Purchase price is a significant factor when it comes to determining the success of a practice acquisition. Unlike in other industries, healthcare transactions are subject to great regulatory scrutiny because the price paid for medical practices must be consistent with fair market value (FMV). The Office of Inspector General of the U.S. Department of Health and Human Services has stated that FMV means “value for general commercial purposes” and that it “must reflect an arm’s length transaction which has not been adjusted to include the additional value which one or both of the parties has attributed to the referral of business between them.” As such, it is critical for health systems to develop their purchase offer to comply with these definitions and avoid an arrangement whereby purchase price is based on the volume or value of referrals.

To be sufficiently thorough and performed according to the highest professional standards, a valuation of a business must encompass three approaches: an income approach, a market approach, and an asset approach. No single valuation approach is appropriate in all situations, so it is always important to consider the specific circumstances of the arrangement when determining FMV.

Income approach. The income approach is a general way of determining the value of a business by using one or more methods through which anticipated benefits are converted into value. It is applied by forecasting the future cash flow stream that the physician practice is expected to generate and then discounting it to the present value using a risk-adjusted rate of return. This approach can be challenging to apply because most independent physician practices distribute all available cash flow to physician owners as compensation. Furthermore, physician compensation is likely to be higher once the practice has been acquired by a health system. To comply with the FMV standard, the expected post-acquisition physician compensation must be consistent with the compensation assumption used in the financial forecast. If the practice is not expected to generate free cash flow, the income approach will not produce a positive enterprise value for the targeted practice.

If the acquiring entity offers a reduced post-acquisition compensation package to the physician owners, the practice is likely to generate a future return and the income approach can reasonably be applied. Private equity firms have been successful in implementing this model to close physician practice transactions, particularly for larger practice deals. However, health systems should consider the following potential challenges when agreeing to reduce physician compensation to pay a higher purchase price:

  • Physician productivity, as measured in work relative value units (wRVUs), tends to decline with reduced compensation levels as demonstrated by the collapse of physician practice management companies in the 1990s.
  • Physicians are likely to be dissatisfied with the reduced compensation and will request a compensation enhancement commensurate with their peers.
  • Physician recruitment can become difficult if compensation is below the market value level.

Accordingly, most health systems make the strategic decision to enhance physician compensation while remaining both competitive and within FMV guidelines.

Market approach. The market approach is a general way of determining the value of a business by comparing the target business with similar businesses that have been sold. Transactional data are used to derive valuation multiples such as price to revenue and price to earnings before interest, taxes, depreciation, and amortization (EBITDA). However, most practice acquisitions are private transactions with minimal public information regarding purchase price, historical financial performance, and post-acquisition employment terms. Therefore, the market approach typically is not used to value physician practices.

Asset approach. The asset approach is based on the principle of substitution, which assumes that a prudent buyer would pay no more for a business than it would cost to assemble all the individual assets and liabilities that constitute the business. Under the asset approach, a practice’s tangible and intangible assets are valued separately, then aggregated to determine the FMV purchase price.

Competition will influence whether intangible assets, such as workforce in-place, will be purchased. Other intangible assets such as patient charts, website, tradename, and phone number may be considered when determining a FMV purchase price given the specific facts and circumstances of the practice and the market.

Practice Advisors 360 is the nation’s leading advisory company. Contact us today at (844) 360-8360 or visit us online at practiceadvisors360.com