Publicly driven health care merger and acquisition fever has died down dramatically since the retreat of major physician practice management corporations such as FPA Medical Management several years ago. Saavy investors have become increasingly wary of the industry after MedPartners called off merger plans in 1998. Concerns accelerated as the Cain Brothers Index of publicly traded PPMCs declined by more than 90 % in some cases, during the last 3 years. Nevertheless, the urged to merge in the private small practice arena has been robust and industry consolidation has been fueled by the continuing squeeze on the American medical practitioner. Correspondingly, the decision to buy, sell, or merge a medical practice is often a financial and emotional one. Therefore, it is critical that physicians fully understand how podiatric medical practices are valuated, beginning with the following informal, and then more formal, definitions.
The "asking price" is often an arbitrary and difficult to substantiate price which is typically reduce 25-50% after negotiations.
The "realistic price" is one that both buyer and seller believe is fair.
The "friendly price" is usually used for associates, partners or other colleagues.
The "creative price" involves is derived by creative financing. For example, the practice may actually provide the down payment in this case.
The "emotional price" may involve either a motivated buyer or seller who pays an under or over inflated price for the practice.
Most appraisers use "fair market value" as the standard to derive a reasonable value for a practice, which means an arm's length transaction of "any willing buyer and any willing seller", and without synergy's of a specific buyer.
The "business enterprise value" of a practice equals a combination of all assets (tangible and intangible) and the working capital of a continuing business.
The value of "owner's equity" equals the combined values of all practice assets (tangible and intangible), less all practice liabilities (booked and contingent).
The "working capital value" equals the excess of current assets (cash, accounts receivable, supplies, inventory, prepaid expenses, etc.) over current liabilities (accounts payable, accrued liabilities, etc.).
What Items Have Value?
A medical practice's tangible and intangible assets can be grouped into six broad categories. Physical assets, such as real estate and leaseholds, medical equipment and furnishings, or accounts receivable are included here. While non-physical assets, such as goodwill, restrictive covenants, and an able and assembled workforce are included in this category.
The Appraisal Process
The following should be done before the actual practice appraisal process begins:
- Choose an appraiser who understands the managed health care industry.
- Acquire historic financial information and consolidated statements, operating statistics, CPT, utilization and acuity rates.
- Eliminate one-time, non-recurring expenses, adjusted or normalized for excessive or below normal expenses.
- Understand key assumptions used in financial projections.
The IRS issued guidelines in 1995, suggesting that appraisers use the general methods of the Uniform Standards of Professional Appraisal Practices: which recognize three approaches to medical practice valuation: (1) income method (2) market method and (3) cost method.
1 (a) Capitalization Method
The excess earnings, or capitalization method estimates value by dividing normalized historical or current income by an appropriate rate of return for the buyer. This method does not require assumptions.
1 (b) Discounted Method
Discounted Cash Flow Analysis requires assumptions to estimate practice value by discounting future net cash flows to their present worth based on market rates of return required by an investor. Understanding the key assumptions produce a meaningful estimate of practice value. Some of which include:
- Projections of future practice revenues, productivity, reimbursement trends and shifts in payer mix.
- Projections of practice cost structures and projected physician compensation.
- After-tax practice cash flows.
- Reinvestments to replace equipment or other assets.
- Residual practice value at the end of the forecast period.
- Discount rate based on the practice specific weighted average cost of capital.
- Practice efficiencies, operations and competitive market conditions
The DCF analysis consistently produces higher values than other methods of estimating practice value because there may be supportable reasons to forecast improvements in future practice performance.
2. Marketplace Multiples
Market transaction multiples are ratios developed by correlating actual practice sale prices to key practice performance measurements. Common multiples include comparisons of sale price to revenues, sale price to earnings before interest and taxes (EBIT), sale price to earnings before interest, taxes, and depreciation allowance (EBITDA), gross revenue, net revenue, and the sale price to number of physicians. Market transaction multiples are typically limited to serving as a benchmark for testing the reasonableness of the other approached.
3. Cost Approach
The cost approach calls for the identification and separate valuation of all the practice assets, including goodwill, depreciated over 15 years. Moreover, the cost approach is more labor intensive than using the business enterprise analysis to estimate practice value; especially for a new practice which typically include the expenses involved in the acquisition of space, office furnishings, equipment, marketing, advertising, staff development; and losses incurred during the start-up period. This estimate of "replacement cost or cost avoidance" value represents an upper limit (or ceiling) of value, and is generally not considered useful in estimating the value of a going concern medical practice.
Structuring Sale Transactions:
One the practice price has been determined and agreed upon, the actual sales deal can be structured in several ways.
(1) Stock Purchase v. Asset Purchase
In an asset transaction, the buyer will receive a tax amortization benefit associated with the intangible value of the business. This tax amortization represents a non-cash expense benefiting the buyer. In this case, the present value of those future tax benefits is additive to the business enterprise value.
(2) Corporate Transactions
PPMCs historically have acquired the medical practice assets, excluding real estate, and have entered into management service agreement (MSA) with the physician. The deals, involving some multiple of earning before income taxes (EBIT), usually involve a combination of cash, common stock, notes receivable, and possibly assumption of liabilities. The receipt of common stock can increase the practice price by as much as 40-50% more for accept the corresponding risk, in lieu of cash.
Common Buyer Mistakes
- Belief in the selling doctor's representations and attestations. Always be skeptical and verify data.
- A desire to change the culture of the practice to quickly. Be careful, since patients may not adjust quickly to rapid change.
- Uses up all available cash without keeping a reserve for potential contingencies.
- Creates a conflict with the seller by recognizing any weakness and continually focusing on it for a bargain price.
- Doesn't realize that managed care plan contracts can be lost quickly, or may not be always transferable.
- Suffers from the paralysis of analysis, since money cannot be made by continually checking out a medical practice; only by actually running one. Buy the practice after a reasonable due diligence period, move on to the next evaluation, or become an employed doctor.
- Not appreciating the uniqueness of each practice and using inaccurate "rules of thumb" from the golden age of medicine.
- Not hiring an appraisal professional who will testify in court, if need be, using the IRS approved USPAP methods of valuation. Always assume that the appraisal will be contested, because many times, it is.
Financial Planning Considerations
Some financial planning considerations of practice appraisal include working capital, which increases the sales price and physician compensation. For example, if the goal is to maximize practice value, negotiating a lower salary within an affordable range, will increase the sales price. This relationship is an inverse one, since practice value correlates directly with the net cash flow available after all practice expenses, including physician compensation, have been paid. Other financial planning considerations might include:
- A letter of introduction from the selling doctor to all the patients of record.
- Confirmation that the practice is not involved in any type of litigation. A personal assets guarantee from the buyer, and death and disability insurance if there is any seller financing involved.
- A letter of intent with good-faith deposit placed into an escrow account until contractual matters are completed and the sale is brought to a close.
Fee Schedules and the "Art" of the Deal
Competent practice valuation specialists typically work on a contingency basis and may charge a retainer to cover out of pocket expenses. Fees usually are about 1-2% of the value of the practice and may take 14 days to complete depending on source data. Flat fees are becoming increasingly popular since a sliding scale or percentage fee may be biased toward over-valuation in a declining marketplace. Fees range from $3,500-$25,000 for the small, to average, to large size medical practice.
Medical practice valuation is as much art, as financial planning science, and it is easy to discern that what we are really looking for is a price range, with a reasonable floor and ceiling. After all the mathematical due diligence has been performed, the next step in the sale process is just good old fashioned negotiation, negotiation and negotiation.
Medical Business Advisors is a closely held consortium that was founded with the simple but revolutionary mission: "To provide America's doctors with the unbiased information, communications, and human resources needed to grow their personal financial assets and enhance their medical practices, in an ethically responsible manner".
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