Determining the Value of a Medical Practice

The value or worth of a medical practice to a third-party buyer in an acquisition is often the subject of much debate, theoretical analysis and often confusion. As the healthcare environment undergoes its cyclical market rituals that often includes the acquisition of physician practices, the employment of physicians and then ultimately the divestiture of money-losing strategies, the issue of what a practice is worth invariably plays a leading role.

Historical look at market drivers
A brief, recent historical framework is useful for understanding the market drivers that result in the physician practice acquisition cycles. As recently as the mid 1990s, the imperative for hospital systems all across the United States was the development of the integrated delivery network (IDN). The conceptual idea of the IDN included a multi-faceted organization that included the primary care physician as the “gatekeeper” physician that served not only as the first point of contact for the patient experience but also as the entry point into the rest of the IDN. In most cases, a patient had to see their primary care physician in order to get authorization or referral to a specialist.

The central money making part of the IDN was the facility-based services that included the hospital at the core but might also include other ancillary services such as imaging, surgery centers and other outpatient services. Finally, in many cases, the IDN might have included its own managed care health plan that served little purpose except that the IDN could manage all aspects of the health insurance risk and reap the related financial rewards.

Given that the primary care physician was the central gatekeeper into the rest of the IDN, the imperative for health systems was to aggregate as many primary care physicians under its IDN umbrella, especially if those physicians had historically been referral sources to competitor hospitals. Thus, the primary care physician acquisition frenzy of the late 1990s was born.

The competition for the acquisition of primary care practices became fierce as a result of the potential level of referrals to the facilities that made the most money in the IDN. However, given that any consideration paid to a physician for a referral is a direct violation of numerous federal and state anti-kickback statutes, IDNs could theoretically pay the physician a price based only on fair market value (FMV) of the practice with no consideration for the value or volume of referrals to the IDN. As a result, great pressure was placed by many hospitals on independent valuation firms to derive a high valuation so that a successful acquisition could be facilitated.

Value of a practice
Determining the value of a medical practice should, in theory, be fairly simple. Like most small privately held businesses, the value is either a function of the future earnings that can be generated from the business or the value of the identifiable tangible and intangible assets that can be deployed to generate a future earnings stream. This may sound simple in theory but in practice, a number of variables can be introduced to confuse the analysis.

For a physician practice, the single greatest variable is the compensation level of the physician who is working in the practice. In theory, if the level of compensation paid to the physician is low enough to produce positive earnings after all expenses, the practice has a measurable level of value. In practice however, most medical practices pay all earnings out to their physician shareholders. As such, if this is the model post-acquisition, then the practice has no going-concern or operating value. After all, who would buy a business that will never make money for its shareholders? Therefore, the single greatest determinant of value for these practices was the level of agreed upon physician compensation and the expected future earnings.

This is where things got really ugly. The disjoint between the assumed level of compensation included in most valuation analysis and the actual level of compensation paid to primary care physicians post-acquisition resulted in financial catastrophe for a large number of IDNs in the late 1990s. Physicians who were making $500,000 per year from working very hard in their medical practice were paid $1 million for their practice and were guaranteed to make $500,000 per year. In most cases, the only thing that improved post-acquisition was the physician’s golf handicap. Hospital systems lost tens of millions of dollars each year as a result of these arrangements.

By the early 2000s, most hospitals were working to unwind their failed IDNs and divest themselves of money losing physician practices. In most cases, the hospital sold the practices back to the physicians based on the value of the fixed assets (furniture and equipment).

Lessons learned
The following lessons learned by hospital systems relating to physician practice acquisitions during this period were both painful and obvious.

  • A physician practice rarely has going-concern or operating value based on the expectation of a future earnings stream. If the practice generates earnings in the future, the physician will expect to receive all or most of it as part of his or her compensation.
  • The values of the identifiable tangible and intangible assets of a physician practice are the best measure of the value of the practice — with the majority of the practice value based on the tangible assets of furniture and equipment.
  • Physicians are accustomed to being compensated on a basis that is in direct proportion to their productivity. A guaranteed salary will almost always result in a lower level of productivity.
  • Physicians generally have an acute understanding of the operating costs incurred by their practice and limit those costs in a direct effort to maximize their earnings. Once the relationship between operating expenses and compensation is removed, operating expenses increase dramatically.
  • A physician in private practice is accustomed to significant autonomy in almost every respect. In general, these physicians will make terrible and expensive employees.

Examining today’s market
Fast forward to 2008 and we find that many aspects of our healthcare environment have changed dramatically.

  • IDNs are no longer a prevalent strategy for hospital systems.
  • It is rare that a hospital that has a managed care plan as part of its healthcare system.
  • Primary care physicians are no longer gatekeepers for managed care plans.
  • Patients have unfettered direct access to specialists.
  • Specialists (surgeons, cardiologists, oncologists, etc.) have expanded ownership in services historically owned by hospitals.
  • Professional reimbursement — especially for specialists — has continued its rapid decline.
  • Physician operating costs — especially medical malpractice costs for specialists — has continued to increase.

These changes have altered the business and economic landscape and have thrust the specialist into the forefront as the primary referral source for patients into a hospital or outpatient services setting. This new (or old) role enjoyed by the specialist has often been offset by the financial and administrative realities that include lower reimbursement; higher administrative burdens necessary to adjudicate managed care claims; onerous, or sometimes impossible, costs of medical malpractice coverage; additional time required to serve patients armed with internet downloads; and, in many cases, the loss of the intrinsic rewards of being in private practice.

Simultaneously, hospitals are striving and, in some cases, struggling to retain the referral relationships of the physician specialist and stem the tide of specialist investment in competing facilities that serve to erode the revenues and earnings of the hospital. These include surgery centers, heart hospitals, radiation therapy centers and a host of other high-margin businesses.

The combination of the foregoing market conditions has set the stage for the next iteration of the hospital acquisition cycle of physician practice investment. This has rekindled the debate over the value of the physician practice — or specifically, in this case, the specialist.

Current valuation characteristics
The core of the valuation issue continues to revolve around the prohibition for any consideration to be paid to a physician in relation to the volume or value of referrals. Most for-profit and not-for-profit hospitals are far more attuned today to the ramifications of running afoul of federal and state anti-kickback statutes, and in many cases, have internal and external legal counsel oversight of physician-hospital transactions. Additionally, the painful lessons learned from the financial catastrophes of the 1990s have been etched (well, almost) into the minds of the administrators who are responsible for financial and operating results. The following are generally the resultant characteristics of an acquisition in today’s environment.

  • An acquisition valuation based on the fair market value of identifiable tangible and intangible assets.
  • A physician compensation structure based on a measure of productivity, generally relative value units (RVU).
  • A FMV analysis and opinion on the physician compensation structure.

While, in most cases, the structures are far from perfect, the lessons of the 1990s appear to have had some meaningful effect on how hospitals are structuring their relationships with physicians. However, measuring the value of the medical practice is still fraught with some danger.

New challenges and risks
We once again find hospital systems engaging in cross-town competition in an effort to outbid their rivals for the acquisition of medical practices — more specifically, the specialist. Naturally, a determining factor in who wins the bidding process is based upon who can come up with the highest price. As a result, the pressure on independent valuation professionals to rationalize a higher value is becoming more intense.

While hospital systems have learned that the value of a medical practice (one that does not have significant non-professional revenue sources) is best measured by the value of its assets, the new question seems to be concerned with what are “assets.” While there is no formal definition for an asset pursuant to an acquisition, our company (VMG Health) defines assets as those resources that can be deployed by the acquirer in order to generate a return on investment whether in its current form or in an alternative environment.

Most tangible assets are relatively obvious:

  • Furniture and equipment are easy to identify and relatively easy to determine value.
  • Tenant improvements have an original cost and can be depreciated over the life of the lease.
  • Inventory can be valued at its cost.
  • Other tangible assets are generally nominal.

Intangible assets can be more complicated. There is clearly a value to a trained workforce, which is the primary intangible value of most medical practices. However, that value can vary depending upon location and market conditions. There might be a value to a trade name depending upon the market’s perception of the name, and there may be value in certain other intangible assets, although generally nominal.

Value of medical records
Notice that we have not included “medical records” as a tangible or intangible asset. Medical records are ultimately an item that rests under control of the patient. A medical record cannot be deployed as an asset and cannot be transferred to an alternative environment without the patient’s permission. As such, a medical record does not in itself generate a return to an investing shareholder. The only value that can be ascribed to a medical record is the cost avoided to copy the record in the event of a legal transfer of that record.

In many cases, value of intangible assets may be allocated to a medical record. However, this is merely an issue of arbitrary allocation and not a financial calculation or generally accepted accounting treatment.

Value of trained workforce
Recently, the issue of the value of trained workforce has become an area where the risk of manipulation of the FMV of the practice has become apparent. Trained workforce is defined as the staff (fully-trained) that can contribute to the operations of a medical practice. In order to estimate the FMV of trained workforce, several components must be considered. These include

While certain expenses associated with “replacing” trained workforce are relatively easy to identify, others are based upon professional judgment and experience. This can lead to manipulation by using unusual, lengthy training times, expecting a high level of productivity during the training period and inflated recruiting costs. Each factor considered should be analyzed to ensure an accurate indication as to the FMV of trained workforce.

Role of compensation in valuation
While the FMV of the identifiable tangible and intangible assets can represent a “floor” value of a medical practice, the final answer as to whether there is any value over and above this floor amount rests in the compensation structure that will be put into place following the transaction. Physicians in private practice are accustomed to getting paid all earnings that are left after all expenses have been paid. This expectation will not change in a post-transaction environment. However, the new owners of the medical practice will require some return on their investment which should, in theory, reduce the level of compensation of the physician — no ownership equals no required return.

If a physician is expecting a big payday from the sale of the medical practice, the only way for this to happen, while remaining in the bounds of FMV, is for the physician to take less in salary than could be paid after the owner’s return is considered. However, the risk here is that, not too far in the future, the physician will forget about the amount received when the medical practice was sold and demand he or she be paid a similar salary that was earned historically. This can quickly sour the employed-physician relationship.

Realizing that compensation has a direct impact on the purchase price of a medical practice and understanding that the physician generally will require a similar level of compensation than has been historically enjoyed, most transactions involving medical practices include a compensation structure that pays out all earnings (less an appropriate return) to the physician, often times in the form of a pre-compensation earnings (PCE) split. A 90/10 split, for example, pays the physician 90 percent of PCE with the owner retaining 10 percent as a return on investment.

As previously discussed, a fixed, guaranteed salary over a definite period will oftentimes result in reduced productivity on the physician’s part if no mechanism is included in the employment agreement to penalize the physician for lower production and reward the physician for increased levels of production.

Understand FMV, law before proceeding with acquisition
While there was a time in the past where medical practices were purchased by hospitals and IDNs at a price that included, in some instances, high levels of intangible value, the lessons learned through those relationships have impacted the way transactions involving medical practices now occur. At the end of the day, we arrive back to the conclusion that the value of a medical practice is mainly comprised of the FMV of its tangible and intangible assets and typically contains little or no goodwill.

Further, in cases where medical practices are purchased by an entity where the physician could be or is a referral source, federal and state anti-kickback statutes and the Stark laws must be considered to ensure compliance. This has led, in many cases, to the purchase of medical practices for the tangible assets and only easily identifiable and measurable intangible assets.

While every situation is unique, you should clearly understand the facts and circumstances of any specific medical practice and the post-transaction compensation structure in order to provide an accurate estimate of the FMV of that medical practice. Failing to understand, identify and measure the appropriate factors that drive the valuation of a medical practice can not only result in poor financial performance but might also lead to violations of federal and state anti-kickback statutes.

Mr. O’Sullivan ( is a senior partner with VMG Health. Mr. Warrington ( is a senior associate with VMG Health. VMG Health is recognized by leading healthcare providers as one of the most trusted valuation and transaction advisors in the United States. Learn more about VMG Health.

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