The topic of paying goodwill and intangible value in hospital acquisitions of physician practices has become hotly debated. Questions continue to be raised whether goodwill or intangible assets should be considered in the purchase of a physician practice and whether they could be considered payment for referrals. Intangible assets and goodwill drive income in a physician practice and should be considered an important part of the acquisition because without the intangible assets, the practice has limited ability to generate income and limited value to a willing buyer.
If the physician practice didn’t have patients or didn’t have its workforce, value of the practice would be limited to its tangible assets. However, if a practice has patients and is an operating practice with experienced staff, value can be higher than the value of a practice’s tangible assets. When a hospital acquires a practice, the hospital is more interested in its intangible assets than tangible assets. I have never talked to a hospital that has said, “We want to acquire this physician practice because we really want their exam tables. That practice has the best exam tables of any other practice in the area!” Most buyers would agree the value lies in the trained work force, patient base, and established practice (going concern).
As appraisers, it is our job to put ourselves in the shoes of the buyer as well as the seller and arrive at a value the buyer and seller would agree to, without the compulsion to buy or sell and without consideration for value or volume of referrals. In my opinion as an experienced appraiser of health care practices, paying for goodwill and intangible assets in a physician practice acquisition is supportable as fair market value (FMV) and commercially reasonable.
Is payment for goodwill payment for referrals? If the payment is upfront and isn’t contingent on future referrals, is the physician being compensated for ANY future referrals? Granted, it may not be a wise business decision for a hospital to pay a physician for goodwill upfront when the physician quits shortly thereafter without a transition plan in place, but the payment in this fact pattern cannot be construed as paying for future referrals.
It may be more prudent to pay physicians for goodwill and intangible value upfront rather than increasing annual ongoing compensation, a practice I have seen occur to consummate a deal to offset a lower practice value. A one-time payment is less risky because annual ongoing compensation is difficult to decrease once set. If you look at the STARK and anti-kickback cases over the past 10 years, have there been any cases involving the upfront payment made to the physicians for the purchase of their practice? I have not found any. However, there have been numerous cases involving annual payments to physicians. Clearly, higher scrutiny is being placed on annual ongoing payments to the physicians rather than the one-time payment made in relation to an acquisition.
Let’s Be (Commercially) Reasonable
Is it commercially reasonable for a hospital to pay for intangible value and goodwill in the acquisition of a physician practice? The definition in the Stark law states:
An arrangement will be considered “commercially reasonable” in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician of similar scope and specialty, even if there were no potential designated health service (DHS) referrals.
Most buyers would agree the most valuable assets in an operating physician practice are the patient base and the work force that services those patients. Therefore, it is commercially reasonable to assign value to the assets that would contribute to the success of the practice. Could it be construed as commercially unreasonable for a hospital to assign value for assets such as lab equipment if they already own lab equipment? Clearly, the hospital is not interested in more lab equipment when it has its own. It should be considered commercially reasonable to pay for goodwill and intangible value in a physician practice acquisition—because that is truly what is considered “valuable” to the buyer. When a hospital wants to expand its services, the best way to do that is to purchase an existing practice. A prudent investor often makes the same decision to buy versus build a business because it takes less time, effort, and expense to purchase an existing business than to start from scratch. If a hospital started a practice from scratch, it would have to wait for the patients to come through the door. During the ramp-up, a hospital incurs more expense than revenue, which can be very expensive over time.
The Real “Business” of Buying and Selling
The process in which a hospital today seeks to acquire a physician practice is different than the purchase of any other business interest. In a non-health care acquisition process, a buyer and seller (without a compulsion to buy or sell) sit down at the table. The seller often starts with a higher price, and the buyer starts with a lower price. They discuss the benefits of the transaction and ultimately agree to a price. Normally, during the process, both parties end up compromising to reach an agreement.
In contrast, if a hospital wants to buy a physician practice, an appraiser needs to get in the middle and decide what the buyer should pay the seller. Intuitively, the FMV at which an appraiser arrives should be the same as what a normal buyer and seller would agree to (without considering value or volume of referrals). However, under normal situations, would a physician agree to sell their practice for just the value of its tangible assets? I don’t think so unless the Insight Article © Wipfli LLP 2 physician was under a compulsion to sell. However, if they were under a compulsion to sell, that would not be considered FMV.
So why is there concern over payment for goodwill or intangible assets in a physician practice acquisition? Why indeed!
In Reality, It’s Mostly About the Intangible Assets
In operating businesses, intangible assets often include patents, trademarks, customer base, and systems in place. Intangible assets are those assets that can drive income for the business. Profitable businesses (health care and non-health care) that have been in existence for a period of time have goodwill or intangible value, however, goodwill and intangible assets are often not recorded on a Practice’s balance sheet. In a large percentage of transactions negotiated between buyers and sellers, without the compulsion to buy or sell, value is allocated to intangible assets, and the value typically can have greater value than the value of the tangible assets, especially in profitable service entities such as physician practices. The intangible value is developed through an owner’s historical effort to build up the business to a point where it is generating a reasonable income plus investment return for the owner. These past efforts by the seller create value for a buyer. Intangible assets do have value in physician practices. So how can appraisers calculate the FMV of the intangible assets along with tangible assets in physician practices?
Fair Market Value
Valuation methods have been developed over the years to assess the price a buyer and seller would agree to, without the compulsion to buy or sell. The methods generally fall under three categories: income (income generated over time), market (comparable transactions), and cost (cost to re-create) approaches. Under the premise of FMV, there is no rule that states only one approach can be considered or that an entirely different approach can't be used for estimating the FMV. The only rule is to figure out, “If there were a true buyer and seller without the compulsion to buy or sell, what would that price be?”
To assess FMV, any combination of the three methods can be used, and there are many different nuances to the three methods. In the valuation of most business, appraisers should consider all three approaches to value. Since we are trying to figure out what a true buyer and seller of a business would do, the market approach is often utilized.
Many health care appraisers have indicated that there is limited market data or that the information on physician practices is unreliable. However, there have been thousands of physician practice acquisitions in the past 10 years so the data on some of these transactions should be available. Some of these transactions can be found in a database called Goodwill Registry, published by Health Care Group.
The Goodwill Registry has been in existence since 1990 and currently includes 2,000 physician practice transactions that have occurred between 2003 and 2013. The database breaks down the data by specialty and provides information on the date of sale, location, revenue, profitability, purchase price, and goodwill value. I do not recommend using the data from the 1990s, but there are plenty of transactions that have occurred within the past 10 years that can provide reasonable support for the FMV of a physician practice. As a firm, we have decided to utilize the Goodwill Registry for our valuations. In addition, we provide transactions to Health Care Group’s Goodwill Registry database that we ensure are accurate and portray the FMV for what a willing buyer and seller would agree to. Used responsibly, the market approach can be a reasonable approach to use in the valuation of a physician practice. In my opinion, preparing a market approach, even if the data may not be reliable, is better than not doing the market approach at all. If the approach arrives at a value different from the other approaches, it may not be considered.
In the income approach, the normal process is to estimate the net cash flow of a practice and discount it back to today’s dollars at a risk-adjusted capitalization rate. For physician practices, future physician compensation is factored into the analysis. This generally would indicate no goodwill value; however, there can be exceptions when it may be appropriate to calculate the difference in income using a with-and-without analysis. The income approach is often used in lost-profits calculations. Hospitals likely go through this same thought process when they consider their alternatives: (1) recruit a new physician, or (2) buy an existing practice.
This analysis factors in the cost difference between the two decisions. In most cases, the hospital will be better off buying an existing physician practice. In most small business, 100% of the income from the business is paid to the owners as compensation. Independent physician practices are not alone in that scenario. Even though many small businesses allocate 100% of profits to compensation, many transactions involving small businesses have goodwill or intangible value assessed. Buyers understand the value is in the existing customer base or other intangible attributes of a business that make it successful.
The analysis to arrive at FMV needs to follow the same thought process as buyers and sellers. Buyers and sellers often look at their different options, including the cost to recreate. That is where the cost approach comes in. The cost approach should consider all the costs associated with a buyer’s potential time and related costs to establish an operational practice. Those costs will be more than just the cost of purchasing equipment. The time it takes to ramp up the business and bring patients in as well as develop the work force is one of the most expensive aspects of developing a physician practice.
There are multiple ways of assessing value for the patient base and work force in place that appraisers historically have utilized for other businesses. These same approaches can be utilized to value the intangible assets of a physician practice. In all valuations, the appraiser is required to consider the income, market, and cost approaches to value and decide which approach is most appropriate factoring in the decision-making process of a buyer and seller without the compulsion to buy or sell. As we do with all the valuations we perform, a conversation with the buyer and seller should occur to help the appraiser understand what they consider to be valuable in reference to the transaction they are considering. Using this process, you can arrive at a price that is both fair market value and commercially reasonable. In addition, it provides both parties the understanding that the appraiser is truly considering their perspectives.
Intangible Assets and Value Matters!
Based on my discussions with many buyers and sellers of physician practices, there IS intangible value in a physician practice. As an appraiser of Healthcare Practices, I work with the buyer and seller and arrive at a transaction that can achieve the goals of both entities and are within the guidelines of Stark and anti-kickback regulations. The key is to understand the nuances of these transactions and consider all factors that a buyer and seller would consider, without consideration for value or volume of referrals and without the compulsion to buy or sell.