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Practice Valuation: How They Get That Number

More than goodwill and a fresh coat of paint factor into the equation.

Practice Valuation: How They Get That Number

More than goodwill and a fresh coat of paint factor into the equation.

BY BILL KEKEVIAN, ASSOCIATE EDITOR

Whether your practice is merging with another or selling to a larger group practice or some other entity such as a hospital network, you may feel overwhelmed in trying to ballpark the practice’s value. Determining the value of your practice requires you to separate your emotional attachments and take an objective approach. It also requires you accept some hard realities and maybe even lower your expectations. Selling any business is a complex process, but, luckily, experienced guides are available to help you navigate through it.

Physicians typically think their practices are worth more than their market value, according to Keith Borglum, a medical practice broker and appraiser in Santa Rosa, Calif. For nearly 30 years, Mr. Borglum has consulted with health-care organizations in strategic planning, practice management, marketing and valuation. This article will explain what does and does not impact your practice’s value.

Components of a Valuation

Valuation is an agreed upon financial worth of a physician’s practice. It can be determined using one of three approaches: the income approach, the market approach or the cost approach (See sidebar, page 53). Within each of these approaches are several components an appraisal will take into account:

Physician’s compensation. That is, your take-home over the last several years.

Goodwill value or intangible assets. This includes the infrastructure, patient base and staff expertise. Rick Koval, a consultant with BSM Consulting, Reno, Nev., equates this to the difference between having a practice and building a practice.

Net equity. This comprises everything a practice owns minus what it owes — assets minus liabilities.

Accounts receivable. Obviously this is the value of services already provided but not yet paid for.

Fair Market Value

Unless you’re lucky enough to nab a “strategic-needs buyer” — that is, a buyer primarily interested in your location and willing to pay a premium — practices looking to sell need to establish their fair market value. The International Glossary of Business Valuation Terms defines fair market value as: “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical buyer and seller, acting at arms length in a open and unrestricted market, when neither is under compulsion and both have reasonable knowledge of relevant facts.”

In other words, it’s the price that would be agreed upon as long as both parties are willing, but not desperate, to make the transaction, and neither party is trying to pull a fast one. That may sound intuitive, but it’s important to acknowledge that determining the fair market value is the goal, not simply obtaining an appraised or intrinsic value, Mr. Borglum says.

“There has to be a value for being an owner that is higher than being an employee,” he says. “That’s what sellers have to understand. It’s that extra profit above what a doctor can make as an employee.”

Before You See an Appraiser

In truth, you can’t make last-minute improvements before the appraiser comes in. Any appraiser is going to review at least your last three years worth of compensation. “Improvements anticipating sales need to take place years in advance,” Mr. Koval says. For physicians with that kind of lead-time, he provides a few tips.

For example, if you’re looking to retire a few years down the road, from a practice valuation standpoint, reducing your patient traffic is basically shooting yourself in the foot, according to Mr. Koval. It’s tempting to ease in to retirement and eliminate aspects of your practice, but an appraiser will note a drop in patient flow as a sign of a business that isn’t growing. That hurts a practice’s value. Explaining a reduction in procedures or patient flow as a lead-in to your retirement doesn’t garner buyer’s sympathy. The real-world impact is that patients have moved on and the practice has lost value.

“A lot of physicians are under the impression it’s best for them not to buy new equipment if they’re preparing to retire,” Mr. Koval says. That’s often a mistake. Purchasing a femtosecond laser or other modern piece of equipment is an expenditure most buyers are going to expect and will be able to find elsewhere. Outdated equipment, including furniture and fixtures, can take $50,000 to $100,000 off the sale price, Mr. Koval says. “That’s a lot of additional value,” he emphasizes.

He does, however, note one exception to this rule: EMR systems. They may be more expensive for a retiring doctor to purchase than they’re worth, according to Mr. Koval.

Aesthetic improvements may elevate the value of a home, but they don’t necessarily have the same impact on the fair market value of a practice, Mr. Borglum says. “A new paint job isn’t really going to add value to the office, unless you’re in a competitive market and it keeps you from losing patients,” he says. “A nice clean office is only better than a dirty looking one if it increases dividends.”

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Taking Inventory

Naturally, then, the first step to calculating your practice’s value is to compile some basic data. This includes a balance sheet, an income statement and cash-flow reports. You should also take an inventory of your assets (such as equipment and furnishings). When measured against liabilities, the value of these tangible assets can influence a practice’s overall net equity,

Also, consider that most equipment and furniture will have depreciated in value. Any equipment older than five years may have no value in an ever-evolving field, according to Mr. Koval.

Besides up-to-date equipment, practices with a higher value display a stable financial performance over a course of three to five years without revenue drops or steep expense increases, Mr. Borglum says. “The more the seller earns through income above and beyond what they can earn at a job, the higher the value is,” he adds.

Accounts Receivable

“Receivables represent the value of services already rendered for which collections have not yet been received,” says Mr. Koval. “That has value, it’s just not in the form of cash.” The value of receivables, he adds, should be commensurate with the collections the buyer expects to derive from those accounts. In other words, these accounts are considered income, but sellers usually continue collection efforts on their own. However, in co-ownership arrangements, in which an associate becomes a partner or shareholder, receivables are often included in the buy-in to provide the means for compensation of the associate during the initial period of co-ownership.

Overvaluing Goodwill

“Most people think their property is worth more than what the fair market thinks,” says Chris Gauvin, a valuation specialist at VMG Health in Dallas. Anecdotally, that makes sense. Physicians who have spent years pouring their blood, sweat, toil and tears into a practice may allow that history to color their views, he says. Doctors may place more emphasis on the idea of goodwill value, Mr. Gauvin notes — an estimate that includes a practice’s patient base and community standing, among other intangibles.

Goodwill value, he explains, only has value if it is measurable in dollars. Mr. Gauvin echoes those concerns. Community involvement and a positive reputation cannot be directly linked to future profits, he says. If a physician thinks she has an excellent reputation, she may be confusing sociological goodwill with economic goodwill and overlooking that her good reputation leaves with her. The Health Care Group, a consulting firm in Plymouth Meeting, Pa., said in a 2006 report that goodwill value can range from 25% to 40% of the total revenue of a successful ophthalmology practice for a year. While acknowledging that value varies, Mr. Koval is more comfortable saying goodwill is closer to 20% or 25%.

Current Trends

“We’re seeing a lot of consolidation among big hospitals,” Mr. Gauvin says. He’s not the only one making that observation. The analytics group at Moody’s Investor Services is also predicting an expansion of hospital groups and similar health-care entities. As Medicare lowers reimbursements, these organizations are now looking to merge to become more efficient and achieve economies of scale.

Three Approaches to Practice Valuation

Once you’ve taken inventory, you must select one of three potential paths for discovering the fair market value of your practice. The three approaches, according to the Web site Becker’s Hospital Review, are:

Income approach. This method is based on the estimated cash flow the practice purchaser can expect. This is culled from the aforementioned financial documents. An appraiser will be looking for steady growth in physician income, not just in the stability of the practice.

Cost approach. This approach considers the cost of recreating the practice, taking into account the costs of producing or replacing the assets. Here, the focus is on the current market value of those assets plus the agreed upon value of any intangibles. “An appraiser will look at a practice’s expenses. Maybe they’re overstaffed or their volume is declining. Those things can drive the value down,” says Mr. Gauvin.

Market approach. This approach weighs a practice’s value against competing practices in the area, but it may not be very applicable in medicine where pricing and terms of acquisitions are more complex than in other businesses, according to Mr. Gauvin. “Unless you have a really big group, like 30 or more physicians, the market approach doesn’t really work,” he says. The focus is increasingly on compensation, or the income approach, he adds.

Consultants interviewed for this article are wary to guarantee percentages or break down dollar-by-dollar the impact of any one component of the practice valuation. They warn that no one-size-fits-all formula exists for determining value. Like selling real estate, it requires knowledge of the market.

Mr. Gauvin expects a more competitive employment market as a result. “If you’re selling, the market will also be more competitive,” he says. “A bigger hospital system has more employment opportunities whereas a smaller group has a higher up-front purchase price.” In other words, if hospitals are feeling pressured to consolidate, they may find themselves to be strategic-needs buyers after all.

“What I’ve seen after the Affordable Care Act is physicians becoming more risk adverse,” Mr. Gauvin says. “They see it as a positive in that they’ll receive higher volume. In terms of driving transactions, they’ll probably see it as an opportunity. From a buyer perspective, it might make an acquisition more attractive and from a seller, you can sell to that, so it’s a positive too.”

Knowing the elements of a practice valuation and how each element is weighted will make that seller all the more knowledgeable. OM