A physician needs to value his medical practice for many important purposes. A physician selling his practice or ownership interest and a practice associate buying into a practice are the most typical. Other important purposes include divorce, estate planning and insurance. This article discusses some valuation concepts used when a physician is either buying or selling a practice.
Business valuation is the process of estimating the value within a reasonable range of a business entity or ownership interest by a qualified, impartial and disinterested person. Differences in value among valuation analysts often arise since the process is an imperfect science that combines both professional judgment and opinion. A Certified Valuation Analyst (CVA), regarded as being technically qualified to perform business valuations, has to abide by ethical standards while performing valuations. The CVA is one of four industry-accepted credentials and is one of two requiring a CPA license. Fewer than 3% of CPAs in public practice have earned a valuation credential.
The product of a valuation is a report, which comes in many formats. Full valuations are necessary for estate and litigation matters, for instance, but not when a physician is contemplating the sale of his practice. An analyst instead writes a short report after calculating the practice’s asking price and floor value. Good reports generally include the features, background and financial information of the business and the valuation methodology and conclusion of the analyst.
Value and price are separate economic concepts. Value has different standards or meanings: fair market value is one. The Internal Revenue Service (IRS) defines fair market value in its Revenue Ruling 59-60 as the market price which property would change hands between a hypothetical willing buyer and seller for cash or its equivalent with neither under any undue outside influence. The IRS issued this ruling in 1959 and it remains one of the most important guides for valuation analysts. The true test of practice value, however, is the market price a willing buyer pays a willing seller.
The other standards of value include fair value, investment value and intrinsic value. The legal requirements in divorce, estate and shareholder matters determine the standard used by the valuation analyst. If not required by the law, the client and analyst can agree on the standard based on the client’s preferences. The standards are based on different premises of value such as going concern and orderly liquidation. Each premise assumes the most likely transactional conditions surrounding the purpose of the valuation. A practice can have several values depending on the purpose, standard and premise.
When selling a practice, a physician is influenced by his motivations and perceptions and often thinks his practice is more valuable. If a physician by himself prices the practice higher than it should be, it may not sell quickly (or not at all) possibly resulting in patients, practice associates and other employees unwilling to risk the uncertainty to leave. The buyer may also experience financial difficulty by paying too much. A physician should therefore use a business valuation analyst for establishing the value before selling his practice. For this purpose, an analyst would use the fair market value standard in a going concern premise. If the practice were inappropriately valued using an orderly liquidation premise, a more conservative premise than going concern, it will be a mistake as costly as a physician pricing his practice too low. Proper valuations may be costly, but not having one could be costlier.
Valuation analysts use one or combine any of the three principal approaches to value medical practices: Income, Market and Asset. Practice value is the sum of monetary, tangible and intangible assets. Though many factors affect practice value, value is closely related to future economic benefits such as sales, earnings or cash flows over a forecasted period. For practical purposes, the term earnings represents the quantification of all these economic benefits. Earnings should yield a fair and consistent rate of return on the investment because its mere existence is not enough to justify investing in a practice.
Of the three approaches, the Income Approach is based on the practice’s ability to generate earnings and is more commonly used to estimate medical practice value. In the Friendly Hills and Harriman Jones Medical Center transactions, valued at $165 million and $20 million, respectively, the IRS preferred the discounted cash flow (DCF) method. The DCF, which is one of several methods under the Income Approach, uses multiple period discounting when the earnings and growth rate are forecasted to be materially different from its past performance. The valuation analyst converts the earnings forecasted by the practice into a present value using a discount rate appropriate for medical practices in today’s market. The single period capitalization method, by comparison, is used for practices with stable earnings and a constant growth rate. Unlike the two medical centers, the vast majority of transactions are for sole or small group practices with values less than $1 million in which the excess earnings method is frequently used and is still accepted by the courts and the IRS. This method is included in the IRS’ Revenue Ruling 68-609 for valuing intangible assets.
The Market Approach involves comparing the medical practice with similar practices sold in the private marketplace using public data. This approach may be the most credible and understandable of the three when data on comparable practices are available. Since comparable data are seldom available, an analyst may have to make certain adjustments to make the transactions comparable. If the practice is exceptional in its marketplace (i.e., more profitable) or if its future performance will be different from its past, the value using this approach may not be relevant.
A valuation analyst adjusts the balance sheet or book values of a medical practice’s assets to fair market value and liabilities to current value using the Asset Approach. The difference between the adjusted assets and liabilities is the net book value or equity of the practice, which is generally its minimum value. The replacement costs of tangible or physical assets are used to adjust office furnishings, medical instrumentations and real estate (i.e., land and office buildings) owned by a practice. An analyst uses net asset value, asset accumulation and excess earnings methods under this approach.
A physician may estimate his medical practice’s value using a ‘rule of thumb’, which is mathematical relationship between variables based on industry experience and observation. It is generally expressed as a multiple such as ‘one times earnings’ and usually applies to a specific type of business. Rules of thumb have never been more than minimally accurate and are increasingly unreliable because of changes in and diversity and complexity of the medical marketplace. Therefore, they are seldom used exclusively by an analyst and are not a substitute for a proper valuation. They do, however, provide a useful frame of reference of practice value. If an analyst sets the practice value on the lower end of the range and its value in the marketplace is anywhere between ‘one to four times earnings’, then the physician may be less concerned that the value is unreasonable. If an analyst sets the value well outside the range, in either direction, then the physician may be more concerned.
The median price for primary care practices was about 28% of the past year’s gross sales with some practices selling for between 50 and 100 percent during the 1990s according to the National Goodwill Registry. The April 2003 issue of Medical Economics, a healthcare publication, mentioned that prices for medical practices are often as low as 5% and rarely exceed 30% of the past year’s gross sales. Exceptional practices get at least 25% while most practices get no more than 20%. Managed care has influenced the values of medical practices. Intangible assets account for about 90% of the purchase price when accounts receivable is excluded and 70% when included. A practice’s accounts receivable, a monetary asset, can have substantial value while its tangible assets, except for real estate, usually have minimal value. Those familiar with business valuation methods rarely value practices based exclusively on a percentage of gross income — a rule of thumb.
The answers to the following questions affect the value of the medical practice:
- Is the medical practice a solo or group practice?
- How is the practice income shared by the members of the group?
- What are the specialties of the practice?
- How many years has the practice been in business
- What are the contracts of the practice?
- Is the goodwill in the practice personal or practice (enterprise) goodwill?
- Does the practice have Buy-Sell agreement in place?
Intangible assets are the sum of all identifiable and unidentifiable (goodwill) non-physical assets with earnings (economic value) and ownership rights to those earnings (legal existence). Intangible assets such as unused patents can, however, exist without economic value. Goodwill is an intangible asset that arises from factors such as name, reputation, patient loyalty and location not separately identified. Stated differently, goodwill is the excess of monetary, tangible and identifiable intangible assets. Since lay people confuse goodwill, the term will mean the sum of all intangible assets. Goodwill is the biggest component of a medical practice’s value. Not surprisingly, the existence, nature and extent of goodwill when valuing a practice for any purpose is controversial. A valuation analyst can determine the factors contributing to goodwill and whether ‘professional goodwill’ and ‘personal goodwill’ is distinguishable. As mentioned earlier, practice value is closely related to earnings. As the marketplace matures, earnings are driven down requiring a practice to have a competitive advantage, or goodwill, to sustain above-average earnings for long periods. A physician may not pay for goodwill perceived as personal. If he does, he should pay for it only when the seller enters into a non-competition agreement.
Non-competition agreements restrict the rights of owners and employees from profiting from their past ownership or employment relationships. The agreement may, for instance, restrict a physician from taking patients after selling his practice or ownership interest. The agreement may also prohibit a practice associate, both during employment and for a period afterwards, from working for a competitor. A practice associate may also be restricted from taking patients after leaving employment or starting a competing practice. In addition, the agreement may be used to guard against the possibility of a key employee giving confidential information to a competitor or a practice associate starting his practice with the proprietary knowledge. The period and radius guidelines for these agreements vary. Without proper planning, a physician may fail to update his agreements before marketing his practice possibly resulting in a lost sale.
Laws enforcing non-competition agreements vary by state and require an attorney with specialized healthcare knowledge. Courts do not enforce these agreements when, in recognizing that our economic system is based on free competition, the agreements restrain competition. On the other hand, courts enforce these agreements to protect the legitimate interests of medical practices in keeping the competitive advantages they developed (goodwill). Attorneys often recommend having non-competition agreements signed upon employment and having employment agreements that contain non-competition language. In those states allowing non-competition agreements, a buyer may require that practice associates and key employees agree to the transferability of their agreements.
A business valuation of a medical practice by a business valuation analyst is important when a physician is either buying or selling a practice or an interest in one. Valuations are also important in other financial, tax and litigation matters.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.