Valuation Services to Determine a Physician’s Ownership Interest in a Practice
A definitive answer for practice valuation is elusive, whether the task is the purchase of the ownership interest of a retiring physician partner, or the fair market value to be charged to an associate who is buying an ownership interest in an existing practice. A statistical analysis can result in a usable estimate and should be a combination of the Income Approach as prime consideration with less weighting for balance sheet valuations for tangible and intangible assets. The income approach determines value by converting anticipated benefits into current value via return on investment through discounted cash flow of projected performance. This approach accounts for variables that may affect the valuation of the practice such as productivity, costs, and charges. It assumes a prudent buyer will not pay more than the present value of the anticipated stream of earnings, thereby demanding the highest degree of attention to the forecast methodology.
The use of a discount factor of between 12% and 15% over a period of time reflects the value of compounding and is related to the impact of risk, cost of capital, and market conditions. It is important to recognize there is no gold standard for physician practice valuations. The methodology to be utilized for valuing a practice is derived through extensive research, physician interviews, and a process of elimination which may be subjective to the author. The acquirer or purchaser of the ownership interest must realize a Return on Investment (ROI) via either a direct incremental increase in volume or indirect increase through continued referrals by physicians of the types of patients who fit the profile. I have conducted many physician practice valuations as an independent third party on a per project basis and can provide references.
Where and What Is the Exit Strategy for Today’s Physician?
Physicians today face a real conundrum: as partners in practices or as sole proprietors, how do they plan for their exit from the business they have built up for so many years if the goodwill can’t be monetized?
During these times of financial uncertainty, physicians are considering the full spectrum of asset disposition. Should one be trying to sell a physician practice, consider a merger, or just plan for an extended phase-out with no end value?
Coming to grips with a realistic valuation of what the practice is worth is challenging. This will be important to ascertain, as valuations are becoming increasingly warranted for numerous reasons, such as facilitating hospital acquisitions, determining merger and acquisition and buy-in and/or buy-out of equity, and complying with regulations relating to Stark laws, anti-kickback statutes, and IRS regulations.
Physician practice acquisitions are far-removed from the halcyon days of physician practice management companies (PPMs) of the mid-to-late 90s. Today, without stock as the currency used to purchase practices, each practice must stand on its own with an anticipated internal rate of return sufficient to repay the purchaser for the investment.
During the mid-90s, a proliferation of physician practice management companies (PPMs) dotted the landscape as aggressive purchasers of physician practice assets. Restricted from owning physician practices under the legal boundaries prohibiting the corporate practice of medicine, the value of a physician practice was limited to the tangible and intangible non-real-estate assets of the group for a lump-sum payment of cash, PPM stock, or a combination of the two.
Physicians who were selling their practices in exchange for cash were the most fortunate or lucky ones. In many cases, the currency used was common stock in public companies who acquired physician group practices by promising potential windfall profits upon the sale of the stock. PPMs dealt with the backoffice aspects of a practice. Their waterloo occurred when they were unable to grow physician practice revenue and profits, and their inability to squeeze enough profits and efficiencies and better managed care contracts due to the excessive weight of the administrative burden of both the practice and the corporate overhead collapsed the companies. By 2000, the PPM business had seen its zenith of the mid 90s evaporate into a sinkhole within a five year period, and the industry had dissipated, leaving many physicians without administrative tools to run their business, devoid of cash as they had given their accounts receivables away to the PPMs, and with retirement plans that were wiped out in the collapse. Those who tendered for stock certificates now worthless were faced with the reality of having to start over with no accounts receivables, and in some cases, no retirement funds.
For the next few years, the utterance of the words “physician practice management companies” brought a scowl to the faces of physicians. But over time, the reality is that the problem remains. There is no gold standard exit strategy. Hospitals and health systems have now become aggressive purchasers of physician practices. Management Services Organizations (MSOs) have proliferated by offering the backoffice services without the imposition of control over the profits of the practice. Hospitals view it as a way to protect market share by keeping prospective admissions in the fold, as opposed to losing those patients aligned with a retiring physician who must now seek a replacement somewhere else in the market. But the MSO does not address the omnipresent dilemma of monetizing the value of the practice upon retirement.
Accurate practice valuation may require a combination of approaches including historical cost, market cost, and income approaches as indicated below:
- Historical Cost – To be based on Generally Accepted Accounting Principles (GAAP), a valuation must adhere to the principle of objectivity. Financial statements in this scenario will assess the value of the assets on the basis of historical or acquisition costs. A physician practice valuation based on the acquisition cost of the assets meets the objectivity requirement using a balance sheet analysis of assets and liabilities. In this scenario, a purchaser would not pay more than the owner’s equity component (the difference between assets and liabilities). It tends to overlook the value of intangible assets such as patient charts that can’t be reflected on a balance sheet, but is a pure negotiation of value.
- Net Realizable Value – This method assesses the value of the assets net of liabilities, plus adds a factor for intangible assets, specifically patient charts. The challenge with this approach is a lack of objectivity. The valuation of charts is an issue as the Methodology Value of the patient charts is higher when the selling physician stays as opposed to a scenario where a replacement physician comes into the practice and patients have no established loyalty to the new physician, thereby putting at risk the continuity value of the patient relationships (charts). Patients will literally travel hundreds of miles to retain an allegiance to physicians who have served their needs for years. But the retirement of the physician will end the need for this action and the successor practice will become geographically undesirable and generally easier to replace with a more conveniently-located physician. Thus, the retention rate of charts at the time of a physician’s exit from the practice becomes a key issue. Chart value may vary from $10 to $20 each based on these factors and the ability to retain patients over time looms in significance.
- Market Cost – This approach measures the cost to acquire a comparable physician practice in the open market by comparing it to other practices in a similar specialty that have sold, with a separate value for tangible and intangible assets. The obvious limitation is the difficulty in obtaining reliable data on the sale of practices since they vary by size, payor mix, growth potential, ratio of charges to receipts, and cost structure.
- Income Approach – This approach determines value by converting anticipated benefits into current/present value via return on investment through discounted cash flow of projected performance. This approach accounts for variables that may affect the valuation of the practice such as productivity, costs, and charges. It also measures the value of the intangible assets because they are reflected in the ongoing practice revenue. It assumes a prudent buyer will not pay more than the present value of the anticipated stream of earnings, thereby demanding the highest degree of attention to the forecast methodology. Future capital expenditures to replace obsolete or depreciated assets are an important factor and must be part of the overall practice equation. Succession planning in a scenario where the incumbent physician is leaving is a critical consideration for both staffing and compensation. Anecdotal evidence suggests the sale of physician practices may lead to a decline in productivity because the incumbent physician is not as motivated due to income guarantees, or the new physician is unable to retain the number of patient charts and the inherent annuity derived. The benefit of enhancement opportunities through cost control, marketing, and revenue/charge maximization may positively impact this hypothesis. The use of a discount factor over a period of time reflects the value of compounding and is related to the impact of risk, cost of capital, and market conditions.
In summary, a definitive answer for practice valuation is elusive, but a statistical analysis can result in a usable estimate and should be a combination of the Income Approach as prime consideration with less weighting for balance sheet valuations for tangible and intangible assets. But irrespective of the methodology utilized, it is important to recognize there is no single methodology for physician practice valuations. The approach to be utilized for a physician’s practice would be derived through extensive research and a process of elimination which may be subjective to the author. The acquirer must realize a Return on Investment (ROI) via either a direct incremental increase in admissions to affiliated hospitals or indirect increase through referrals to specialists associated with affiliated hospitals. The acquired physician practice must also be independently profitable at some point whereby additional subsidies are not required to support the ongoing business.
Other Considerations/Risk Factors
- Specialty – primary care or specialist – and potential for admissions to hospitals
- Physician compensation
- Return On Investment (ROI) by acquiring entity
- Facility location on-campus versus off-campus
- Retention of a high percentage of annual encounters
- Payment, charge, and payor mix
- The selling physician’s reputation
- Quality of staff
- Market and competition
- Regulatory factors and OAG compliance, should rules change at the state or federal level
- Upside potential to add additional patients
- Economies of scale plus and minus for billing fees, group purchasing, and managed care contracting
So what does a practicing physician aged 55+years old do to facilitate and optimize an exit strategy? Here are the choices:
- If the physician is in a group practice with multiple partners, begin a dialogue well in advance of the anticipated departure date, i.e. at least one year ahead. It is important not to blindside one’s partners.
- Whether the physician is in a group practice or solo, consider hiring an associate at least a year ahead of the retirement date and formalize a transition plan for a buyout.
- Merge with another physician group, but in exchange for delivering new patients to the acquiring group, there should be a guaranteed salary expectation and defined buyout for a period of time in recognition for the accretive business being brought to the amalgamated group.
- Exercise the Buy/Sell with current partners in the medical practice.
- Align with a hospital MSO and sell the assets, becoming a salaried physician with incentive until the agreed-upon retirement date.
- Do nothing, and send a letter to all patients at least six months in advance.
Of the six elucidated approaches indicated above, there is no tried-and-true approach as personal preference will dictate what is best for the physician anticipating a seamless transition. But it seems to be logical to address the fact that, in most cases, 30-plus years of medical practice have resulted in some goodwill based on the reputation cultivated that can be monetized. It is in some ways analogous to walking away from a paid-in-full house rather than selling it. Especially in these challenging economic times when nothing is certain as it relates to one’s investment portfolio, abdicating the opportunity to enhance one’s financial nest egg is foolish, and smacks of wishful thinking, a position naively implying invincibility, and narrow- mindedness.
And lest we forget, the patient – a source of revenue and professional satisfaction for, in many cases, years and generations of family members – deserves to be graciously transitioned as well in a manner that is respectful of their dedication to the physician. To navigate through this crucial decision-making process with the goal of maximizing the value and minimizing the hassles, it is important to access to healthcare industry expertise from a trusted business adviser.
For further information, contact A.J. Rosmarin/ Rosmarin Consulting
- 972 361 0011 – office
- 214 507 1838 – cell