COVERSTORY

What's your practice worth?

Here's how to value your practice and close a deal, even in a market that isn't what it once was.

By Ken Terry
Senior Editor

Thinking of selling your practice? Don't expect a windfall. Prices for primary care practices have dropped substantially from the mid-'90s, when hospitals and physician practice management companies were snapping up every office and clinic in sight. In those days, practices were going for between 50 and 100 percent of a year's gross revenue. Today, the figure tops out at about a third of gross, say consultants.

One reason for the drop in values is that hospitals are no longer buying primary care practices; in fact, many have divested them. Most PPMCs have long since imploded. And while groups are still buying practices here and there—either to expand their geographical reach or their referral base—they're not paying much.

So who are the buyers? For the most part, they're associate physicians who want to become owners. Realize, though, that whether you sell to an associate or someone who's looking to relocate to your area, it may take more work than you think to sell it. Here's what you need to know to make the task as easy as it can be—and assure that you'll get the most you can from the sale.

What you can charge for, and what you can't

There are four components of practice value: hard assets, cash, accounts receivable, and goodwill. In addition, some groups own real estate, which may provide an income of its own and could be more valuable than the practice.

Only 30 to 40 percent of buy-sell agreements require associates to buy accounts receivable, says Mark Smith, executive vice president of Merritt, Hawkins & Associates, a physician recruiting firm in Irving, TX. And that percentage is decreasing, he adds.

While A/R can be a substantial amount, hard assets such as exam tables, office furniture, and computers are rarely worth more than $20,000 in a primary care practice. So the biggest component of practice worth is goodwill, which is the sum of all the intangible qualities of a practice.

Goodwill accounts for about 90 percent of the purchase price when A/R is excluded, according to Mark Kropiewnicki, whose firm, The Health Care Group in Plymouth Meeting, PA, tracks practice sales in its Goodwill Registry. If A/R is included, goodwill is about 70 percent of the price.

One way to get a sense of practice values is to check the Goodwill Registry (see "What goodwill is worth"). But the registry has limitations: It doesn't provide regional breakdowns, it includes pro-forma valuations done for divorce settlements, and, above all, it doesn't include the many practices that found no buyers or were sold for close to nothing.

To determine the goodwill value in your practice, you can look at recent sales of comparable practices in your area or employ accounting methods such as discounted cash flow or excess-earnings capitalization (see "Methods of figuring practice value"). But more intuitive methods of valuation may serve you just as well. For instance, how much would it cost an associate to start his own practice, and how much less would he make than he could in yours? "What he's paying for is the ability to start earning from Day One more than he'll be able to make on his own with a bank loan," says Atlanta-based consultant Gary Matthews.

If you're using this approach, consider whether hospitals in your area are willing to help new doctors set up practices, which may lower the value of your goodwill. Many hospitals, Smith explains, offer primary care physicians a one-year income guarantee if they agree to stay in the area for three or four years. If they remain that long, their "loan" will be forgiven. In addition, Smith notes, some hospitals provide free management services and even help new doctors find call partners.

It's this institutional largesse, he says, "that keeps the buy-ins in check." And by placing a lid on buy-in prices, hospitals effectively limit practice values.

Also consider whether managed care in your area is dragging down practice values by lowering reimbursement to physicians. In northern Virginia, for example, where the biggest plan is paying 80 percent of Medicare fees, practices are being sold for the value of hard assets and, sometimes, A/R. "Goodwill has totally evaporated," says Steve Messinger, a consultant with MedTactics in Arlington, VA. Practice values have also fallen sharply in other East Coast metropolitan areas and much of the Midwest.

In the South, where HMOs and capitation have made fewer inroads, the median income of primary care doctors is substantially higher than elsewhere in the country—and so is the worth of their practices.

Prime sources of goodwill: location and "spread"

The theory that managed care penetration diminishes the value of goodwill doesn't hold true in California, though. While HMOs remain dominant in that state, and doctors' incomes have been beaten down, family practices there are worth slightly more than the national average. There are several reasons for this: West Coast groups are still buying practices, managed care companies still need primary care physicians, and some areas of California are very attractive to doctors.

That explains why physicians are plentiful in San Diego. The stiff competition has made practices more valuable in San Diego—and southern California generally—than they would be if the turf were less hotly contested.

"If patients are banging down the doors to get in, practices aren't worth much because it's easy to start up a new one," explains Jeff Denning, a consultant in La Jolla, CA. "But when it's hard to get into a market, and it's difficult to get listed on the better plans because of competition, established practices have a great deal of value."

Whatever your location, say consultants, your practice needs a healthy "spread" between the income levels of partners and associates to be worth anything. "The smart practices don't pay an associate like a partner; they pay him like an employee," says Denning. "If you pay an associate close to what you're making, you can't expect to sell him anything, because he's already got it."

Here's how the "spread" works in establishing practice values: Say the goodwill value of a $1 million-a year-practice is $300,000. If there are two partners, and an associate is buying in, each doctor's share of the goodwill would be $100,000. The associate would pay that amount plus his share of hard-asset value over four or five years, explains Kropiewnicki. But instead of paying cash, he'd work for less than his share of the profits.

If the practice's net income is $500,000, each partner is entitled to $166,600. If the associate has been making $120,000, the year after the buy-in he'll make $130,000, the second year, $140,000, and so on until he's getting an equal share. The difference between the new partner's share and whatever he's earning each year will total close to $100,000 within five years.

Kropiewnicki notes that these kinds of buy-sell agreements work the same way in reverse on the buyout side. "Say each doctor is making $167,000. When the senior physician decides to leave, his patients should still generate an income stream of $167,000. But the practice isn't going to pay somebody $167,000 to do that doctor's work. It's going to pay a new associate maybe $100,000. So for the next two to five years, part of that $67,000 profit goes to the retired doctor."

Watch out for the taxman

If your practice is considering this "sweat equity" approach, have an accountant examine the tax implications. When someone buys a partnership in return for forgoing future income, in effect he's paying for it with pre-tax dollars. This is something a sharp IRS agent might catch, notes Michael LaPenna, a consultant in Grand Rapids, MI. An audit could lead to assessment of back taxes and penalties.

One way to avoid this, he says, is to tell associates upfront that they'll be earning less than the going rate; but after four years, if all goes well, they'll be able to buy a partnership for as little as $1,000. If you do this consistently with all associates you recruit, he says, the IRS will probably accept it.

The "spread" in better-performing practices might be as much as $75,000 to $100,000 if you start the associate off at $90,000 to $100,000 a year, says Michael D. Brown, a practice management consultant in Indianapolis. But the spread in many practices is probably less than that because median compensation of primary care physicians is only $149,000, according to the Medical Group Management Association.

A practice that pays associates higher salaries has less value because the spread is lower. Hence the buy-in should be lower too. But paying associates too much and then charging them a nominal amount to become a partner not only reduces buyouts but also encourages turnover. "We see a lot of medical group unrest because many physicians say, 'I could make more if I were an independent physician,' " says Steve Messinger. "Ten thousand dollars to join a partnership isn't much of a commitment. It's easy to walk away from that if you figure you can make $30,000 more."

If you're an associate, you should also approach buy-sell agreements with eyes wide open. Messinger recalls the experience of a pediatrician who was joining a three-doctor group in New York. The other physicians were going to let her buy in for a nominal amount, but she would have had to buy out the senior partner for a much larger sum five years later. When she balked, they rewrote the agreement.

Gary Matthews has seen agreements that required associates to pay for an equal share of the practice but allowed them to be paid on the basis of their productivity. That's not fair, he says. If you buy a third of a practice, you should get a third of the income.

Getting associates to buy in is an art

Young physicians are increasingly risk-averse, say consultants, and fewer of them are interested in starting up their own practices or buying partnerships. Still, recruiter Mark Smith believes that three-quarters of them would welcome the opportunity to become a partner in a successful practice.

What makes young doctors reluctant to join a practice with a buy-sell agreement, he says, are the horror stories they've heard. "The worst one is the buy-in that never happens. After two years, the associate suddenly realizes, 'Oh my gosh, this doctor is going to retire and wants me to buy all this goodwill, and he has an inflated value on his hard assets, and he expects me to buy A/R, too.' "

Before a young doctor joins your practice, says Smith, he should be told how the buy-in and the buyout will be calculated. It's pointless to discuss numbers at this stage, because they'll fluctuate with the financial condition of the practice and the number of partners. But the employment contract should state the methodology of the buy-sell agreement and specify when the practice must make a partnership offer—usually after one to two years.

If you're thinking about bringing in a potential partner, start looking for that doctor five to seven years before you plan to retire, cautions Brown. "Otherwise, you'll end up locking the door and selling off the A/R and equipment for some horrible below-book value."

It can be painful for a soloist to hire an associate and subsidize him while he gets started, notes LaPenna. Nevertheless, you may have to bite the bullet if you hope to get anything for your practice. And plan on spending a fair amount of time in the search, because fewer doctors want to be soloists these days.

In general, "the physician who's selling his practice or recruiting an associate has to do more prospecting for an associate or a buyer," says Matthews. "But in some areas of the country, this is a good time to sell a practice and to buy into one."

What goodwill is worth

Here are median percentages of annual gross revenues that primary care physicians across the country are getting for the goodwill in their practices. Goodwill normally represents between 70 and 90 percent of a practice’s value.

Methods of figuring practice value

Discounted cash flow

This approach relies on an estimate of future cash flow discounted to present value. For medical practices, a DCF valuation often projects cash flow for five years, with a typical discount rate of 15 percent. The prediction of cash flow is based on historical cash flow as well as assumptions about rates of increase or decrease in revenues and expenses. The discount rate is derived from expected inflation, the cost of capital, and the risks of doing business and of the health care business in general.

Since discounted cash flow involves so many assumptions, it tends to produce higher valuations than other methods.

Excess-earnings capitalization

In this method, excess earnings might be regarded as the difference between what you earn and what the average local doctor in your specialty makes. Or it could be viewed as the difference between what you'd have to pay an associate to do your work and your own income.

A typical capitalization rate for physician practices is 17 percent. To calculate goodwill, divide your after-tax excess earnings by this rate. For instance, an FP who earns $200,000 a year, compared to an average of $150,000 in his community and specialty, would have excess earnings of $50,000. If $35,000 remains after taxes, he'd divide that by 17 percent, and his goodwill would amount to $205,882.

An advantage of this approach is that it's based on historical income, rather than theories about the future.

Market transaction approach

The market approach, like home appraisals, is based on how much similar practices have recently sold for. This yardstick is difficult to use unless there have been a lot of practice sales in your community. And practice sales in other markets may not apply to values in your areas.The other caveat is that while the market approach may be useful in establishing a range for your practice value, it doesn't necessarily reflect the particulars of your practice. Consequently, this approach is seldom used as the primary valuation approach.

 

Ken Terry. What's your practice worth?. Medical Economics 2003;7:106.