Increasingly, physicians are choosing to enter employment relationships with larger practices or hospital-affiliated entities instead of owning their own practices.
Employment contracts will often include non-competition covenants that restrict the employed physician from competing with the practice during and after the employment relationship has ended. Unfortunately, with the rise in physician employment, there has also been an increase in disputes when the employment is terminated and the physician chooses to compete with the practice.1
Employment laws and covenant not to compete requirements vary from state to state. For example, in Texas, covenants not to compete are intended "...to protect the goodwill or other business interest of the promisee [which in most cases is the employer]".2 Among other requirements specific to physicians, "the covenant must provide for a buy out of the covenant by the physician at a reasonable price, or, at the option of either party, as determined by a mutually agreed upon arbitrator or, in the case of an inability to agree, an arbitrator of the court whose decision shall be binding on the parties...".3
In some cases, the parties may choose to indicate a specific buy out price or formula for the covenant within the employment contract, such as 1 times the physician's annual salary. While convenient, setting a price upfront in this manner may not reasonably capture the value of the goodwill or other business interest at risk should the physician choose to compete. Alternatively, the parties may decide to state the buy out price will be based on a fair market value price to be determined at the time of termination, which can be complicated and beyond the capabilities of the parties to determine on their own.
Therefore, parties often turn to appraisers to assist in determining the "reasonable price" for the buyout of a covenant not compete.
While the Texas statute does not provide any further definition of "reasonable price", it does clearly state what the covenant is intended to protect: "the goodwill or other business interest of the promisee." Therefore, appraisers can use common valuation approaches to value these assets, including the cost, market, and income approaches. However, in most cases, an income approach would be the most likely applicable method as there is no market place to establish market prices specifically for covenants not to compete and a cost approach is not used to value goodwill.
In performing an income approach for this purpose, the appraiser may consider performing a "with and without competition" method to directly value the covenant. Or as an alternative, the appraiser could value the entire practice under the income approach and then carve-out the identified tangible and intangible assets, leaving behind the "residual goodwill". In either case, the appraiser would need to consider how the terminated physician will impact the cash flow to the promisee (i.e. the practice). And this is where it gets complicated.
The cash flow impact of a physician to a practice can vary based on many factors, including but not limited to:
1. The physician's name, reputation and expertise;
2. The physician's role and tenure with the practice;
3. The physician's ability and willingness to engage in competition;
4. The specialty of the practice, such as primary care, surgical, or hospital based;
5. The practice's location, market position, payer mix, payer contracts, size, and other factors.
Since these factors can vary from physician to physician, practice to practice, and can fluctuate over time, the value of a covenant can also vary as well. However, reasonable estimates can be used and a reasonable price can be determined under an income approach methodology to value the goodwill or other business interest of the specific physician.
Therefore, the key takeaways in determining the reasonable price for a covenant not to compete buy out can be summarized as:
1. The reasonable price calculation should be consistent with the applicable state's laws and should capture the value that is intended to be protected by the covenant not to compete.
2. Commonly used valuation approaches can be used to assist in determining a reasonable buy out price.
3. The use of a simplified formulaic approach, such as 1 x annual compensation, while convenient, may or may not be appropriate and may run the risk of over-valuing the covenant in the early years of employment and under-valuing it in later years.
4. Buy outs that are too low could run the risk of being perceived as an inducement to refer and run afoul of anti-kickback laws.
5. Determining a reasonable price can be complicated and the outcome can vary from physician to physician, yet it can be done and can result in a value that fairly compensates the employer for the loss in value and provides a reasonable option for the physician staying in the market area and competing instead of leaving and starting over in a new market.
For additional questions or comments regarding this article or other valuation issues, please contact Don Barbo, Managing Director, VMG Health, 214-369-4888, don.barbo@vmghealth.com
1 More Physician Employment Means More Breakup Disputes, Modern Healthcare, July 30, 2016.
2 Texas Business and Commerce Code, Title 2., Sec. 15.50.
3 Ibid