Introduction

Between the recession and proposed healthcare reform, many physicians wonder whether their practices would have much value if they decided to sell them. Experts agree that well-established practices with solid revenues are still worth more than the value of their hard assets. Opinions differ, however, on how much practices are worth and whether that worth is headed up or down.

Overall, reimbursement cuts and an increase in the number of physicians seeking employment have depressed practice values. But the competition of hospitals for market share and their efforts to lock in physicians in preparation for changes in Medicare payment policies have supported practice worth in some areas.

Practice values vary in different markets, and the acquisition strategies of local hospitals explain most of these differences, says Alan B. Simons, a Philadelphia-based principal in the healthcare valuation practice of LarsonAllen LLP. Where hospitals are competing for market share, he says, “Values are being pushed higher. In less active markets, practice values are fairly minimal.”

Stephen Messinger, a principal with ECG Management Consultants in Arlington, Virginia, disagrees. “Because of regulatory requirements, there’s been little upward pressure in practice valuations, despite the fact that we’re seeing more and more physicians being hired by hospitals and big groups. Part of the reason is that we’re not usually seeing the bidding wars that we used to see for practices.”

Across the country, there is downward pressure on practice values, partly because of reimbursement cuts by Medicare and private payers, Messinger says. The shakiness of their income stream is driving more physicians to seek hospital jobs “to get a steady paycheck,” Messinger says. “The growth in supply of physicians seeking employment is having a suppressive effect on the market for medical practices.”

The Value of Primary Care

Michael La Penna, a healthcare consultant in Grand Rapids, Michigan, agrees that practice values have fallen in many areas, and he sees little value in primary care practices beyond their hard assets. Only “brand-name” specialty practices that earn substantially more than their peers are really worth much, he says.

Simons disputes this assertion, noting that primary care physicians are among the most highly recruited doctors, and that Medicare is starting to shift some money from specialists to generalists.

But La Penna points out that demand for primary care physicians may actually reduce the value of their practices. Where there’s a shortage of primary care in a market, he says, hospitals may offer primary care doctors substantially more than they can earn on their own. As a result, the value of a practice diminishes because they and other physicians who want to earn more can simply go to work for a hospital. Also, where demand for physicians is high, it’s relatively easy to start a practice, so doctors are less interested in buying an existing practice.

Specialty practices, on the other hand, may have substantial value because of their ancillary revenue streams and their value to hospitals, La Penna says. A well-established urology practice with lithotripsy equipment or a cardiology practice that brings in far more revenue than its competitors may be able to command a higher price than a lower-earning practice that is not considered a leader in the field.

Regional differences may also exist, he adds, because of the prevalence of managed care and certificate-of-need laws. “In Texas, an orthopaedic practice might be able to start a surgery center, while in Michigan, there’s a CON [constitutional] law that prevents them from doing higher-end capital development. In New York, doctors can’t really do anything because of the CON law.”

Hospital and Physician Buyers

That hospitals have a growing interest in acquiring practices is the major factor in the market today. The extent of this buying binge — which reminds some observers of the hospital feeding frenzy of the ’90s — is dramatic. Between 2002 and 2008, the percentage of Medical Group Management Association member practices that were hospital-owned shot up from 24% to nearly 50%, while the percentage of physicians working for hospitals increased from 25% to 37%. Medical Group Management Association members don’t include solo or 2-doctor practices, but there’s no reason to think that those practices are being sold more slowly than larger groups.

Simons believes that eventually most physicians will work for hospitals. In the meantime, he says, there are some good opportunities for entrepreneurial physicians who want to own practices. And physicians who want to sell their practices may also be able to get a decent price, depending on their specialty, location, and other circumstances.

Because of federal regulations, hospitals cannot pay more than fair market value for practices, and they cannot compensate employed doctors at a higher-than-fair market rate. Paying doctors above that level in expectation of referrals would violate the Stark and antikickback rules, and not-for-profit hospitals embarking on that practice would also violate the private inurement rules of the Internal Revenue Service.

Nevertheless, hospitals often pay more for a practice than another doctor would. This is partly because they can — as long as they stay within the bounds of fair market value. Also, they may perceive that it is less risky to buy an existing practice with a revenue stream than to recruit a doctor from outside the area and help him or her start a new practice, Simons notes.

Most hospitals also have a strategic goal in buying practices. That objective may be related to referrals, procedures, competition, physician “alignment,” or something else.

“The fear of losing referrals and the joy of gaining them still drives hospital decisions,” notes La Penna.

On the flip side, practice owners are having a harder time selling partnerships. Fewer young physicians are interested in acquiring a partnership, which entails additional responsibilities and often a hefty buy-in. Also, the differential between associates’ and partners’ incomes has shrunk in recent years, and it’s hard for an owner to ask for much of a buy-in if he’s making only slightly more than his physician employees.

The discussions about partnerships are usually quite informal, notes La Penna. “The two doctors never agree that the associate will pay $160,000 and write it down. The senior doc will say, ‘You can get a job for $110,000, I’m going to pay you $90,000, with no bonus for 2 years, and then I’m going to give you 25% of the practice.’ Nobody valued the practice.”

A bigger group that wants to buy a small practice may not hire an appraiser, either, La Penna says. But it generally has a structured approach to purchasing practices and might pay a modest amount for what is known as “goodwill” (see the discussion of practice value components, below). On the other hand, the group might pay the practice owners out over 3-5 years. Hospitals, which typically do formal valuations, “are paying higher, and they’re paying now,” he says.

What’s Included in Goodwill?

The classic components of practice value are hard assets (equipment and fixtures), cash, accounts receivable, and goodwill. Medical buildings and other real estate holdings are not usually included in a practice sale.

Increasingly, physicians and hospitals are also excluding accounts receivable. Physicians can get more out of accounts receivable by working it down themselves, notes Messinger. Many hospitals don’t want to deal with such accounts, partly because of liability concerns, Simon comments.

Goodwill is often regarded as the sum of all the intangible assets of a practice, including its reputation and its excess earning power. But many appraisers define goodwill as the practice’s “residual value” after calculating the worth of identified tangible and intangible assets. Intangibles may include the physician workforce, staff, location, telephone number, patient charts, and other such definable features as an investment in an electronic health record.

What, then, is goodwill? From the viewpoint that a practice can be worth more than the sum of its parts, goodwill is the premium a buyer will pay for the practice because of its value compared with other practices in the same specialty or its strategic importance. For instance, the practice might include a surgeon with a national or a statewide reputation, or it might be the top pediatric or ob/gyn practice in town.

When Simons and his colleagues valuate practices for hospitals, however, they focus only on identifiable assets to avoid any implication that the hospitals are paying more than fair-market value.

“In markets where there’s not a lot of competition, hospitals will generally buy the tangible assets and won’t pay anything for the intangibles or goodwill,” he says. “In competitive markets, we’re trying to keep the value limited to tangible and intangible assets and not have them go off and develop calculations that are pie in the sky.”

While La Penna says hospitals pay for goodwill only in exceptional cases, Messinger sees them paying “nominal goodwill” amounts in most purchases. Primary care physicians frequently receive signing bonuses, and hospitals may extend themselves in other ways. For example, Messinger recalls an orthopaedic group that borrowed money to buy a magnetic resonance imaging machine. When the doctors were negotiating to sell their practice to a hospital, they pointed out that the hospital wasn’t offering enough to pay off the money borrowed for the machine.

“So the hospital said, ‘We’ll extinguish the debt,’ which was a couple of hundred thousand dollars. It was absolutely goodwill, within the fair market value of the practice, so the hospital felt comfortable about it, and it made the transaction possible. But it was really a nominal value for goodwill.”

Another major variable in practice valuation, which can affect the value placed on goodwill, is the compensation package that the physicians negotiate. Because of regulatory requirements, purchase price and compensation are considered together in arriving at fair market value.

So if physicians receive less for their practices, they may be paid more as employed physicians, notes Robert Wade, a healthcare fraud and abuse attorney in South Bend, Indiana. Messinger agrees. “Rather than load up the hospital’s balance sheet with goodwill, what they do is pay tiny bonuses and add more to compensation to make the transaction feasible.”

Ways to Calculate Practice Value

The methods used to compute the dollar value of practices are discounted cash flow, market value, and the cost or asset approach. The discounted cash flow method calculates the “present value of a practice’s future earnings stream discounted at an appropriate risk-adjusted rate of return,” notes Simons.

The problem with this approach, he says, is that most practices don’t have a positive cash flow because they distribute all profits to the partners and/or because the hospital will pay them more than they could earn in private practice. “So when a hospital acquires them, there’s no cash flow the hospital can expect to receive from the practice.”

Still, appraisers do use discounted cash flow to valuate practices. La Penna looks at the cost of capital and the risk factor. Although interest rates are at historic lows, he notes, the future income streams of practices are increasingly risky because of the changes in the healthcare environment.

“So as this stuff drags on, the discount rates we’re using go way up because of the risk. But they go down because of the recent decline in interest rates.” Today, he says, the discount rates, which rise as practice values fall, are approaching 20%, compared with 15% to 16% a few years ago.

Another method of assessing practice value is the market value approach. This is similar to figuring out how much to ask for your house: You find out the purchase price of similar practices in your area that were sold in recent years.

Besides calling former practice owners, you can get some information about practice sales from the Goodwill Registry, a listing of sales in various specialties and how much goodwill was included in them. The Goodwill Registry is available from The Healthcare Group in Plymouth Meeting, Pennsylvania.

Unfortunately, this registry includes fairly sparse data for many specialties, with a focus on The Healthcare Group’s own consulting clients. Also, the registry does not reveal anything about physician compensation after the sale or which valuations were done in the context of divorce proceedings. The registry also doesn’t include practices that were sold with no goodwill.

Simons says his firm looks at the Goodwill Registry, Pratt Stats, Irving Levin Health Care Acquisition Record, and the Institute of Business Appraisers database. “None of them are really good,” he says, because the underlying information is confidential and is limited to what has been disclosed. So, like most appraisers, he simply uses these data as a “reality check” in computing practice values.

Simons primarily relies on the asset approach to valuation. First he identifies all of the tangible and intangible assets and assigns a fair-market value to each. Then he adjusts the balance sheet of the practice to come up with an overall figure for its market value.

Different appraisers use different methods. But in the end, the value of your practice is what a buyer is willing to pay.

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