Key Indicators for Medical Practice Valuation
Like many industries which undergo a period of rapid consolidation and speculative buying, physician practices have declined in value, at least as far as third party buyers on Wall Street are concerned. The focus of today’s valuation activity is once again on the traditional value indicators important to the physician buyer and seller. Valuation is about future cashflow, and a good valuation considers, to the extent feasible, those factors that may cause future cashflow to differ from historical cashflow.
Physician Work Codes and Practice Income
The element (and a critical one) of physician practice value that is least understood by valuation consultants is the coding of services provided by the physician. Coding refers to the work code assigned to a patient service by the physician. This code determines the payment the physician will receive for the service from insurance companies. The codes were developed by the American Medical Association and are known as CPT (for Current Procedural Terminology) Codes.
A patient who has previously been treated by a physician is considered an established patient. There are five codes typically available to a physician for recording the service provided to an established patient. Each of these codes has a dollar value attached to it by the myriad of health insurance companies. The higher the code, the greater the payment made. For example, the typical office visit for a patient visiting the doctor for a routine health complaint is coded as 99213 or a Level III, and a typical payment by an insurer for this service is $50. If the service is coded as a Level IV, the payment may rise to $70. A level II, in contrast, may only be paid at $35. (The actual payments vary with each insurer). It is easy to see that the income of a practice can be manipulated – deliberately or otherwise – through the use of the codes. Of course, there are rules for assigning the codes and the physician must document the services performed in the patient’s medical record to justify the code.
A quality valuation report will include a comparison of the coding of the practice being valued to statistical norms for that physician’s specialty. (Such a review is even advisable as part of the documentation in a loan request.) The norms for the Medicare population are readily available from the Health Care Financing Administration’s website. As with many other sets of statistical data, the distribution of codes generally follows the classic Bell Curve. The preponderance of codes are Level III, with a lesser amount of Level IIs and IVs, and still fewer Is and Vs. The actual percentage of each varies according to the specialty training of the physicians. Cardiologists, for example, use the Level IV code far more frequently than do family practice doctors. A coding pattern that is inconsistent with statistical norms may (may) indicate improper use of codes that in turn would affect the certainty that historical revenues would continue.
The Regulatory Environment
The government’s influence on the practice of medicine is pervasive and at times surprising to those unfamiliar with it. One grouping of the many statutes impacting the finances of a medical practice is the so-called Stark Laws. These laws are designed to forbid certain referrals by physicians in exchange for financial incentives. Although this may sound simple, the implications are expansive. In a group practice, the compensation plan employed by the physicians to determine who is paid how much must be Stark compliant. For example, if the practice has a laboratory that performs blood chemistry tests, the income from those tests cannot be allocated to the physician who ordered the test. Instead, it must be pooled and allocated in some fashion that does not incent the physician to order tests. Another common problem area involves the performance of tests by outside vendors, such as those who supply cardiac stress test and ultrasound equipment. Arrangements between the physician and such companies are subject to special scrutiny. A quality valuation report will at least pose these questions and attempt to flush out whether some problem might exist.
Financial Indicators
Perhaps in light of the rapid rise and fall of the Technology Sector, the old adage "Cash is King" will once again dominate investment analysis. In small physician practices, cash basis accounting is the norm and, in fact, desired. The complexity of valuing physician accounts receivable makes accrual accounting an art form at best, and since very few accountants have the expertise (or the budgets) to do it properly, accrual statements often give a misleading view of the practice. Accounts receivable may be an important part of a secured loan, but it is the cashflow they generate that will pay the loan.
Key financial indicators include the following:
The most readily available source of statistical data to compare a practice is from the Medical Group Management Association (MGMA). Many accounting and consulting firms with significant number of physician clients will maintain their own data as well. The principal weakness of the MGMA data is that it is gathered from large group practices that are not directly comparable to small practices of several physicians. Nonetheless, it is the standard used, and in the hands of an expert valuator, the comparison is meaningful.
Earlier in the article it was suggested that the typical patient visit resulted in a payment to the physician of $50. Many health plans require the patient to pay a portion of that charge, known as a co-pay. A typical co-pay is $10 and that represents 20% of the typical payment the physician will receive. Therefore it is critical that the physician’s staff do an effective job of collecting the co-pay at the time of service. If it is not collected at that time, it may never be collected. And the cost of collecting small balances is very high as a percentage of what is collected. Collection of patient co-pays at the time of service is one of the critical indicators of good practice management. Co-pay collection rates should be in the vicinity of 95% or better.
Senior Doctor Rights
Many transactions involving small medical practices are cluttered with so-called Senior Doctor Rights or SDRs. Typically, the selling physician attempts to sell a ratable share (say 50%) of the value of a 100% controlling interest while retaining that same 50% or even 60% of the value via the SDRs! To illustrate, assume that the entire practice is worth $300,000 on a 100% control basis, and the buyer is to purchase 50%. The price is $150,000, right? What if the seller retains the right to the office location, all patient charts and the phone number if the deal doesn’t work? Is the buyer’s 50% interest still worth $150,000? What if the seller has a veto over all practice decisions that cannot be agreed on? Is the buyer’s 50% interest still worth $150,000? Certainly not. Readers familiar with valuation theory know that SDRs are really lack of control discounts applicable to the interest purchased by the buyer and represent a substantial diminution in the value actually acquired. Lenders engaged in financing such a transaction need to study the actual transaction documents carefully to be certain the buyer is in fact acquiring the equity interest serving as collateral for the loan.
Enterprise (Practice) Goodwill and Personal Goodwill
The theory underlying Enterprise Goodwill (going concern value) is that the positive cashflow of a going concern has value independent of the individual physician. A lender should always carefully consider the presence of Enterprise Goodwill, and particularly so when the selling physician is retiring soon after the transaction. At the same time, the question needs to be asked if Enterprise Goodwill can be transferred without a covenant not to compete and if such a covenant is obtained, is it enforceable. That portion of the Enterprise Goodwill attributable to the covenant is a personal asset, not a business asset.
Going Concern Intangibles of a Medical Practice
The potential for Enterprise Goodwill should not be underestimated nor undervalued. Buyers should always compare the purchase price of an interest in an established practice to the cost of establishing their own practice. This process is analogous to the classic "market" and "cost" approaches in a real estate valuation. A non-exhaustive listing of the intangibles of an established practice follows:
Conclusion
In today’s environment, a good purchase and a good loan require careful consideration of a number of factors that are frequently overlooked or not even recognized. Medical practices remain a highly regulated and uniquely personal business that require careful analysis on the part of the lender to assure that the loan will be repaid. Two adages may serve you well when looking at the financing of any small medical practice purchase:
"The plural of "anecdote" is not "data" (Al Bothe, Jr. MD, University of Chicago) and
"The graveyards are full of indispensable men" … "some of whom owned medical practices." (Charles DeGaulle and Mark Dietrich, respectively).
(Mark O. Dietrich, CPA, ABV is accredited in business valuation by the AICPA. His book, The 1999/2000 Medical Practice Valuation Guidebook, can be purchased through his firm’s website at http://www.cpa.net/.