The health care industry has undergone changes over the past few years in response to changing public, economic and insurer demands – but some things have remained the same. For instance, most health practitioners are primarily engaged in the independent practice of general or specialized medicine. They typically operate private or group practices in their own offices, in centers or clinics – or in facilities such as hospitals or HMO medical centers. These practitioners may provide a wide assortment of specialized services, including comprehensive preventive, cosmetic or emergency care.

The intangibles are often referred to as the economic return expected from the bundle of rights associated with the tangible assets combined with staff. Let’s take a closer look at the impact of goodwill and other factors on a practice’s value.

Changing demographics affect the competitive intensity for a client base in a desirable geographic area – especially in areas with numerous practitioners. Typically, a practitioner requires a significant equity investment to establish a practice (few transactions are all-cash). According to the Goodwill Registry, 20 to 50 percent of the values of as many as two-thirds of practices’ sales prices consist of "goodwill."

The most common intangible is goodwill. A valuator typically bases this adjustment on the practice’s size, location, history, client diversification and profitability. Determining goodwill value requires specific data, including the number of clients, the transferability of the client base and the stability of revenue flow. Most professional practices are service businesses. This means that even large firms’ clients typically develop a relationship with one practitioner. A medical practice is unique in that it requires a license and a considerable investment in education, thus limiting the pool of potential buyers.

There are two types of goodwill. Practice goodwill is more easily transferable and includes the practice’s location, nature and how long it has been operating. It also includes the capital structure, employee and supplier relationships, agreements, and advertising. Professional goodwill, which is not as readily transferable, includes the practitioner’s education, experience, skills, reputation, work habits, demonstrated earnings power, and comparative professional success and personality. The transferor typically attempts to retain goodwill by strategies such as personal introductions and remaining at the practice for an agreed-on period.

Areas of goodwill that may be associated with both practice and personal goodwill are:

·  Competition level.

·  Referral base.

·  Client type.

·  Work habits.

·  Age and health of the practitioner(s).

·  Fee schedules.

·  Length of time in practice.

·  Source of new clients.

·  Area demographics.

·  Costs associated with setting up a new practice and attracting new clients comparable to the revenue benefits of the firm being valued.

Some may argue that the cost to assemble tangible assets combined with the efforts of ownership to duplicate a similar amount of annual revenues to the entity being appraised (in effect, the cost to create) is, in part, the goodwill of a business. The middle ground likely lies with the Missouri Supreme Court’s definition of goodwill: the part of a practice’s value that exceeds its tangible assets resulting from clients’ tendency to return to or recommend the practice, regardless of the individual practitioner’s reputation.

Other intangibles may consist of:

·  Organizational, technological and proprietary know-how client lists.

·  Computerization of databases.

·  Contracts, noncompete and other agreements.

·  Favorable leases.

·  Reference library, which may include procedures and manuals.

·  Telephone numbers.

·  Supplier contracts.

·  A trained and assembled work force.

The asset’s remaining useful life is also quite important to consider, particularly if it is less than 10 years.

The most common method valuators use to measure any goodwill is to capitalize (apply a multiple to) excess earnings, using Revenue Ruling 68-609. A valuator weights a practice’s historical pattern assuming that past performance can predict the future – keeping variables, such as market influence, in mind.

The other method a valuator may use is to consider the difference between sales price and tangible asset value. A firm’s tangible assets are usually represented by capital and undistributed profits in the form of fixed assets and cash. Rarely does a purchase include a share in the practice’s accounts receivable or work in process that may exist at the time of transfer.

Determining a practice’s future growth requires subjective judgment and consideration of the risks associated with this versus alternative investments. The value of most professional practices is based on the timing, riskiness and volume of future cash flows generated. Keep in mind that a buyer is interested in paying the seller an amount based, not on what the seller generated in the past, but on what the buyer considers a likely return in the future. This cash flow comes to an equity holder in two forms: compensation for labor and return on equity in the form of distributions or capital gains.

Distributable cash is available to the owner after meeting all necessary operating expenses and reasonable compensation.

Many courts perceive goodwill’s value to be speculative and prefer a value that reflects net book value, including accounts receivable and unbilled work in progress. Goodwill may also exist when it is not recorded on a cash-basis entity’s balance sheets and would also include fully depreciated equipment and leasehold improvements. Cash-basis accounting may require an adjustment to the accrual basis to reflect work-in-progress, accounts receivable and payable, and other financial items. Accounts receivable include business booked but not performed and business concluded, not paid, or aged and sent to collection.

This may require discounting of aged receivables based on payment history. One of the risks associated with buying an interest in a professional practice is continuity. Establishing a payout and vesting period for a specific duration, agreed on by both seller and buyer, is ideal. Distribution of gains and losses should be capped annually. In addition, notification of withdrawal within a certain time with forfeiture of interest and a noncompete agreement are all integral components to a successful transfer. The noncompete agreement may be difficult to enforce, but no buyer wants to pay "good money" if he or she knows that the seller may open a practice nearby.

Purchasing an interest in a practice based on its size is relevant because of structural (operational, financial and legal), transactional and market differences. In most cases, a smaller practice has not created durability that can allow for a key person’s departure with nominal economic impact on the practice. In smaller practices, a purchaser is buying a job, so equity will be mostly attributed to owners’ salaries. A buy-sell or a buy-in agreement may provide an interest holder with a degree of liquidity by specifying a value.

Smaller practices typically feature lower multiples if the buyer’s perspective is that client relationships have limited history or will not be retained. The potential pool of buyers is also limited, consisting of those having professional licenses, appropriate skills and financial means.

In conclusion, there are many components that make up the value of a medical practice. The weight assigned to the each component varies from practice to practice. A valuation done by a certified valuation expert can assist the physician in accurately establishing either the sale price to an outside buyer or the buy-in of a new doctor.