Much has been written during my 30-plus years as an ophthalmic consultant about the various ways to structure an associate buy-in plan. But now, the current market activity involving private equity (PE) in ophthalmology practices is raising the question of how relevant the historical norms or valuation methods normally used in these transactions are. PE investors apply a more commercial, business-like approach to valuation. Unlike a physician on a buy-in track, a PE investor focuses on the business’ earnings stream after considering all operating costs, including the fair market labor rate for all physicians (including owners). For this investor, it is the residual cash flow that forms the basis for determining the value of the practice.
That became apparent last year, when several PE firms struck deals with carefully chosen ophthalmic practices. The who of course was important, but it was the what — the strength of the earnings system — that attracted the attention of these investors.
As for the practices that have entered in to a transaction with a PE investor, they will have to reconsider their associate buy-in deals, because some of the earnings stream that had previously been allocated to the physicians in the form of compensation is now re-directed to the PE firm that bought them.
For the majority of practices that either have not completed a transaction or contemplated one with a PE investor, in many respects it is “business as usual.” This article will discuss “norms” of what today’s associate buy-in will look like.
ELEMENTS OF VALUE
Despite PE’s current impact on ophthalmology, determining the structure for a fair and realistic associate buy-in still requires that all parties establish and analyze the basic numbers that go into such an endeavor, including the ever-changing concept of “goodwill.”
Let’s examine the three basic components of value in a business:
1. Identifying assets and determining fair market value
The first basic component of value in a business relates to the assessment of the company’s equity. Equity is determined by subtracting outstanding liabilities from the value of company assets as of the valuation date.
There are three categories of assets:
- Current assets. These include cash in the bank, inventory, the collectible value of accounts receivable (A/R) and notes receivable (due within 12 months).
- Fixed or tangible assets. These include medical and office equipment, furnishings, and leasehold improvements.
- “Other” assets. These include deposits (on facility leases and investments held by the company (i.e., ownership shares in an ASC).
Note that most practices report finances on what is referred to as the “cash basis” of accounting. Under this method, A/R is not included on the company’s balance sheet. If they are recorded on the balance sheet, there is generally a “contra” account for deferred income. As such, it is important to “add back” the estimated collectible value of A/R as of the valuation date. In determining this amount, the appraiser needs to subtract an amount that considers any contractual adjustments from the gross A/R.
When completing an estimate of value, the appraiser must determine the current fair market value of the assets owned by the company. In the case of tangible assets, the appraiser most often attempts to “restate” the book value (cost of tangible assets less depreciation) to market value by one of two methods. One approach is to hire a third party to provide an assessment of the market value of the tangible assets. Alternatively, the appraiser may use an accounting method that restates the value of these assets by using a depreciation schedule that more closely aligns with the useful life of each asset. This exercise is important because tangible assets are normally depreciated for tax purposes at an accelerated rate compared to their actual useful life. Regardless of the method, the primary objective is to get to an estimate of fair market value.
2. Accounting for debts and other obligations
From the estimated fair market value of assets, the appraiser subtracts the value of outstanding debts and obligations of the company. Obligations normally fall into two categories:
- Current liabilities. These include any obligations of the company due in the 12 months following the valuation date. They include accounts payable, accrued payroll, bank lines of credit, as well as the “current portion” of any long-term loans — the amount of principal due on the loan in the next 12 months. The appraiser attempts to “match” current liabilities with the value of current company assets. The difference between the value of current assets and current liabilities is “net working capital.” The appraiser needs to make an adjustment to take into account current liabilities that may not otherwise be recorded on cash basis financial statements, such as accounts payable and accrued payroll.
- Long-term liabilities. These include bank debt and capital leases. Practices normally use two types of leases: operating and capital leases. In an operating lease, the lessee pays a lease payment for the right to use a piece of equipment. The expense of an operating lease is recorded on the income statement. Capital leases function in a similar fashion to bank loans. One key difference between operating and capital leases is the buy-out option at the expiration of the lease term. In an operating lease, the lessee can acquire the equipment based on fair market value at the expiration of the lease term. In the case of a capital lease, the lessee can normally acquire the asset for a nominal sum, and the remaining obligations of the lease are recorded on the balance sheet as a long-term liability. The value of the equipment is also listed as an asset (less accumulated depreciation). As is the case with bank financing, the practice can depreciate assets financed through a capital lease.
3. Determining equity value
Total liabilities (current and long-term debt) are subtracted from the fair market value of company assets in determining the adjusted equity value for the business. Other adjustments may be made to arrive at the final value for buy-in purposes.
In most instances, the adjusted equity value is used as a basis for determining one’s share purchase. The total value is divided by the number of outstanding shares to determine the price per share. This amount is multiplied times the number of shares to be sold to arrive at the total purchase price. In most practice buy-in arrangements, the seller will finance the share purchase over a period of three to five years at a market rate of interest. The seller may be one or more physician-owners or the entity. In some cases, the company will sell shares to the associate, which dilutes the interests of existing shareholders.
WHAT ABOUT GOODWILL?
A practice’s goodwill, an intangible asset, is more difficult to value. It is usually measured based on a practice’s earnings level. Realistically, good will can be measured in terms of the ability of the owner-physicians to earn more as compared to peers or associate, nonowner physicians. Owner compensation includes the package of wages, bonuses, retirement contributions, dividend payments and other owner-physician benefits.
Many factors contribute to goodwill, including the practice’s name, brand, operating infrastructure, location and quality of its physicians and staff. In the simplest of terms, a practice with high earning potential likely has a greater amount of goodwill value when compared with a practice with high overhead and little prospect for growth.
Within the context of an associate buy-in, measuring goodwill is often based on whether the new associate can earn more money as a partner compared with her earnings as a nonowner employee. Historically, a new associate pays for the goodwill through a pretax income differential. The buyer is subject to an income reduction over the course of an agreed-upon time frame (i.e., three to five years). The amount of income reduction is either a fixed amount or a percentage of net earnings and is reallocated to the current partners.
Historically, the percentage income adjustment has proven more popular because of its “self-correcting” nature: The associate pays the owners more if she earns more, and less toward this component of the buy-in if she earns less.
While the basic buy-in structure, which includes some element of practice goodwill, has not changed, what has become more nuanced is that every deal needs to be considered on its own merit. Do not use a cookie-cutter approach. Practices need to consider many factors when structuring the buy-in, including:
- The goals and objectives of the owner(s). For example, an owner highly motivated to bring on a successor may want to make the deal more attractive by reducing the share price and/or pre-tax income adjustment.
- The difficulty in recruiting a new associate. When recruiting a new associate proves tough (i.e., the practice’s location is not sublime) a seller may make the deal more attractive to entice and retain the new associate.
- The “value add” of the new associate. If the new associate possesses special training and/or skills, this may form a basis for providing some downward adjustment to the buy-in.
- Succession planning among family members. A transaction involving a sale between family members may likely involve special considerations.
WHAT DOES THE FUTURE HOLD?
With the changing face of health care, many factors make private practice more challenging. That said, ophthalmology offers many unique opportunities in which private practices can survive and thrive. The increasing demand for eye-care services, availability of cash-pay services and the emergence of new technology bode well for the specialty despite the ongoing challenges in third-party contracting and the changing reimbursement landscape.
Premier practices that have not otherwise entered into a financial transaction with an investor will continue to demand a premium price (from a valuation standpoint). Consolidation will continue at an accelerated rate as PE investors bring fresh capital to the market. A PE-backed practice will, however, need to re-evaluate historical buy-in models, since some portion of the practice’s cash flow will be paid to an affiliated management company and unavailable for distribution to the owner(s). This may serve to reduce the income opportunity of current and future non-owner physicians and, as such, make the possibility of partnership unattainable. OM