We have received numerous comments from administrators that an attorney has recommended the involvement of a valuator during the formation of a surgery center. While we do not believe the involvement of a valuator is always necessary in the planning phases, certain aspects of an operating agreement have consequences on the future value of the surgery center. It is important to understand that certain critical points in an operating agreement can affect future value and the considerations that a valuator may make in determining a surgery center’s value. Gaining an understanding of these key elements can also assist an owner in assessing the value of an interest currently because the more restrictive these provisions are, with regards to lack of control and marketability, the lower the value; while the more restrictive the non-compete provision, the higher the value.
The following highlights terms of an operating agreement that might affect the surgery centers ability to meet future economic goals.
Assessment of risk
Within every valuation performed by a valuator, the valuator will assess the risk of the investment made by the potential buyer when purchasing the interest in the surgery center. These risks include the ability of the center to maintain its payor mix, case mix, cost structure, etc. Certain provisions in an operating agreement might affect the surgery center’s ability to meet wits projected financial and operational goals.
▪ Non-compete agreement. Operating agreements generally contain a provision related to its owners maintaining a financial interest in a competing center during a period in which the owner has a financial interest in the current surgery center and for a period thereafter. The non-compete agreement might also restrict an owner from having an agreement such as a management or consulting agreement with another surgery center. Finally, the non-compete may restrict the owner from employing staff or leasing equipment to another surgery center.
A non-compete agreement may be strictly related to ambulatory surgery centers. In today’s competitive environment, hospitals and health systems are entering into management agreements with physicians. If the non-compete agreement only addresses ambulatory surgery, the owners might get around the operating agreements restrictions by entering into an agreement for the management of a hospital outpatient department.
This provision is generally for a fixed period of time. The longer the period of time and the farther the radius from the center, the more restrictive and, hence, the more likely the owner will stay with the surgery center and continue to do cases. The valuator will generally review the local market and verify that the distance restriction actually is constrictive enough. Also, the valuator will note that a non-compete agreement generally prevents a physician from holding a financial interest in another center and does not prevent a physician from performing cases in another center.
Assessment of control
Valuators will take a “lack of control” discount for any interest in which the owner does not have control over the operations of the surgery center. Control is not determined by the percent owned but by the owner’s ability to legally control the operations of the business.
▪ Majority, quorum, or unanimous. Certain decisions are made by either individuals or groups with different levels of authority. For example, the operating agreement may specify a particular manager who directs the daily operations of the center. In this case, the question is who has the ability to replace this manager.
Voting rights is more of a legal issue than a valuation issue. With regards to valuation, the ability to control is based upon the required number of shares required to approve a motion, the number of shares being valued and the number of shares outstanding.
For example, if a center is owned by two physicians, a third physician is purchasing 10 percent equally diluting the other two physicians and the center requires a majority vote for most actions, the 10 percent owner will have some level of control when the other two physicians do not agree. The 10 percent block owner does not have full control since the two other physicians can approve motions without the 10 percent block owner. Therefore, a discount for lack of control is still warranted.
▪ Multiple classes. Each class (i.e., level of ownership comparable to general versus limited partners or preferred versus common stock ownership except that rights are defined in the operating agreement) is reviewed based upon its ability to control the operations of the surgery center. For example assume four classes of units are created (A through D). If units A and B sit on the board of governors and have the only vote to decide who is on the board of governors, these units are more controlling that units C and D. The operating agreement might be written such that units C and D have certain blockage rights or these unit holders might sit on certain decision-making committees. The greater the ability to control the operations of the business, the higher the value of the block of ownership.
It is very difficult to explain to owners of a surgery center why their interest is worth less than their peers even though they both own a 5 percent interest. Therefore, the developers of a surgery center should thoroughly understand the control provisions of the operating agreement between the member classes and explain these upon formation.
Assessment of liquidity
The valuator will take a discount on the value of an interest based upon the expected time and cost the interest would take to sell.
Overall, the discount should be specific to the entity and the market for the particular interest. If a significant number of eligible buyers are present in the local market (i.e., physicians who meet eligibility requirements and are not restricted for other reasons as non-compete agreements), the holding period would be short and a lower discount would apply.
If the sale is for a large interest, the interest might take significantly longer to sell depending upon the ownership makeup of the center. For example, if a controlling interest is valued and the current ownership makeup is 100 percent physicians, the interest will take shorter to sell than a controlling interest in which the other 40 percent is owned by a management company and a hospital. Other management companies are looking for opportunities related to the former and not the latter.
While it was noted that the majority of valuations HealthCare Appraisers (this author’s company) performs are for transactions in which there is already a buyer and a seller, the fair market value requires the valuator to review a transaction as hypothetical and determine the value of the interest in the open market.
▪ Limited ownership. An operating agreement may limit the number of units an individual physician or group may own. This restriction has minimal effect on the valuation of a small block of units. However, in the case of a larger block, this restriction might limit the number of potential buyers.
For example, a hospital is looking to increase its ownership interest, through a 30 percent purchase, in a center owned by a hospital, management company and physicians. The hospital and surgery center management company is unlikely to allow this block to be sold to any of its competitors. Therefore, the block can be sold to the current owners as a whole or in multiple pieces. If a restriction in the operating agreement prevents the current owners from owning more than a certain amount, it might be very difficult to sell this block on the market. If the market is highly competitive (i.e., a number of surgery centers operate in the local market), resulting in a low number of physicians not already involved in a competing center, this interest would be even more difficult to sell, therefore arguing for a higher discount for lack of marketability.
▪ Length of ownership. Operating agreements sometimes contain a provision requiring owners to keep their ownership for a certain number of years after the purchase of the interest. This provision is might make selling the interest difficult because of its restrictive nature.
▪ Right of first refusal. A right of first refusal will allow the surgery center and/or its partners to purchase the interest of a physician prior to the sale to a third party. The longer the period that the other owners have to decide to purchase a seller’s interest, the more restrictive this provision is on a seller. The economics of the center and the development of other opportunities are less likely to occur within 30 days than 120 days, resulting in a lower likelihood that a potential buyer will walk from a transaction. A valuator might disregard the length of the right of first refusal because of the distributions of the center may offset any issues caused by an owner requiring to hold an interest longer.
Application of provisions
The appropriate use of the above provisions might vary depending on the purpose of the valuation. If a surgery center is owned solely by physicians and the goal is to keep the value low for future physician owners, owners may wish to be as lenient with these provisions as possible (e.g., have multiple owners with no control and no non-competes). If the goal is to sell an interest to a management company and make the most money possible on the sale, the operating agreement should be more strict with regards to non-competes, control at the level the manager wants to purchase (e.g., generally majority ownership), and shorter rights of first refusal.
-- Curtis Bernstein is a manager at HealthCare Appraisers. His national practice specializes in valuation, transaction advisory, strategic and operational consulting services. Contact him at Cbernstein@hcfmv.com. Learn more about HealthCare Appraisers.
The following highlights terms of an operating agreement that might affect the surgery centers ability to meet future economic goals.
Assessment of risk
Within every valuation performed by a valuator, the valuator will assess the risk of the investment made by the potential buyer when purchasing the interest in the surgery center. These risks include the ability of the center to maintain its payor mix, case mix, cost structure, etc. Certain provisions in an operating agreement might affect the surgery center’s ability to meet wits projected financial and operational goals.
▪ Non-compete agreement. Operating agreements generally contain a provision related to its owners maintaining a financial interest in a competing center during a period in which the owner has a financial interest in the current surgery center and for a period thereafter. The non-compete agreement might also restrict an owner from having an agreement such as a management or consulting agreement with another surgery center. Finally, the non-compete may restrict the owner from employing staff or leasing equipment to another surgery center.
A non-compete agreement may be strictly related to ambulatory surgery centers. In today’s competitive environment, hospitals and health systems are entering into management agreements with physicians. If the non-compete agreement only addresses ambulatory surgery, the owners might get around the operating agreements restrictions by entering into an agreement for the management of a hospital outpatient department.
This provision is generally for a fixed period of time. The longer the period of time and the farther the radius from the center, the more restrictive and, hence, the more likely the owner will stay with the surgery center and continue to do cases. The valuator will generally review the local market and verify that the distance restriction actually is constrictive enough. Also, the valuator will note that a non-compete agreement generally prevents a physician from holding a financial interest in another center and does not prevent a physician from performing cases in another center.
Assessment of control
Valuators will take a “lack of control” discount for any interest in which the owner does not have control over the operations of the surgery center. Control is not determined by the percent owned but by the owner’s ability to legally control the operations of the business.
▪ Majority, quorum, or unanimous. Certain decisions are made by either individuals or groups with different levels of authority. For example, the operating agreement may specify a particular manager who directs the daily operations of the center. In this case, the question is who has the ability to replace this manager.
Voting rights is more of a legal issue than a valuation issue. With regards to valuation, the ability to control is based upon the required number of shares required to approve a motion, the number of shares being valued and the number of shares outstanding.
For example, if a center is owned by two physicians, a third physician is purchasing 10 percent equally diluting the other two physicians and the center requires a majority vote for most actions, the 10 percent owner will have some level of control when the other two physicians do not agree. The 10 percent block owner does not have full control since the two other physicians can approve motions without the 10 percent block owner. Therefore, a discount for lack of control is still warranted.
▪ Multiple classes. Each class (i.e., level of ownership comparable to general versus limited partners or preferred versus common stock ownership except that rights are defined in the operating agreement) is reviewed based upon its ability to control the operations of the surgery center. For example assume four classes of units are created (A through D). If units A and B sit on the board of governors and have the only vote to decide who is on the board of governors, these units are more controlling that units C and D. The operating agreement might be written such that units C and D have certain blockage rights or these unit holders might sit on certain decision-making committees. The greater the ability to control the operations of the business, the higher the value of the block of ownership.
It is very difficult to explain to owners of a surgery center why their interest is worth less than their peers even though they both own a 5 percent interest. Therefore, the developers of a surgery center should thoroughly understand the control provisions of the operating agreement between the member classes and explain these upon formation.
Assessment of liquidity
The valuator will take a discount on the value of an interest based upon the expected time and cost the interest would take to sell.
Overall, the discount should be specific to the entity and the market for the particular interest. If a significant number of eligible buyers are present in the local market (i.e., physicians who meet eligibility requirements and are not restricted for other reasons as non-compete agreements), the holding period would be short and a lower discount would apply.
If the sale is for a large interest, the interest might take significantly longer to sell depending upon the ownership makeup of the center. For example, if a controlling interest is valued and the current ownership makeup is 100 percent physicians, the interest will take shorter to sell than a controlling interest in which the other 40 percent is owned by a management company and a hospital. Other management companies are looking for opportunities related to the former and not the latter.
While it was noted that the majority of valuations HealthCare Appraisers (this author’s company) performs are for transactions in which there is already a buyer and a seller, the fair market value requires the valuator to review a transaction as hypothetical and determine the value of the interest in the open market.
▪ Limited ownership. An operating agreement may limit the number of units an individual physician or group may own. This restriction has minimal effect on the valuation of a small block of units. However, in the case of a larger block, this restriction might limit the number of potential buyers.
For example, a hospital is looking to increase its ownership interest, through a 30 percent purchase, in a center owned by a hospital, management company and physicians. The hospital and surgery center management company is unlikely to allow this block to be sold to any of its competitors. Therefore, the block can be sold to the current owners as a whole or in multiple pieces. If a restriction in the operating agreement prevents the current owners from owning more than a certain amount, it might be very difficult to sell this block on the market. If the market is highly competitive (i.e., a number of surgery centers operate in the local market), resulting in a low number of physicians not already involved in a competing center, this interest would be even more difficult to sell, therefore arguing for a higher discount for lack of marketability.
▪ Length of ownership. Operating agreements sometimes contain a provision requiring owners to keep their ownership for a certain number of years after the purchase of the interest. This provision is might make selling the interest difficult because of its restrictive nature.
▪ Right of first refusal. A right of first refusal will allow the surgery center and/or its partners to purchase the interest of a physician prior to the sale to a third party. The longer the period that the other owners have to decide to purchase a seller’s interest, the more restrictive this provision is on a seller. The economics of the center and the development of other opportunities are less likely to occur within 30 days than 120 days, resulting in a lower likelihood that a potential buyer will walk from a transaction. A valuator might disregard the length of the right of first refusal because of the distributions of the center may offset any issues caused by an owner requiring to hold an interest longer.
Application of provisions
The appropriate use of the above provisions might vary depending on the purpose of the valuation. If a surgery center is owned solely by physicians and the goal is to keep the value low for future physician owners, owners may wish to be as lenient with these provisions as possible (e.g., have multiple owners with no control and no non-competes). If the goal is to sell an interest to a management company and make the most money possible on the sale, the operating agreement should be more strict with regards to non-competes, control at the level the manager wants to purchase (e.g., generally majority ownership), and shorter rights of first refusal.
-- Curtis Bernstein is a manager at HealthCare Appraisers. His national practice specializes in valuation, transaction advisory, strategic and operational consulting services. Contact him at Cbernstein@hcfmv.com. Learn more about HealthCare Appraisers.