For a variety of reasons, the acquisition of medical practices by hospitals has become more attractive in recent years. The volume of acquisitions is increasing steadily and therefore physicians and their advisors need to understand the valuation process which drives the purchase price. Almost all hospitals hire a valuation firm that “represents” their interests. We believe that in order to level the playing field, each party should retain their own valuation experts.
The purchase of medical practices by hospitals is very strictly regulated by the federal government, and falls under what is commonly known as “Stark Laws”. The Stark Laws are designed to ensure that health care costs remain affordable and that medical delivery systems (hospitals, clinics, and doctors) don’t become monopolistic. The crux of the laws as they relate to medical practice M & A are that purchasers can’t pay more than Fair Market Value (FMV) for the practices, and can’t include any future revenues related to potential referrals. The practical significance of these provisions is that in order to ensure the FMV standard is met, hospitals engage valuation firms to provide valuations for each transaction.
Valuing a medical practice can be somewhat more complicated than valuing businesses in other industries because of several factors, including certain compensation considerations (also regulated), the highly contracted nature of revenues, differing specialties and sizes of practices, the presence of “personal goodwill” related to physicians, and the very different dynamics found in different markets. Each of these factors can have a dramatic effect on the value of a physician practice. The good news is that the process for valuing physician practices is just like the process for valuing traditional businesses.
The process of valuation under the FMV standard requires consideration of multiple approaches to valuation (income, market, and asset), as well as consideration of any and all aspects of a business that would be important to hypothetical buyers and sellers. Thus, the FMV standard opens up the field of consideration widely. The restrictions imposed by Stark, certainly narrow that field, taking out many of the factors that would be important to a typical strategic (or synergistic) buyer. The key to understanding the effects of the restrictions is often found in a discounted cash flow analysis, or even multiple discounted cash flow analyses.
Along with the restrictions related to potential future referral revenues, it is extremely important to understand the effect compensation has on valuation. As mentioned above, compensation is also a regulated area within physician practice M & A. In order to ensure that buyers / employers are not paying more than FMV and disguising the “overpayment” as compensation, compensation must fit within certain established guidelines related to productivity. An often-heard phrase in physician practice transactions is “you can get more for the practice if you’ll take less pay”. Interestingly, this statement isn’t always true, and one doesn’t necessarily have to take less pay to get more for one’s practice; the key is understanding the value of the practice before entering into in-depth discussions of a potential transaction.
Although the sale of a physician practice appears similar to the sale of any other type of professional service business, it is not. The governmental restrictions imposed on these transactions remove the transactions from the world of market forces and places them into a world of modified Fair Market Value. This doesn’t mean that sellers are relegated to taking what is offered. Rather, it means that sellers must be more educated and prepared, and that they may need to seek the same type of professional advice that the buyers are required to obtain.