I had to turn down an invitation to speak at NACVA this past June in favor of my 35th wedding anniversary.  I would not have decided differently, but was surprised to see that Bob Cimasi’s presentation was devoted in its entirety to refuting the White Paper written by me and 7 other co-authors and published in the American Health Lawyers Association Hospitals and Health Systems Rx publication.

There are a variety of specious arguments in the presentation, but I will limit myself to a few.

There are a variety of citations to IRS CPE texts and the Friendly Hills private letter ruling in support of the notion that it is appropriate to use the cost approach to value physician workforce in place.  These citations conveniently ignore the fact that the CPE texts clearly state that the cost approach is used to allocate the value determined under the Income Approach (discounted cashflow method) and CRITICALLY that the appraisal in support of the Friendly Hills private letter ruling included a letter from the managing partner of the physician practice that stated the following:

 “It has been clearly stated to the partners that, in the past, their compensation reflected not only the value of their medical services, but also the profits attributable to their ownership of the Network; that the latter element will be replaced by a cash payment, which they can invest … that the Medical Group’s income will thereafter be derived from arms-length contract for medical services; and that these rates will necessarily be significantly lower than the total historical income they have been receiving …”   

Now, less there be any doubt what is stated here, “the Medical Group’s income will thereafter be derived from arms-length contract for medical services; and that these rates will necessarily be significantly lower than the total historical income they have been receiving” is in stark contrast to many of the transactions that take place where physician workforce is paid for and post-transaction the physicians receive a higher income than they historically earned.  There is simply no basis whatsoever for believing that the IRS was unaware of the interrelationship between practice valuation and physician compensation. 

I still have a copy of that letter, which was an integral part of the valuation and the granting of IRS approval for the transaction.

Perhaps the most outlandish argument is using Bankruptcy case law and theory in suport of fair market value and commerical reasonableness in a healthcare transaction.

One of the many arguments against the White Paper’s position that there be an income return analysis to establish value  is that somehow a “cost decrement” or reduction in expenses gets around the requirement that the hypothetical investor of the fair market value standard would not invest in something that generates no income.  Income is revenue minus expense, of course.  All things held equal, if revenue stays constant and expenses go down, income will increase. However, if there is no revenue in the first instance that does not violate the prohibition against DHS referrals, even if expenses are less, there is no income for purposes of the requirement that the expense reduction be commercially reasonable in the absence of referrals. 

It is hard to envision that a transaction based upon an expectation of losing money is commercially reasonable for the hospital, although the presentation supports it based upon Bankruptcy case law.  Certainly, if all hospitals entered into such transactions expecting to lose money and did not have the benefit of referrals from the transaction to DHS, they would all go bankrupt.  Perhaps that is the connection.

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  • Mark – I tend to agree with your opinion above. However, with regards to the second to last paragraph, I am not sure I fully agree. I was at the NACVA seminar and while in Dallas, I was able to discuss this issue with a very senior former IRS agent. He and I seemed to agree that cost decrement is a valid method for determining the value of a business.

    That is, if I need this business for some reason and I would otherwise have to recreate the business, I would be willing to purchase the business as opposed to create it. However, I need a reason to want to create it. Take for example a scenario in which I build computers and I needed a specific chip to make my computer run. If the company that made that chip was losing money, I would be willing to purchase that company (most likely) for more than the value of its fixed assets. The company owns the staff and procedures necessary to make this chip (probably also a patent, which physician practices generally do not own).

    I understand this example may be a specific buyer so please ignore that fact for my example because I think any hypothetical buyer in this scenario would likely purchase this company. The bigger issue with the scenario is that the buyer is only willing to purchase the chip company to keep the computer company running with the ability to earn a return in the future on the sale of computers.

    When I translate this to healthcare, my concern is not the FMV of the practice under the application of valuation theory as much as FMV under the healthcare regulatory guidance (i.e., without the value or volume of referrals). Why would a hospital system otherwise need to recreate a physician practice that is otherwise already established in its market and pay for the hospital’s cost decrement if the practice is already established. What costs are decremented?

    Further, with regards to workforce in place, I see valuators assigning value to this assets in Right to Work states and the workforce has no contractual requirements to remain employed? Would the Anaheim Angels pay milliions of dollars for Albert Pujols if they had no contract for him to play tomorrow?

    Overall, I believe that companies with years of development of staff, policies, branding, etc. should have value in excess of its fixed assets. In a personal service business, this value is distributed as profits to the owners through compensation or distributions.

    This fact significantly complicates these transactions and until I hear a reason on why the cost approach should be applied that does not indirectly tie back to the value or volume of referrals, applying the cost approach with no projected future income of the company should be challenged; mayby not by the IRS but definitely by the OIG. I occassionally hear that we would otherwise need to create a practice because we are becoming an ACO or the physicians might leave the market. I find these arguments hard to swallow at this time but a regulatory body could prove my thoughts to be incorrect (e.g., you do not have to build a practice to have an ACO; physicians are generally dedicated to a specific hospital and with ACOs, they would likely join without a huge payment to purchase the practice).

    I appreciate your input on this topic as always.

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