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Risk assumption in shareholder buyouts

By Vasilios J. Kalogredis, J.D.

With the ever changing medical marketplace, there are many physicians leaving their practices to pursue other opportunities. Quite often, we are seeing physicians leaving their practices much earlier than anyone had anticipated, in light of the economic pressures caused by dramatically increasing malpractice insurance premium rates and flat or decreasing reimbursement rates from third parties.

Also, it is quite true that the valuations of medical practices in most area locales have dropped dramatically from where they were in the mid-1990’s when hospitals and large teaching institutions were falling over themselves to offer big prices to physicians for their practices. Because of this, many practices’ shareholder documents call for buyout formulas/prices which are unrealistically high in today’s weaker health care economic climate.

This is one reason why we urge our group practice clients to look critically at their inter-doctor agreements on at least an annual basis to be sure that all of the doctors are comfortable with how realistic the documents currently are. It is always dangerous to generalize, since each practice situation is unique. Some practices still have a reasonably high intangible value because of their unique situation. However, the average practice out there does not have the large goodwill element that it would have had five or six years ago.

One of the risks of having agreements in place that do not reflect the realities of today is that it might actually encourage one of the owner/doctors to leave the practice in order to get the “big buyout.” Furthermore, one of the justifications for a goodwill/intangible element in a buyout in the past was that the group would be able to hire a replacement physician to work as an employee for a period of years and then as a less than equal “partner” for a period of years before becoming a “fully equal compensation” owner. This spread in compensation provided the funds from which the departing doctor would receive his buyout and often left some extra profit for the remaining practice owners. In today’s climate, where groups are often losing doctors much more quickly than they can replace them, this theory is not really working.

Therefore, if a doctor leaves and has a reasonably high goodwill buyout in his agreements, the remaining doctors may be “stuck” with this without having the ability to take advantage of the patient base/referral patterns goodwill left behind by the departing doctor. The doctors remaining may already be fully busy and may not be able to hire a new doctor to pick up the slack and maintain the patient and dollar volume that the departing doctor had been generating while in the practice. When that is the case, the buyout price really ends up coming, at least partially, from the doctors who remain. That causes economic problems and bad feelings.

This sometimes results in a “race out the door.” Others have called it a “last doctor standing” club whereby the last one remaining gets “stuck” with a practice he/she cannot handle and buyout arrangements which are unaffordable.

I am not trying to create a “gloom and doom” scenario here. However, these are issues that are real and must be faced by the doctors in a group to be sure that their inter-doctor arrangements reflect the realities of their circumstances today.

There are several ways in which a group can attempt to at least minimize the negative impacts of such events.

As a general rule, when groups discuss and negotiate their “partnership” arrangements (before anyone knows who will be the next to leave) it is generally believed that the “good of the group” should be paramount so that the practice will be able to do reasonably well into the future and not be “bankrupted” by the buyout obligations. There are various provisions which may be included in the documentation in order to minimize the potential problems.

Most groups will require a relatively lengthy notice of termination time frame by a departing doctor before that physician may receive a full buyout from the practice. For example, some agreements call for a minimum of 180 days prior written notice for a departing doctor to voluntarily terminate employment. If less than that is provided, the buyout entitlement which the departing physician would otherwise receive would be reduced by 1/180th for every day less than 180 days for which such notice was not given.

Other groups will attempt to minimize the financial drain on the practice/remaining doctors by capping the buyout payments in any given fiscal year to a certain percentage of the practice’s gross income or net income. There is no magic percentage that fits every situation. With the help of one’s advisors, projections should be put together and critically looked at to determine what realistic “safety zone” would make sense. For example, one group we recently worked with capped the annual buyout payments to four percent of the practice’s net income – including salaries, bonus and retirement plan contributions for the remaining physician/owners of the practice.

Others will clearly state in the documentation that some or all of the buyout entitlement would be “forfeited” if the departing doctor were to compete (as defined in the documentation) with the practice upon departure and for a reasonable (perhaps the time frame of the buyout payments) time period after departure.

Other groups will provide for a lesser buyout for the doctor voluntarily leaving the practice, in comparison to what that doctor would receive if he/she were to leave the practice on account of death, disability or defined retirement (for example, a minimum of age 65 and 20 years in the practice) period of service.

Although it is not common, some groups are now attempting to balance the need to protect the group with the desires of the departing doctors to get a larger buyout than just the hard assets and receivables by using a form of “replacement physician” concept.

For example, we recently worked with a dermatology practice whereby the departing doctor would have certain financial obligations to the practice unless and until a replacement physician is employed by the practice. In the one situation, the departing shareholder doctor would agree to be responsible for up to nine months from the date of departure, as a setoff against the purchase price to which he would otherwise have an entitlement, for his pro rata share of the payment of any interest payments of the practice; the lease payments for any office real estate; the lease payments for any major practice equipment; and the like. By doing that, it does attempt to balance things from a financial risk standpoint between the two sides of the equation.

Some groups will state that there will not be a goodwill payout at all until a replacement physician is hired by the practice in a circumstance whereby the departing doctor left voluntarily. This sounds good. However, it can be very difficult to administer and can open the door to “arguments” about how hard the practice is working to try to find a replacement physician.

The bottom line is that each group needs to look at its situation very carefully and critically to assure that everyone understands what the present documents say and what the economic realities of the day are. With the assistance of experienced advisors in this field, the group will hopefully be able to arrive at a buyout arrangement that balances the interest of all parties and that the doctors can live with.

Another thing to be aware of relates to who is responsible for making the payments. If one is dealing with a practice that is a professional corporation or LLC (where there is limited liability on behalf of the owners), the entity alone is responsible for making these payments unless and until individual physicians personally guarantee the obligations. It is therefore important to look at the documents and see if the physician and/or his/her spouse are guaranteeing these obligations for the departees.

Vasilios J. Kalogredis, J.D., is Founder and President of Kalogredis, Sansweet, Dearden and Burke, Ltd., a boutique health care law firm in Wayne, Pa.

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