At yesterday’s session on Cost of Capital with Carol Carden at the BV Conference, one of my colleagues raised the question from the floor about whether “valuing the transaction” in healthcare constitutes strategic value. It clearly does not. Among the many aspects of the healthcare industry is the regulatory construct which requires fair market value as a standard in all valuation engagements. Therefore, one of the things that an appraiser must learn in practicing in the healthcare industry is how to apply the FMV standard of value to valuation models where someone unfamiliar with the regulatory construct might inadvertently develop strategic value – or, for fear of developing strategic value, default to valuing some “hypothetical” transaction.
“Terms Make the Deal” is a common cliché’ in transactions but it is not an indicia of strategic value. As a simple example, consider the value of a noncompete agreement as part of the enterprise value of a given medical practice. Assume that the seller has the ability and intent to compete post-transaction absent a contractual provision precluding that competition. A Hypothetical Buyer would pay less for the business – if pay anything at all – absent the noncompete, while a hypothetical seller expects to be paid for not competing in addition to being paid for the value of the other assets being sold. Thus, the noncompete has an identifiable value – that can be determined through a “with and without” analysis – and two different Fair Market Value prices would be determined for the Enterprise based upon the Terms of the Deal. The question is not whether the presence or lack of a covenant presents Strategic Value – it does not – the question is what Hypothetical Buyer and Seller would reach as a purchase price for the business with and without the noncompete.
The discussion cannot stop there. The Terms of the Noncompete itself determine its value. Thus, a noncompete with a geographic restriction of 10 miles might be expected to have a value less than one with a geographic restriction of 25 miles, assuming that the catchment area of the medical practice extended beyond 10 miles. The sale of the practice with a 10 mile noncompete provision versus one with a 25 mile noncompete provision would have two Different Fair Market Values! Nothing about the geographic range of the noncompete term represents strategic value so long as the Appraiser focuses his or her attention on what a Hypothetical Buyer and Seller would agree to as a transaction price.
As I responded in yesterday’s session, Appraisers need to focus on what actual assets are being transferred. One of the important lessons learned from the literature on FAS 141/142 and the focus on valuing the left – Asset – side of the Valuation Equation is that the Market Value of Invested Capital is the aggregate of the Assets of the Business. If the Transaction Documents pull out certain of those assets – like Accounts Receivable net of payables, for example, which is a common exclusion in a medical practice sale – a Hypothetical Buyer and Seller would and in fact must adjust the actual Transaction Price, notwithstanding any conclusion of MVIC – or, risk regulatory review due to paying for something you did not receive, a primary indicator that a prohibited buying-of-referrals motive was present.
As I further stated several times during the presentation, the 2008 Tax Court Case Derby makes it very clear that the Appraiser must – read that must – review the actual transaction documents specifically with respect to the post-transaction compensation and terms of the noncompete in order to determine the value of what was transferred. If the actual documents are not available, key assumptions such as post-transaction comp and noncompete terms must be obtained from the client and they should be 1) specified in the Report and 2) considered for a Representation Letter. This is a left-hand side or Asset approach to valuing transaction in contrast to the simpler, default right-hand or Invested Capital Approach. Assets have a Fair Market Value just as does Invested Capital and due to the Terms of the Deal, the two may not always be equivalent because either 1) some element of the Invested Capital is not transferred like working capital or 2) the terms of the transaction transfer more or less value that what the Appraiser’s generic concept of the transaction might be, such as a noncompete with a 10 versus 25 mile radius.
In healthcare transaction we encounter these nuances more often than not. We are expected under the regulatory standard of practice to assign value to these nuances, otherwise the transacting parties and the Appraiser risk civil or criminal prosecution.
As a final thought, real estate appraisal and transaction are no different! If a hypothetical buyer makes an offer on a home and the Building Inspection determines that the heating system is about to fail and will cost $10,000 to replace, one expects that the Hypothetical Buyer and Seller will make an adjustment to the Offer Price – or else a transaction will not take place. Simpler still, if there are two otherwise identical 4 bedroom homes located in the same neighborhood and one has been recently renovated with new kitchen cabinets, bathroom fixtures and a deck and the other requires updating, they will have two different prices. The reason is that the condition of the underlying component assets being transferred differs! The utility and the present value of expected future outlays by the owner to maintain House 2 are greater than House 1 making House 1 more valuable today!
Don’t fall victim to the tired argument that valuing the actual assets transferred in a transaction somehow constitutes strategic value. Only the Fool of Circus-man PT Barnum’s famous adage would pay $10 for a $5 bill.