Physician Practice (& Ancillary Business) Valuation: Appraisal Theory and Applications

1. Physician Practice (& Ancillary Business) Valuation: Appraisal Theory and Applications Presented by: Randy Biernat, CPA/ABV BKD, LLP

2. Introduction Assumed Knowledge Level Types of Businesses to be Discussed Level of Detail for Presentation Standard Disclaimer

3. Content Overview Current Trends & Market Conditions Healthcare-specific Standard of Value Regulations Affecting Standard of Value Physician Practice Valuation Methods FMV in Physician Compensation Case Study Enforcement

4. Healthcare Market Overview Consolidation Trends Push for Clinical Integration Impact of Healthcare Reform Reimbursement Trends Enforcement

5. Drivers of Acquisition Consolidation of Market Share Declines in Reimbursement / Payor Mix Practice Recruitment / Succession Issues Capital Needs / EMR Anticipated Healthcare Reform Impact

6. Anticipated Physician M&A Activity • Per 2011 Accenture physician employment survey

7. What Physicians are Saying • Only 29% of physicians are not in a financial relationship with a hospital. • 56% of physicians want alignment to increase their incomes. • 40% want to align to ensure a more consistent income stream. • 90%+ thought physicians should be involved in: • Hospital performance improvement • Hospital executive leadership • Hospital board We are ready

8. Regulatory Environment Non-profit Compliance Anti-Kickback Statute Stark Law

9. Non-profit Compliance What is it? – Many hospitals are 501(c)(3) organizations and must be operated for public benefit (private benefit to insiders must be incidental) How does it apply to valuation? – Payments in excess of FMV can trigger loss of non-profit status or intermediate sanctions

10. Anti-Kickback Statute (AKS) What is it? – A prohibition on the paying, receiving or offering remuneration in exchange for or to induce the referral of any item or service for which payment is made under a government program (e.g. Medicare) How does it apply to valuation? – The explicit sale of referrals as developed in a valuation can be an indicator of an AKS violation

11. Stark Law What is it? – A prohibition on certain referrals which limits entities from billing government payors for services furnished, unless an exception applies How does it apply to valuation? – The appraiser must understand the exception being utilized and the general implications of not paying for the “value or volume of referrals”

12. Standard of Value From R.R. 59-60 to “Healthcare FMV” Entity to Compensation Valuation Implications to Appraisers

13. Fair Market Value (R.R. 59-60) The typical standard of value is classically defined by Revenue Ruling 59-60: “The price at which property would change hands between a willing buyer and willing seller, neither party being under any compulsion to buy or sell, and both having reasonable knowledge of all relevant facts, with equity to both.”

14. Fair Market Value (Stark) “…the value in an arm’s length transactions, consistent with the general market value. ‘General market value’ means the price that an asset would bring, as the result of a bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party….” (Stark regulations at 42 CFR § 351)

15. Fair Market Value (Stark) “the definition of “fair market value” in the statute and regulation is qualified in ways that do not necessarily comport with the usage of the term in standard valuation techniques and methodologies.” (Phase II – 69 FR 16107 – March 26, 2004) Bradford Decision: court acknowledges fair market value differences between Stark and traditional entity valuation standard of value

16. Facts and Circumstances • “Ultimately, fair market value is determined based on facts and circumstances. The appropriate method will depend on the nature of the transaction, its location, and other factors.” (Federal Register, Vol. 72, No. 171, CMS, 42 CFR Parts 411 and 424) • The sum of regulations affecting R.R. 59-60 is what is called “healthcare fair market value”

17. Implications of “Healthcare FMV” Avoid “investment value” No consideration of downstream referrals No consideration of hospital rates No consideration of specific economies of scale Limitations on use of opportunity cost Deal must make sense between purely arms’-length players

18. Commercial Reasonableness An arrangement will be considered ‘commercially reasonable’ in the absences of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician of similar scope and specialty, even if there were no potential DHS referrals. (CMS definition in Stark interim final rule, phase II)

19. Commercial Reasonableness v. FMV How are they different? Commercial reasonableness looks to the details of a specific transaction in a broader context than the payment calculated under the fair market value standard. What does this mean for appraisers? Check with counsel for how to apply! Limited guidance exists about how to apply the definition and where responsibilities lies for consideration and compliance.

20. Tips on Applying Healthcare FMV Working closely with qualified counsel will help ensure you are making assumptions and using data consistent with the legal opinion To the extent possible, both parties should sign off jointly on major assumptions Trade offs in quality, timeliness, and believability will dictate whether or not an appraisal can be delivered

21. Physician Practice Common Deal Terms • 5 year term, (fixed compensation for 2-3 yrs.) • 0% - 25% increase in pre-sale compensation • Fixed assets separately appraised • Nominal amount of intangible value • Working capital excluded (Cash, A/R, A/P) • Personal debts excluded • Non-compete agreements to rival hospitals

22. Asset Sale v. Stock Sale • Buyers prefer asset sales (primarily for liability purposes), while sellers prefer stock sales (primarily for tax purposes) • The practice value should reconcile under either approach. We begin with a stock sale assumption and then make adjustments to arrive at an asset sale value • This reconciliation is useful for the parties

23. Simultaneous Transactions • Appraisers must have knowledge of the financial terms of any other simultaneous transactions as it affects the future cash flows of the selling entity • It is not enough to assume a “market-level” of physician compensation if there is knowledge at the time of the transaction as to the actual future level to be paid

24. Intangible Assets • Appraisers must carefully consider any value assigned to intangible assets in determining fair market value • This is probably the single highest risk factor in performing physician practice appraisal • The standard of value dictates the assumptions allowed under a calculation of value, and in turn, impacts the valuation of intangibles

25. Overview of Valuation Approaches • Asset – the sum of its individual, identifiable assets. • Income – the risk-adjusted present value of expected future cash flows. • Market – the applied relationship between practice value and revenue or cash flow from actual transactions in the marketplace.

26. Valuation Approach Utility Debate • Income Approach v. Asset Approach • The two methods tend not to reconcile in physician practice valuation. • That is, a cost to replace methodology (asset approach) typically provides a value in excess of a discounted cash flow methodology (income approach) when expected future compensation is scheduled to increase.

27. Evaluating the Income Approach • Pros • Well known, trusted appraisal methodology for small businesses • Inherently considers the future compensation in the practice price • Cons • Assumptions can be manipulated • Intangible value is not specifically identified • Methodology inherently captures referrals • Approach pre-supposes that cash flow is the sole reason for investment

28. Evaluating the Asset Approach • Pros • Indicated value is not tied to referrals in any way • Specifically identifies the value of each intangible asset • Cons • Assumptions can be manipulated • Does not account for future benefits/costs associated with transaction terms • Does not require cash flow support the value of an intangible • Does not supply any attribution of intangible return between corporate goodwill and individual goodwill

29. Validity of Asset Approach 1996 IRS CPE Text on Practice Valuation • a well trained, organized, and efficient work force is a valuable asset in any business… The use of the cost approach is based on the premise that for a potential buyer to re-create the particular practice it has to hire and train a similar workforce; that hiring/training process has identifiable costs – for recruitment, orientation, training and lost salary – that form the basis of the valuation process.” • “Medical Practices have going concern value. The buyer of an existing practice purchases a turnkey operation and receives immediate value from the assembled workforce and other assets needed to operate the business.”

30. Validity of Asset Approach • Tough questions of the asset approach • Does workforce in place have the legal standing to be transferred? • i.e., does an employment contract exist? • Is there history to support the claim of a cost to replace? • i.e., has historical employee turnover been considered? • Is paying for an avoided cost to create a “commercially reasonable” action?

31. Typical Intangible Assets Considered • Workforce in Place • Medical Records / EMR • Trade name • Know-how / Clinical Protocols • Customer Lists • Phone Numbers

32. Impact of Linked Future Compensation • Increased compensation is a form of purchase price consideration (Derby v. Commissioner) • Determining the “compensation offset” • In a DCF, the cash flow can be adjusted to reflect the higher compensation – or – a direct purchase price offset can be computed • If the practice value is based on a Cost approach, the compensation offset must be done through a secondary calculation

33. Hospital Losses • Per Physician Losses (MGMA) • Primary Care (Family Medicine): • Range - $25,000 to ($238,000) • Median - ($78,000) • Hospital Revenue - $1.7M • Medicine Specialists (Cardiology) • Range - $103,000 to ($248,000) • Median - breakeven • Hospital Revenue - $1.3M • Surgical Specialists (Neurosurgery) • Range - $73,000 to ($921,000) • Median – ($453,000) • Hospital Revenue - $2.8M

34. Business Valuation – Key Considerations • Future Compensation • Key Personnel Contracts • Support for Intangible Value • Cost Replacement v. Goodwill

35. Comparison of Approaches

36. Case Study 1 - Facts • Hospital to acquire and employ 10 physician family practice (“FP”). • Hospital has a not for profit tax status. • Hospital believes employment will expand patient access and improve care coordination. • FP average physician compensation is $180K • FP will consider employment, but only if compensation is at least $200K.

37. Case Study 1 – FP Financial Summary

38. Case Study 1 – FP Benchmark

39. Case Study 1 – Asset Approach

40. Case Study 1 – Income Approach The following simplified calculation shows the a scenario analysis of average compensation paid out relative to MGMA survey data:

41. Physician Compensation Red Flag

42. MGMA Guidance • “When implementing a production-based compensation plan, practice managers must determine how to reward their highest producing physicians while reigning in compensation.” • “Managers should also understand that… [increased compensation]… takes the form in increases in overall compensation – not increases in compensation per unit of production.” Source: MGMA Physician Production and Compensation Survey, 2010 Report Based on 2009 Data.

43. MGMA Guidance - Graph Source: MGMA Physician Production and Compensation Survey, 2010 Report Based on 2009 Data.

44. Case Study 2 - Facts • Hospital to acquire and employ 10 physician practice specializing in urology (“Practice”). • Hospital believes employment will ensure long-term patient access, improve recruitment and enhance overall clinical integration. • Practice is concerned by the potential for cuts to its professional fees and is willing to entertain offers for employment.

45. Case Study 2 - Facts • Practice’s total annual average physician compensation is $750K, consisting of:

46. Case Study 2 – Practice Benchmark

47. Case Study 2 – Asset Approach

48. Case Study 2 – Income Approach Professional Practice Business Segment Only

49. Case Study 2 – Income Approach TC Business Segment Only (Radiation Therapy)

50. Case Study 2 – Value Reconciliation