

Theory aside, anyone who contests that a physician practice should not have any intangible value is not observant of the general market. A glance at the many valuation databases is indicative that intangible value is an integral part of most of the transactions that have taken place. Many of these transactions have taken place in the past ten years, well after the medical practice bull market of the 1990s, yet they continue to show large amounts of intangible value in their multiples. These databases are full of all kinds of buyers motivated by all kinds of different parameters, from health systems, to individual physicians, to physician groups, to private and public investment firms. To ignore such wide consensus, based upon the presence of these varied types of buyers, appears to be ignoring the data supplied by a free market in which intangible assets or goodwill are an integral part. It is true that the market method may have its faults, but to ignore an overwhelming aggregation of data that suggests a general trend appears to be suspect.

A final, yet unquantifiable way of viewing such transaction is by looking at the transaction from the view of a selling medical practice. More specifically, the seller has to assess what they are giving up versus what they are receiving, net of taxes (an often times overlooked aspect of any transaction). Many would contend that they are not giving up anything since they maintain their compensation or even enhance it. However, many times they are giving up a tremendous amount, besides simply the value of their tangible assets. Sometimes, they may be giving up some of the professional autonomy they may enjoy. This can take the form of increased bureaucracy, more clinical oversight and more time in administrative functions. They may be in a worse future negotiating position with the acquirer 3 to 5 years from now, and will likely be subject to a non-competition agreement going forward. They may be giving up total professional independence itself. While inherently unquantifiable, many of these items would often require a willing seller to raise the stakes above the mere value of the tangible assets of their practice. Otherwise, the marketplace for medical practices would likely be full of supply and demand curves that never meet.

Bibliography

1. James Pinna. JD and Matt Jenkins, JD, The Anti-Kickback Statute and Stark Law: Avoiding Valuation of Referrals.
2. Robert F. Reilly, Tax Exempt Healthcare Organization Valuation Issues.
3. Mark Dietrich, CPA/ABV, Choosing and Using the Right Valuation Methods for Physician Practices.
4. James Hitchner, CPA/ABV, ASA, Financial Valuation - Second Edition.
5. W. James Lloyd, Hospital-Physician Economic Relationships – Assessing Fair Market Value and Commercial Reasonableness.
6. Alan B. Simons CPA/ABV, What's a Practice Worth?
7. Charles Kaiser and Amy Henchey, Valuation of Medical Practices, 1996 IRS CPE Text.

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