The following was written by Jason Ruchaber, CFA, ASA, principal of HealthCare Appraisers.
The valuation of a physician practice is one of the more difficult tasks faced by business appraisers. With significant regulatory restrictions, lack of definitive direction for the application of standard valuation theory, and widely differing opinions of valuation "experts," physician groups and health systems are left wondering what (or whom) to believe.
Though valuation is a process of rendering an opinion for which there is no single correct answer, we believe there are three essential elements of a supportable fair market value (FMV) opinion for physician practices:
- Post-acquisition physician compensation MUST be incorporated into the appraisal;
- Post-acquisition synergies (such as more favorable hospital reimbursement) cannot be factored into the value; and
- Intangible value generally should be supported by the ability of the practice to realize a profit given the anticipated compensation model.
Post-Acquisition Compensation
As a service business, the rate of compensation that will be paid to the physicians post acquisition has a direct impact on the amount of upfront payment that can be supported for their practice. During the 1990s physician practice management companies "created" value for the acquired practice by requiring the physicians to take a pay cut post acquisition. This increased cash flow available to investors and increased the value that the physicians were paid up front. Though this model was generally not successful, the relationship between post-acquisition compensation and purchase price remains. All things equal, physicians who expect to increase their compensation above historical levels post acquisition should expect that the purchase price for their practice will be reduced.
Fair Market Value
If a referral relationship exists between the physician practice and the acquiring entity, the standard of value for physician practice acquisition is fair market value. FMV is defined, in summary, as the purchase price that would be negotiated between two hypothetical parties at "arm's length," who are both knowledgeable of the relevant facts, AND who are not otherwise in a position to refer business to the other party. This standard of value raises two separate constraints related to valuing physician practices. First, and applicable only to healthcare, no consideration can be given to any aspect of the volume or value of referrals. For example, no value can be ascribed to a hospital buyer's ability to generate higher revenue by converting the practice from Part B to provider-based billing status. Second, no value can be ascribed to other strategic enhancements specific to the buyer (such as a hospital's ability to obtain more favorable pricing on professional liability insurance). Consideration of such enhancements would fall into the standard of value known as strategic or investment value. Generally, the practice must be valued as if a transaction were not being contemplated (i.e., as if it would continue to operate as a freestanding, independent practice).
Intangible Value
Perhaps the most highly contested issue in physician practice valuation is whether or not intangible value can exist in the absence of an income stream which fully supports the intangible value. The most conservative valuation practitioners argue "no income stream, no intangible value," while the most aggressive practitioners argue that significant intangible value can, and does, exist regardless of the level of projected income (or loss) of the practice. We believe that the "truth" lies somewhere in between, and that in an "arm's-length" negotiation, physicians would generally be unwilling to sell their practice (that they have likely developed over many years) and become hospital employees solely for the value of its tangible assets (tables, chairs, and equipment); in other words, you would not have a willing seller at that price. Conversely, a buyer will not generally be willing to pay for an asset that does not generate some level of return on investment. We typically find that intangible value should be ascribed to the employment contract/non-compete agreements signed by the physicians (i.e., workforce), and in certain cases, other specifically identifiable intangible value should be considered as well. Of course, any finding of intangible value must be supported by the facts and circumstances of the individual practice, including the post-acquisition compensation model, and some level of profit should be anticipated in the projection.
FMV Pitfall
Valuation experts disagree over key aspects of valuing physician practices, and for any given practice, the differences in valuation opinions can be vastly different. More so than any other type of healthcare valuation assignment, clients must understand the assumptions utilized by an appraiser and independently decide if such assumptions are defensible.
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