Physician Practice (& Ancillary Business) Valuation: Appraisal Theory and Applications

Presented by: Randy Biernat, CPA/ABV

BKD, LLP

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Introduction

•Assumed Knowledge Level

•Types of Businesses to be Discussed

•Level of Detail for Presentation

•Standard Disclaimer

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Content Overview

• Current Trends & Market Conditions

• Healthcare-specific Standard of Value

• Regulations Affecting Standard of Value

• Physician Practice Valuation Methods

• FMV in Physician Compensation

• Case Study

• Enforcement

Healthcare Market Overview

•Consolidation Trends

•Push for Clinical Integration

•Impact of Healthcare Reform

•Reimbursement Trends

•Enforcement

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Drivers of Acquisition

• Consolidation of Market Share

• Declines in Reimbursement / Payor Mix

• Practice Recruitment / Succession Issues

• Capital Needs / EMR

• Anticipated Healthcare Reform Impact

Anticipated Physician M&A Activity

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• Per 2011 Accenture physician employment survey

What Physicians are Saying

• Only 29% of physicians are not in

a financial relationship with a hospital.

• 56% of physicians want alignment to increase their incomes.

• 40% want to align to ensure a more consistent income stream.

• 90%+ thought physicians should be involved in:

– Hospital performance improvement

– Hospital executive leadership

– Hospital board

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We are ready

Regulatory Environment

• Non-profit Compliance

• Anti-Kickback Statute

• Stark Law

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Non-profit Compliance

What is it? – Many hospitals are 501(c)(3) organizations and must be operated for public benefit (private benefit to insiders must be incidental)

How does it apply to valuation? – Payments in excess of FMV can trigger loss of non-profit status or intermediate sanctions

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Anti-Kickback Statute (AKS)

What is it? – A prohibition on the paying, receiving or offering remuneration in exchange for or to induce the referral of any item or service for which payment is made under a government program (e.g. Medicare)

How does it apply to valuation? – The explicit sale of referrals as developed in a valuation can be an indicator of an AKS violation

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Stark Law

What is it? – A prohibition on certain referrals which limits entities from billing government payors for services furnished, unless an exception applies

How does it apply to valuation? – The appraiser must understand the exception being utilized and the general implications of not paying for the “value or volume of referrals”

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Standard of Value

• From R.R. 59-60 to “Healthcare FMV”

• Entity to Compensation Valuation

• Implications to Appraisers

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Fair Market Value (R.R. 59-60)

The typical standard of value is classically defined by Revenue Ruling 59-60:

“The price at which property would change hands between a willing buyer and willing seller, neither party being under any compulsion to buy or sell, and both having reasonable knowledge of all relevant facts, with equity to both.”

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Fair Market Value (Stark)“…the value in an arm’s length transactions, consistent with the general market value. ‘General market value’ means the price that an asset would bring, as the result of a bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party….” (Stark regulations at 42 CFR § 351)

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Fair Market Value (Stark)• “the definition of “fair market value” in the statute

and regulation is qualified in ways that do not necessarily comport with the usage of the term in standard valuation techniques and methodologies.” (Phase II – 69 FR 16107 – March 26, 2004)

• Bradford Decision: court acknowledges fair market value differences between Stark and traditional entity valuation standard of value

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Facts and Circumstances

• “Ultimately, fair market value is determined based on facts and circumstances. The appropriate method will depend on the nature of the transaction, its location, and other factors.” (Federal Register, Vol. 72, No. 171, CMS, 42 CFR Parts 411 and 424)

• The sum of regulations affecting R.R. 59-60 is what is called “healthcare fair market value”

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Implications of “Healthcare FMV”

• Avoid “investment value” • No consideration of downstream referrals

• No consideration of hospital rates

• No consideration of specific economies of scale

• Limitations on use of opportunity cost

• Deal must make sense between purely arms’-length players

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Commercial Reasonableness• An arrangement will be considered

‘commercially reasonable’ in the absences of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician of similar scope and specialty, even if there were no potential DHS referrals. (CMS definition in Stark interim final rule, phase II)

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Commercial Reasonableness v. FMV• How are they different?• Commercial reasonableness looks to the details of a

specific transaction in a broader context than the payment calculated under the fair market value standard.

• What does this mean for appraisers?• Check with counsel for how to apply!

• Limited guidance exists about how to apply the definition and where responsibilities lies for consideration and compliance.

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Tips on Applying Healthcare FMV• Working closely with qualified counsel will help

ensure you are making assumptions and using data consistent with the legal opinion

• To the extent possible, both parties should sign off jointly on major assumptions

• Trade offs in quality, timeliness, and believability will dictate whether or not an appraisal can be delivered

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Physician Practice Common Deal Terms

• 5 year term, (fixed compensation for 2-3 yrs.)

• 0% - 25% increase in pre-sale compensation

• Fixed assets separately appraised

• Nominal amount of intangible value

• Working capital excluded (Cash, A/R, A/P)

• Personal debts excluded

• Non-compete agreements to rival hospitals

Asset Sale v. Stock Sale

• Buyers prefer asset sales (primarily for liability purposes), while sellers prefer stock sales (primarily for tax purposes)

• The practice value should reconcile under either approach. We begin with a stock sale assumption and then make adjustments to arrive at an asset sale value

• This reconciliation is useful for the parties

Simultaneous Transactions

• Appraisers must have knowledge of the financial terms of any other simultaneous transactions as it affects the future cash flows of the selling entity

• It is not enough to assume a “market-level” of physician compensation if there is knowledge at the time of the transaction as to the actual future level to be paid

Intangible Assets

• Appraisers must carefully consider any value assigned to intangible assets in determining fair market value

• This is probably the single highest risk factor in performing physician practice appraisal

• The standard of value dictates the assumptions allowed under a calculation of value, and in turn, impacts the valuation of intangibles

Overview of Valuation Approaches

• Asset – the sum of its individual, identifiable assets.

• Income – the risk-adjusted present value of expected future cash flows.

• Market – the applied relationship between practice value and revenue or cash flow from actual transactions in the marketplace.

Valuation Approach Utility Debate

• Income Approach v. Asset Approach– The two methods tend not to reconcile in physician

practice valuation.

– That is, a cost to replace methodology (asset approach) typically provides a value in excess of a discounted cash flow methodology (income approach) when expected future compensation is scheduled to increase.

Evaluating the Income Approach

• Pros– Well known, trusted appraisal methodology for small businesses

– Inherently considers the future compensation in the practice price

• Cons– Assumptions can be manipulated

– Intangible value is not specifically identified

– Methodology inherently captures referrals

– Approach pre-supposes that cash flow is the sole reason for investment

Evaluating the Asset Approach

• Pros– Indicated value is not tied to referrals in any way

– Specifically identifies the value of each intangible asset

• Cons– Assumptions can be manipulated

– Does not account for future benefits/costs associated with transaction terms

– Does not require cash flow support the value of an intangible

– Does not supply any attribution of intangible return between corporate goodwill and individual goodwill

Validity of Asset Approach1996 IRS CPE Text on Practice Valuation

• a well trained, organized, and efficient work force is a valuable asset in any business… The use of the cost approach is based on the premise that for a potential buyer to re-create the particular practice it has to hire and train a similar workforce; that hiring/training process has identifiable costs – for recruitment, orientation, training and lost salary – that form the basis of the valuation process.”

• “Medical Practices have going concern value. The buyer of an existing practice purchases a turnkey operation and receives immediate value from the assembled workforce and other assets needed to operate the business.”

Validity of Asset Approach• Tough questions of the asset approach– Does workforce in place have the legal standing to

be transferred?• i.e., does an employment contract exist?

– Is there history to support the claim of a cost to replace?• i.e., has historical employee turnover been considered?

– Is paying for an avoided cost to create a “commercially reasonable” action?

Typical Intangible Assets Considered

• Workforce in Place

• Medical Records / EMR

• Trade name

• Know-how / Clinical Protocols

• Customer Lists

• Phone Numbers

Impact of Linked Future Compensation

• Increased compensation is a form of purchase price consideration (Derby v. Commissioner) – Determining the “compensation offset”

• In a DCF, the cash flow can be adjusted to reflect the higher compensation – or – a direct purchase price offset can be computed

• If the practice value is based on a Cost approach, the compensation offset must be done through a secondary calculation

Hospital Losses• Per Physician Losses (MGMA)

– Primary Care (Family Medicine):

• Range - $25,000 to ($238,000)

• Median - ($78,000)

• Hospital Revenue - $1.7M

– Medicine Specialists (Cardiology)

• Range - $103,000 to ($248,000)

• Median - breakeven

• Hospital Revenue - $1.3M

– Surgical Specialists (Neurosurgery)

• Range - $73,000 to ($921,000)

• Median – ($453,000)

• Hospital Revenue - $2.8M

Business Valuation – Key Considerations

• Future Compensation

• Key Personnel Contracts

• Support for Intangible Value – Cost Replacement v. Goodwill

Comparison of Approaches

Valuation Approach

Physician Practice

Ancillary Business

Management Company Hospital

Asset Yes Yes Yes Yes

Income Typically, No Yes Yes Yes

Market No Yes No Yes

Case Study 1 - Facts• Hospital to acquire and employ 10 physician

family practice (“FP”).

• Hospital has a not for profit tax status.

• Hospital believes employment will expand patient access and improve care coordination.

• FP average physician compensation is $180K

• FP will consider employment, but only if compensation is at least $200K.

Case Study 1 – FP Financial Summary

Providers 10 Average WRVUs Produced 6,000 Total WRVUs Produced 60,000

Collections 4,000,000 Cost Before MD Comp (@55%) (2,200,000) Total MD Compensation 1,800,000 Average MD Compensation 180,000

Case Study 1 – FP BenchmarkMGMA Data 25th % Median 75th % 90th %WRVUs 4,000 5,000 6,000 7,000 (A)Collections 300,000 380,000 480,000 575,000 Compensation 150,000 182,000 230,000 290,000 (B)Comp. per WRVU (survey) 33 39 47 59 Comp. per WRVU (calc'd) 38 36 38 41 (B) ÷ (A)

FP ResultsAverage WRVUs 6,000 Average Collections 400,000 Compensation 180,000 Compensation per WRVU 30

Case Study 1 – Asset ApproachFP Book Value Market Value Contemplated

Cash 175,000$ 175,000$ -$ A/R - 350,000 - Inventory - 1,500 1,500 Total Current Assets 175,000 526,500 1,500

Equipment & Furniture 20,000 55,000 55,000

Workforce - 125,000 125,000 Patient Lists - 300,000 300,000 Trade Name - 75,000 - Total Intangibles - 500,000 425,000

Total Assets 195,000 1,081,500 481,500

LiabilitiesAccounts Payable 150,000 150,000 - Accrued PTO 70,000 70,000 70,000

Total Liabilities 220,000 220,000 70,000

Equity (25,000)$ 861,500$ 411,500$

Assets

Case Study 1 – Income Approach

"As-Is" 25th % Median 75th %Collections 4,000,000$ 4,000,000$ 4,000,000$ 4,000,000$ Cost before MD Comp. (2,200,000) (2,200,000) (2,200,000) (2,200,000) Compensation Pool 1,800,000 1,800,000 1,800,000 1,800,000

Compensation Paid (1,800,000) (1,500,000) (1,820,000) (2,300,000)

Annual Cash Flow - 300,000 (20,000) (500,000)

Indicated FMV (4X) -$ 1,200,000$ (80,000)$ (2,000,000)$

FMV of Tangible Assets 361,500 361,500 361,500 361,500

Implied Intangible Value (361,500) 838,500 (441,500) (2,361,500)

The following simplified calculation shows the a scenario analysis of average compensation paid out relative to MGMA survey data:

Physician Compensation Red Flag

MGMA Data 25th % Median 75th % 90th %WRVUs 4,000 5,000 6,000 7,000 (A)Compensation 150,000 182,000 230,000 290,000 (B)Comp. per WRVU (survey) 33 39 47 59 Comp. per WRVU (calc'd) 38 36 38 41 (B) ÷ (A)

FP ResultsAverage WRVUs 6,000 6,000 6,000 6,000 Applied Survey Rate 198,000 234,000 282,000 354,000 Applied Calculated Rate 225,000 218,000 230,000 249,000

MGMA Guidance• “When implementing a production-based

compensation plan, practice managers must determine how to reward their highest producing physicians while reigning in compensation.”

• “Managers should also understand that… [increased compensation]… takes the form in increases in overall compensation – not increases in compensation per unit of production.”

Source: MGMA Physician Production and Compensation Survey, 2010 Report Based on 2009 Data.

MGMA Guidance - Graph

Source: MGMA Physician Production and Compensation Survey, 2010 Report Based on 2009 Data.

Case Study 2 - Facts• Hospital to acquire and employ 10 physician

practice specializing in urology (“Practice”).

• Hospital believes employment will ensure long-term patient access, improve recruitment and enhance overall clinical integration.

• Practice is concerned by the potential for cuts to its professional fees and is willing to entertain offers for employment.

Case Study 2 - Facts• Practice’s total annual average physician

compensation is $750K, consisting of:Amount Description

666,000$ Collections (on approximately 7,500 WRVUs)(266,000) Practice Overhead (~40%)400,000 Professional Compensation

200,000 Net Income from Radiation Therapy Business Segment50,000 Net Income from Building Rentals (Personal K-1 Income)

100,000 Net Income from Mobile Litho Interest (Practice K-1 Income)750,000$ Total Physican Compensation

Case Study 2 – Practice BenchmarkBlended Survey Data 25th % Median 75th % 90th %WRVUs 5,900 7,300 9,600 11,600 (A)Collections 500,000 660,000 800,000 1,150,000 Compensation 300,000 400,000 500,000 650,000 (B)Comp. per WRVU (survey) 40 50 60 75 Comp. per WRVU (calc'd) 51 55 52 56 (B) ÷ (A)

Practice ResultsAverage WRVUs 7,500 Average Collections 660,000 Compensation 400,000 Compensation per WRVU 53

Case Study 2 – Asset ApproachBook Value Market Value Practice Ancillary

Cash 350,000$ 350,000$ 100,000$ 250,000$ A/R - 900,000 325,000 575,000 Inventory - 50,000 10,000 40,000 Total Current Assets 350,000 1,300,000 435,000 865,000

Equipment & Furniture 3,500,000 2,000,000 50,000 1,950,000

Workforce - 200,000 100,000 100,000 Patient Lists - 300,000 200,000 100,000 Trade Name - 200,000 125,000 75,000 Total Intangibles - 700,000 425,000 275,000

Total Assets 3,850,000 4,000,000 910,000 3,090,000

LiabilitiesAccounts Payable - 500,000 175,000 325,000 Accrued PTO - 100,000 50,000 50,000 Note Payable 1,000,000 1,000,000 - 1,000,000

Total Liabilities 1,000,000 1,600,000 225,000 1,375,000

Equity 2,850,000$ 2,400,000$ 685,000$ 1,715,000$

Assets

Case Study 2 – Income Approach

Year 0 Year 1 Year 2 Terminal YearCollections 6,600,000$ 6,800,000$ 7,000,000$ 7,200,000$ Cost before MD Comp. (2,600,000) (2,750,000) (2,900,000) (3,050,000) Compensation Pool 4,000,000 4,050,000 4,100,000 4,150,000

Compensation Paid (4,000,000) (4,400,000) (4,500,000) (4,600,000)

Annual Cash Flow - (350,000) (400,000) (450,000)

[valuation magic]

PV of Cash Flow -$

Professional Practice Business Segment Only

Case Study 2 – Income Approach

Year 0 Year 1 Year 2 Terminal YearRevenue 6,000,000$ 6,180,000$ 6,365,400$ 6,556,362$ Expenses (4,000,000) (4,200,000) (4,410,000) (4,630,500) Net Income 2,000,000 1,980,000 1,955,400 1,925,862

Free Cash Flow Adjustments 150,000 150,000 150,000

Free Cash Flow 2,130,000 2,105,400 2,075,862

Capitalized Terminal Value (17%) 12,210,953

Present Value Factor (mid-year) @ 20% 0.9129 0.7607 0.7607

Discounted Cash Flow 1,944,477 1,601,578 9,288,872 Total Disc. Cash Flow / MVIC 12,834,927$

Less Interest Bearing Debt (1,000,000)

Calculated Equity Value 11,800,000$

TC Business Segment Only (Radiation Therapy)

Case Study 2 – Value Reconciliation

Income ApproachProfessional Practice Value -$ Radiation Therapy Business Segement Value 11,800,000 Combined Value (Income Approach) 11,800,000$

Asset ApproachProfessional Practice Value 685,000$ Radiation Therapy Business Segement Value 1,715,000 Combined Value (Asset Approach) 2,400,000$

Case Study 2 – Compensation

• How should one compare the $750K to survey data?

Amount Include/Exclude Description400,000$ include Professional Compensation200,000 include? Net Income from Radiation Therapy Business Segment50,000 exclude Net Income from Building Rentals (Personal K-1 Income)

100,000 include? Net Income from Mobile Litho Interest (Practice K-1 Income)750,000$ Total Physican Compensation

The right answer, of course, depends on what is in the survey data.

Regulatory Enforcement• $4,100,000,000 recovered in 2010

• More scrutiny being applied to individuals and executives in terms of accountability

• Healthcare fraud recovery is becoming a political discussion point and funding source for various governments

• PPACA also designated funding for increased scrutiny on fraud, as well as tougher sentences

Regulatory Enforcement• 2011 enforcement included actions against

1,430 defendants.

• There are believed to be hundreds of qui tam lawsuits under seal, awaiting judgment.

• New settlements and judgments seem to come out weekly.

Questions & Answers

Contact Information

Randy Biernat, CPA/ABV

BKD, LLP

Direct: 317-383-4271

Email: rbiernat@bkd.com

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