Marketability Discounts in Medical Practice Valuation/Sales

A review of the valuation literature would find that valuators in general believe that some form of discount for lack of marketability or illiquidity should be applied to the valuation of closely-held entities. Marketability is the ability to convert an investment to cash in a short period of time with minimal transaction costs. Traditionally, this discount is applied after all computations under the chosen valuation method have been completed. For example, if the discounted free cashflow method were used to value a 100% controlling interest and the value arrived at was $500, this value would be reduced (typically) by the discount for lack of marketability. Commonly cited reasons for this additional discount over and above that reflected in the discount rate used in the income approaches are 1) the time to successfully complete a sale; 2) the costs of the sale compared to that of selling publicly-traded stock; 3) the risk as to what the ultimate selling price for the valuation subject will be compared, again, to that of a publicly-traded stock; and 4) what form the sales proceeds will take, referencing cash or cash-equivalents versus such items as below market seller-financed debt.

(Author's note: The majority of the studies supporting the presence of a discount for lack of marketability are based upon restricted stock sales and private transactions preceding an Initial Public Offering, generally involving minority interests. Many of these transaction precede the IPO by up to three years, limiting the argument's strength as the valuation dates are not identical if three years apart. The focus of the studies does provide strong support that valuations of privately held companies derived from the Capital Asset Pricing Model or Guideline Company Methods based upon freely-traded minority stock interests, require a discount for lack of marketability. Under these methods, privately held stock is valued "as if publicly traded" prior to the application of any marketability discount.)

We will address each of these factors below, focusing only on medical practices subject to the "fair market value" standard enunciated by the Internal Revenue Service for transactions with exempt entities and (implicitly) for purposes of the Fraud and Abuse and Stark laws.

The following example is used throughout this analysis to illustrate quantitative points.

Example

The value of a medical practice is equal to the present value of the future benefit stream, in this case cash received. Assume the future cash benefit stream on January 1, 1997 (valuation date) is $100 per annum and that the capitalization (and discount) rate is 20%. The practice will have a value of $500 ($100/.20). Assume that it takes six months to successfully negotiate a sale, based upon the valuation report - as would be the requirement for regulatory purposes. The seller receives $500 on June 30, 1997 from the purchaser, and will also receive the $50 (one-half of $100) earned during that time period, if it has not already been distributed. The present value of $500 received six months from now at a rate of 20% is $456. The present value of $50 received at the end of that six months is $46, and the total of the two is $502, actually higher than the $500 when using an end of year convention. If a mid-year or other consistent convention were used, the present values would, of course, be equal and we assume them to be so for this analysis.

1) Time to successfully complete a sale

The underlying theory here is that the seller will suffer some diminution in value between the date of the valuation and the ultimate sales date, if any. The example illustrates that the control owner(s) in the sale of 100% of their medical practice will receive a value on the sale date equal to that on the valuation date, after reflecting the additional distributions they receive from their entity during the period prior to sale.

There is, of course, risk that the valuation conclusion would change if performed on June 30 versus January 1. Long bond rates are volatile as is the valuator's assessment of risk of the valuation subject at any point in time. However, this may result in an increase or a decrease in value and either result is equally likely. "Stale" valuations are generally required to be updated by the exempt acquirer (or its counsel) and thus the valuation date (and amount) is often reset to be closely coincident with the sale date.

2) Costs of the sale compared to that of selling publicly-traded stock

The seller of traded stock pays a relatively small commission on the sale and receives proceeds in five days, being the difference between the sale date and the settlement date. Thus, at the time of sale, there is a sum certain and a date certain as to the sale proceeds. The seller of the typical medical practice does not bear the cost of valuation as the exempt purchaser must have an independent appraisal and pays this cost itself. The seller does, however, bear the costs of legal and accounting representation, and these costs as a percentage of the sale proceeds will more likely than not exceed (significantly) the comparable cost of disposing of publicly-traded stock. Query whether this should be a reduction in the practice valuation which, effectively, charges the seller twice for the same costs: once via reduction of the selling price and again when the costs are paid from the reduced price. (Notwithstanding the research support for marketability discounts described above, having represented numerous sellers in such transactions, the author is certain that no sale would take place if the discount for lack of marketability were explained as being tied to the cost of disposition. Further, it is quite common for much if not all of the seller's costs in small transactions to be paid by the buyer; in this latter case, the valuator and buyer might properly look for or expect the marketability discount, in order that the seller did not receive a double benefit, contrasted with the double cost described earlier herein.)

The counter-argument is most easily understood and analyzed by reference to traded stocks, from which it originates. A buyer of freely-traded minority stock faced with a disposition cost of 15%, for example, would be disinclined to pay a price therefore which did not reflect the cost of disposition. One of the advantages of holding such stock is the ability to convert it to cash quickly and with minimal cost. The hypothetical buyer of a 100% controlling interest in a medical practice is not primarily concerned about liquidating the investment on short notice, but rather on earning a return from the operation of the entity - a "buy and hold" strategy. (The "financial investor" element of the hypothetical any willing buyer definition may be appear to in contradiction with the hypothetical medical practice buyer, but the valuator must reconcile these conflicts in each engagement.)

3) Risk as to the ultimate selling price

This factor is closely linked to the first factor, the time to successfully complete a sale. Once the valuation is performed, it is uncertain that the sale will take place at that price or, in fact, at any price. The seller's or buyer's assessment of the relative value of the future cash benefit stream may be different from that of the valuator and each other, resulting in no sale. In the author's view, as in the first factor, this risk is two-edged: An increase or a decrease in value may result and either result is equally likely.

4) Form of sales proceeds

"Fair market value" is defined as amount in cash or cash equivalents. The research studies supporting marketability discounts find that reported prices paid for privately held companies include restricted stock, for which the "value" may be more or less than reported. Various forms of subordinated and convertible debt may also be used, further compounding the measure of cash and cash equivalents. Smaller transactions involving closely held companies often rely upon seller financing or earn outs, which also affect the value in terms of cash.

Clearly, fair market value must be defined in terms of cash. In the author's experience of dozens of valuations of medical practices and representation of sellers, none of the transactions were measured in terms other than cash. This would be expected, as the regulatory standard is fair market value and this presumes cash or cash equivalence. In those cases where deferred payments are used, they either bear interest, or the parties agree upon, at arms length, the implicit interest rate for purposes of determining the sales proceeds reportable on Form 8594 pursuant to IRC section 1060.

Other factors to consider

If one uses the CAPM to develop a discount and cap rate, or uses a Guideline Company method to value a medical practice, a discount for lack of marketability would seem necessary as both these methods rely directly upon the values of freely traded minority stock interests. This is, however, generally not done as the consensus in the valuation community is that Physician Practice Management Companies are engaged in managing medical practices not practicing medicine, and therefore do not represent Guideline companies.

When a buildup method is used, many (if not most) valuators feel that the underlying use of Ibbotson data in arriving at the base equity discount rate before applying a risk premium for the valuation subject also means this method relies upon the values of freely traded minority stock interests. Query whether the high degree of subjectivity in determining the subject's risk premium does not take the marketability discount into effect? This premium should be based upon actual transactions, or 'comparables,' if possible. Assuming the comparables represent transactions utilizing fair market value as the standard (which is a determination the valuator must make before using them) these comparables should play a critical role in determining the risk premium. In the ideal world, actual transactions, as is the case with the Guideline Company Method, determine risk rates, not valuators. In the author's practice, we have significant experience with actual transactions where the purchase price was based upon an appraisal conducted for regulatory purposes employing the fair market value standard. Discount and cap rates developed from this experience would appear to include marketability factors relevant to our market area.

Standard valuation practice is to take the marketability discount after the valuation model has calculated a value. The model used, if properly adjusted to reflect the cash benefit stream for a controlling interest, will give the value of a controlling interest. Is there a quantitative reason why this discount cannot be built into the buildup method? The following example answers that question with a firm NO.

Returning to our example, assume that the valuator has concluded that a 10% discount for lack of marketability (d) is appropriate. The capitalization (c) rate is 20%. What should the rate (m) be to reflect the marketability discount. m=c/(1-d).

m=c/(1-d)

Substituting:

m=.20/(1-.1)

m=.20/.9

m=.2222

Recalling the value of $500, if a 10% marketability discount is applied, the reported value will be $450. Alternatively, if we apply a cap rate of 22.22% to the future benefit stream of $100, the value will also be $450.

In nearly one hundred valuation or representation engagements, the author has seen only three stock sales consummated; all of the others were asset sales. It would seem far easier to dispose of assets unencumbered by the legal and other burdens of stock, including the reduced tax benefits of stock due to the lack of a step-up in basis for depreciation and amortization purposes of the underlying assets. Due to the prevalence of the corporate practice of medicine doctrine throughout most of the country, asset sales would appear to be the norm and stock sales the exception.

Conclusions

In the author's view, the thrust of the arguments for marketability discounts when valuing a 100% interest in a medical practice rests with the hypothetical any willing buyer's assessment of the future timing and costs of disposition. Factors 1) and 3) are substantially mitigated by the seller's retention of the cash benefit stream prior to a sale, unlike with both freely traded and privately held minority stock interests where the cash benefit stream may be zero unless the stock is sold. Factor 4) is rarely an issue in medical practice sales to exempt entities due to the overriding presence of the fair market value standard and the severe restrictions under the Fraud and Abuse and Stark laws on such things as "earn outs" which have "prohibited referral" implications. Factor 2) seems to have the most applicability as it is clearly costly to both acquire and dispose of a small medical practice, particularly when compared to stock market transaction costs. The author believes these costs (when non-duplicative) are implicitly factored into the ultimate purchase prices reflected in his own firm's experience, but this is clearly a very limited data base. Finally, there appears to be nothing inherently wrong or inaccurate from a purely quantitative standpoint with adjusting the cap rate for the discount for lack of marketability.

Marketability Discount Update, October 29, 1997

I recently returned from the American Society of Appraisers Conference in San Francisco. One of the featured speakers was Christopher Mercer, ASA, Mercer Capital Corporation. I just received his recently published book, Quantifying Marketability Discounts (available for approximately $90 from Mercer Capital at http://www.bizval.com). Mr. Mercer devotes a full chapter to the issue of marketability discounts when controlling interests are acquired, updating an article he published in Business Valuation Review. His thorough and thoughtful analysis provides an in-depth technical analysis of this area. I strongly recommend that anyone with an interest in marketability discounts purchase this excellent reference source.