The Value Your Practice Really Holds
It's up to you to put the appraiser's estimate in perspective.
By Richard C. Koval, M.P.A., CMPE, Incline Village, Nev.

How much is your practice worth?

The question sounds simple, but the answer is often quite complicated and depends on a number of factors that may not be apparent at first glance.

So how do a buyer and seller arrive at a price that's mutually agreeable? A valuator's estimate is important, but it's only a starting point. In this article, I'll look beyond the financial calculations performed by a valuator to try to give you a better idea of what really drives transactions. I'll review the main components of value, but also illustrate how they're applied in real life so you'll know what to expect. In the end, it will be you, through negotiation with the buyer -- not a "magic number" from an appraiser -- that will dictate the value of your practice.

Among the components of practice value, goodwill varies the most. For the latest data from the Goodwill Registry, which represents goodwill values in actual transactions nationwide

Choosing a valuator

As stated previously, an appraiser's determination of practice value is your starting point in a practice transaction. The range of practice value he or she provides will be based on historical and projected financial performance, but also on his or her subjective assessments. This subjective aspect makes selection of a qualified individual important.

A number of resources are available to you, including attorneys, accountants, and consultants. The key factor here is the experience of the individual in estimating value in similar transactions and within your specialty, whether for internal buy/sell arrangements, purchases or sales, or mergers of practices. The individual also should understand the approaches most appropriate for various transactions and model the valuation accordingly. The closer the individual's experience conforms to the specifics of your situation, the more likely the results will be satisfactory.

You should begin by soliciting names from colleagues locally or at conferences. National societies can also provide helpful referrals. Next, contact the individual valuators to determine each person's:

• Level of interest. Does the valuator provide valuations for needs such as yours?
• Availability. Can the valuator meet your expected timeframe for completing the work?
• Qualifications. Does the valuator have specific experience in situations similar to yours?
• Approach. How will the valuator proceed in estimating value and what will the final work product be? Although all valuations are designed to provide an estimate of value, the processes and final work products of the valuators can vary significantly. Some valuators travel to the practice, allowing interview of physicians and key administrative staff, collection of local demographic information, and physical inspection of the practice facility and equipment. The resulting valuation reports tend to be comprehensive, detailed, and lengthy.
  Other valuations can be conducted from afar, based on assessment of financial information and through telephone communication. Valuation reports in these cases tend to be concise and, rather than becoming the focus of the consulting engagement, are often used as a component of determining a larger issue such as a buy/sell structure or purchase/sale agreement. The nature of the transaction and the information needs of the buyer will most likely define the detail needed from the valuation report.
  For the sake of budgetary control, ensure that the components of the valuation report will not exceed your needs. For example, the valuation report required for bank financing or sale to a third party is likely to be extensive, while the report needed for an internal buy/sell transaction may be relatively brief.
• Fees. How much will the valuator charge for services provided? As might be expected, comprehensive valuations tend to be more expensive due to the travel costs and valuator time involved. Such valuations may cost $30,000 or more, while more concise assessments may cost as little as $1,500. Pricing is usually based on an hourly fee or total-project cost; travel expenses are additional. The valuator should provide an estimate based onyour description of the work needed. In general, the complexity of the process should be no greater than the level needed to address the issues calling for the valuation.
• Reputation. What have your colleagues experienced? Obtain names of references who can describe each individual's work in circumstances as close to yours as possible. Ask references for a description of the circumstances in which they used the valuator and the role of the individual therein, and their satisfaction with the quality and timeliness of work performed. Based on information obtained from your interviews of the valuator and his references, you can enhance prospects for obtaining valuation assistance that truly meets your needs.

Expect to provide extensive financial information to the valuator, including income tax returns for the practice, balance sheets, income statements, physician compensation amounts, and other data for at least the prior 3 years.

Determining objective value

With this information, he or she will determine the objective value of your practice. The estimate will take three basic elements into account:

Net equity. Net equity is largely determined from the balance sheet, which lists the assets and liabilities of the practice. Assets include cash and bank deposits, notes receivable (amounts others owe to the practice), inventory (supplies on hand), and tangible assets (equipment, instruments, furniture, computers, leasehold improvements). Liabilities include amounts owed by the practice to others, such as bank loans, assessments, payroll taxes, and similar items. The basic accounting equation states that assets are equal to liabilities and net equity. Thus, the net equity of the practice is determined by subtracting liabilities from assets; it usually encompasses items such as retained earnings, year-to-date net income, stock, capital, and other similar items.

For purposes of valuation, certain adjustments must be made to the net equity amount. The most common involves adjustment of tangible assets from book value (i.e., the amount stated on the balance sheet) to fair market value. This adjustment is appropriate due to the nature of tax-basis accounting. When capital equipment is purchased, accounting rules require the cost to be allocated over the useable life of the item. This cost allocation is called depreciation.

The bottom line: As a buyer and seller attempt to arrive at a mutually agreeable value, one of two situations emerges. In one, the range of potential pricing acceptable to the seller overlaps the range of potential pricing acceptable to the buyer. The value will lie within the intersection of the individual ranges. In the second situation, the respective ranges don't intersect. In that scenario, one or both parties must accept a price higher or lower than their respective estimates of value, or they won't agree on value, and the transaction won't be realized.

In simple terms, if a piece of equipment were purchased at a cost of $10,000, and accounting rules required the item to be depreciated equally over a 5-year term, one-fifth of that cost ($2,000) would be allocated as depreciation expense to each of the 5 years following purchase. After 5 years, the item would be considered fully depreciated, and the book value would be zero. However, accounting rules don't necessarily correspond to the actual useable life of tangible assets. In most cases, depreciation accelerates the expiration of assets and tends to undervalue them. As a result, book value must be adjusted upward to reflect the fair market value relevant to practice valuation.

Internal Revenue Service regulations define fair market value as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." This value can be determined in various ways. One involves subjective assessment by a qualified appraiser or vendor who's familiar with comparable sales of such items. Other methods include adding back a percentage of accumulated depreciation (the cumulative depreciation expense of practice equipment currently in use), or by restating depreciation on a 10-year schedule to approximate the average lifespan of practice equipment. Ideally, the adjustment for fair market value will consider a combination of these methods in some form.

Additional adjustments to net equity may be necessary depending on the accounting convention used. Most practices organize their tax information using the cash method of accounting, which states that revenue is recognized when received and expenses recognized when paid. By comparison, the accrual method of accounting requires revenue to be recognized when earned (i.e., at the time the service is rendered rather than when payment is received) and expenses are recognized when incurred (i.e., at the time a bill is received rather than when paid). Although the accrual method provides a more accurate view of practice financial status, most practices use the cash method for financial statements and tax reporting. In these cases, the value of assets such as inventory (supplies), and liabilities such as accounts payable (outstanding bills) will not likely appear on the balance sheet. Valuation should be adjusted to include these items.

Accounts receivable. Accounts receivable are monies payable to the practice by patients and payers for services rendered and billed. In most practices, these accounts represent the most valuable single asset owned. Although technically an accrual-method item, accounts receivable is sometimes found as a balance-sheet entry for practices using the cash method, offset by a liability account, such as deferred income.

For purposes of valuation, adjustments are necessary to convert the gross accounts receivable balance to its net collectible value. The difference between these two amounts is attributable to contractual allowances (the difference between gross charges and expected collections), discounts (professional courtesy), bad debts, and other write-offs. Adjustment can be made through assessment of each type of reduction, based on historical or projected amounts. A more simple adjustment can be made by determining historical practice collections as a percentage of gross charges, and then applying that percentage to the gross accounts receivable balance. The result of that calculation should represent the reasonable amount of collections to be derived from those accounts.

Intangible assets. The concept of intangible assets, or goodwill, is based on the profit and future revenue streams to be received by the owners. It forms the basis for determining the "going concern" value of the business enterprise. In your practice, intangible assets include the reputation of the practice, its referral relationships, its identity in the market, the momentum and stability of its patient volume, the value of staff expertise, the existence of administrative systems, and other factors. In essence, intangible asset value is based on the factors listed above and is measured by the profits paid to the owners.

Although most ophthalmic practices have demonstrable intangible asset value, some do not. The presence or absence depends largely on the profitability of the practice but is also affected by the valuation method used. For example, a popular and simple approach to intangible valuation is the percentage-of-revenue method, where historical average annual practice collections are multiplied by a defined percentage. The percentage is usually based on comparable transactions within the specialty, derived from surveys or other sources. With this method, any practice with revenue has intangible asset value. In effect, the percentage-of-revenue method emphasizes the value of the practice revenue stream without consideration of overhead or profitability. As a result, the method has reasonable applicability to practice sales where the buyer expects to operate the purchased practice as a satellite or with a different cost structure than has been the case historically. However, when used in other situations, this method can easily undervalue practices with low overhead and overvalue practices with high overhead. As a result, it may sometimes lead to an inaccurate assessment of intangible value.

Another option is the capitalized-excess-earnings method. This approach examines valuation of intangibles based on practice profitability for the potential purchaser, separating the intrinsic value of physician labor from amounts attributable to practice ownership. With this method, practice profitability becomes the critical determining factor and implies separation of the compensation derived from owner labor from compensation amounts attributable to practice ownership itself. Conceptually, labor value is equivalent to the salary amount appropriate for a comparable employed position or to the percentage of collections likely to be paid to an employed physician.

A simplified example: If a physician owner were to produce $600,000 in collections and receive $250,000 in total compensation, and the comparable rate of pay for an employed ophthalmologist were 30% of collections, owner profit could be estimated as follows:

	Context of the sale: In some transactions, various components of value may be excluded. For example, most sales of practices to third parties are limited to tangible assets, inventory, and intangibles. In comparison, stock sales (including buy/sell arrangements) usually include all assets and liabilities of the practice.

Multiplying $600,000 (owner's collections) by 30% (market rate of employed physician compensation) results in $180,000 (amount paid to owner based on labor). Subtracting $180,000 from $250,000 (owner's compensation) results in $70,000, which is the owner's profit -- the amount paid to the owner based on ownership, separated from the intrinsic value of physician labor.

So, in effect, the value of intangible assets is largely based on assessment of the owner's estimated profit. As a result, the method works best if the buyer's levels of overhead and profit will be similar to the seller's. This is most likely to occur in a buy/sell transaction or if the practice is acquired in its entirety and the buyer expects to operate in a manner similar to the buyer.

Both the percentage-of-revenue and capitalized-excess-earnings methods examine practice financial performance retrospectively, which assumes that prior practice performance is a valid indicator of future performance.

A third option for intangible asset valuation is the discounted cash flow method, which approaches intangible asset value prospectively, based on projections of future profitability. Projected profit is then discounted to reflect its current value to the purchaser, with the resulting amount forming the basis for intangible asset value. This method is helpful in cases where historical information is incomplete or unlikely to represent future financial performance.

The value of intangible assets is integrally tied to the revenue streams and profitability of the practice. As a result, various discounts in value arise if revenue or profit is disrupted from historical levels. For example, if a retired physician leaves the practice without a successor and the practice is unable to retain that physician's patients, intangible asset value for the buyout would be negligible.

Or, if a practice is acquired as a satellite to a larger practice but is relocated such that patients choose care elsewhere, intangible asset value would be diminished in comparison with the practice continuing care at its accustomed location. Because of these considerations, intangible asset value is greatly dependent on the context of the specific transaction.

Other factors may apply

When each of these three aspects of value -- net equity, accounts receivable and intangible assets -- is examined separately in this fashion, valuation is considered to be asset-based, inasmuch as each type of asset (net equity, accounts receivable, and intangibles) is valued individually.

In other transactions, a multiple-of-EBITDA approach may be appropriate. EBITDA is an accounting acronym representing Earnings Before Interest, Taxes, Depreciation, and Amortization. This method applies a multiplier to EBITDA to determine total enterprise value. The appropriate multiplier tends to be higher for stable, secure, highly profitable entities, and lower for those at greater financial risk. The resulting amount is presumed to incorporate the entirety of the practice or facility value, including its tangible assets and accounts receivable; no separate assessment is done for these aspects. If the entity maintains debt, that amount is used to reduce value and reflect net equity.

This method is commonly used to assess the value of ambulatory surgery centers due to its exclusive focus on net income and profitability rather than separate assets. Because this approach is commonly used by public companies, it has formed the basis for many of the corporate and physician practice management company transactions concluded in recent years.

Obviously, a valuator has a number of tools available. However, the context of the proposed transaction is another important variable in determining valuation. In some transactions, various components of value may commonly be excluded. For example, most sales of practices to third parties are limited to tangible assets, inventory, and intangibles. In these cases, the seller retains cash, accounts receivable, and other assets, while debt usually is either resolved prior to sale or retained by the seller.

In comparison, stock sales (including buy/sell arrangements) usually include all assets and liabilities of the practice. As a result, the valuation must carefully note included and excluded items based on the context of purchase and sale. In addition, any items deliberately excluded by the seller (typically automobiles, artwork, and other personal effects) must be identified appropriately. In most cases, real estate will be excluded from the valuation and assessed separately by a qualified real-estate appraiser.

The tax treatment of the transaction may also affect value for the buyer and seller. Most valuations assume tax benefits and costs will be borne equitably between the parties. If either party assumes a significant advantage, the transaction price should be adjusted accordingly. Qualified tax advisors should review such matters carefully.

What an appraisal can't show

When a value range is obtained from an appraiser, negotiations begin. Most buyers will initiate discussion at the low end of the range while most sellers will begin at the high end. Despite the valuation range, certain other considerations, which can't be reflected in the valuation itself, may be appropriate to consider. For example:

• The ability of a purchased practice to serve as a satellite location and forestall potential competition may have financial advantages beyond the scope of the valuation document.
• The town in which the practice is located may have emotional appeal to the buyer due to family living nearby, increasing the willingness of the buyer to pay an above-average price in order to make the deal work.
• The practice may be located in a remote area or undesirable neighborhood, limiting the number of potential buyers and depressing the price likely to be obtained.
• The seller may have health issues requiring an immediate sale, motivating sale at a price lower than practice value.

The take-home point

While all of the factors covered in this article are part of the valuation process, ultimately, you must determine the appropriate transaction price in whatever situation you may encounter. The valuation provides a helpful reference, but the "right" price and most "accurate" value truly depend on give and take between the buyer and seller.

Richard C. Koval, M.P.A., CMPE, a member of the Ophthalmology Management editorial board, is vice president of practice management services for The BSM Consulting Group in Incline Village, Nev. You can reach him at rkoval@bsmconsulting.com