More thoughts on Valuing the TransactionNovember 21st, 2010 | Income Approach & Methods | Noncompete Agreements | Reasonable Comp | Regulatory Matters | Valuing Goodwill
At the Maryland seminar, I devoted some time to discussing the “left hand” or asset side of the balance sheet when undertaken healthcare appraisals. The Stark regulations use the word “asset” and the Derby case looks at the fair market value of precisely what was transferred in the transaction at issue in this case. That should not come as a surprise to anyone. The value of an Enterprise is not only the sum of equity and debt but also the sum of all of its assets. As I suggested to the participants yesterday and the earlier post on this topic, the fair market value of a medical practice sold with the net working capital – an asset – would be different than the fair market value of that practice sold without the net working capital (NWC). There was agreement that a hypothetical buyer would deduct the value of the NWC if they did not acquire it. Similarly, there was agreement that if FMV assumes a seller signs a noncompete and that all the underlying business stays with the practice, that a noncompete that was more limited in geographic scope and term would devalue the practice relative to one with a broad geographic range and longer period of time, if the actual noncompete did not extend to the practices entire service area and the seller was capable of competing. That is, of course, why we value noncompetes. Individual intangible assets – subject to having an associated cashflow – can be valued. The weighted average of rates of returns on all the operating assets of a business must of necessity be equal to the weighted average cost of capital derived from the right hand or invested capital side of the balance sheet.
Another example I used was that of an antique instrument cabinet used in a medical practice. Certainly, that would likely be treated as a nonoperating asset and if it was sold with the practice, the transaction price would be higher – value the transaction! There are a myriad of individual terms that a hypothetical buyer and seller will negotiate in a transaction, including post-transaction compensation, noncompetes, salary guarantees and what have you that impact the Fair Market Value of the assets being transferred. Back in the 1990s, the primary reason cited by inexperienced appraisers for the use of median compensation in valuation models – properly debunked then by IRS, me and others and more recently in the Derby case – was that using actual post-transaction compensation would represent “strategic value.” Such a compensation assumption required that a hypothetical investor with reasonable knowledge of relevant facts pay a value for a practice determined using median compensation when in fact compensation to be paid was much higher – and the anticipated cashflows much lower than in those used to determine the value. More PT Barnum reasoning. Value the transaction.
There are, of course, elements of a transaction that if quantified in a valuation model could represent strategic value – using the buyer’s cost of capital, not tax-effecting cashflow because the buyer is tax-exempt, including anticipated inpatient and outpatient referrals, finding value under the Cost Approach for intangibles when there is no value under the Income Approach, using provider based billing in the valuation model, and so on. The skill in distinguishing Fair Market from Strategic Value comes from the Appraisers ability to first identify assumptions that are consistent with FMV and then quantify those assumptions in the valuation model. Citing some undefined “hypothetical transaction” for purposes of Fair Market Value when the actual transaction is different results in a price being paid for the transferred assets that is not based upon what was transferred! That is never Fair Market Value.
At least for regulatory purposes in healthcare, transacting parties had better be da@#ed certain that transaction terms not contrary to the regulatory construct are considered in the price paid and appraisers do well to specify in engagement letters, reports, assumptions and limiting conditions and/or representation letters that changes from the underlying assumptions of what is transferred and the terms of that transfer may affect the concluded fair market value.
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