By Daniel M. Bernick, JD, MBA
With advances in medicine, more and more outpatient procedures are migrating from the hospital into ambulatory surgicenters. And with the migration comes an attractive investment opportunity for surgeons and other proceduralists. Surgicenter involvement typically offers the surgeon increased control over the facility in which he or she performs procedures (via ownership of voting equity in the entity) and financial rewards (dividends to the doctor derived from facility fees.)
But as with all opportunities, there are risks to consider. Investment in a surgicenter (whether construction of a new center or buy-in to an existing center) requires contribution of significant capital (perhaps $50,000 or more) and execution of complex and substantial legal documentation. Potential investors are thus well advised to seek professional assistance from health care lawyers and consultants in evaluating the financial and legal aspects of the proposed arrangements.
Types of Surgicenter Deals
There are two basic types of surgicenter transactions, from the buyer’s perspective. It’s the old “make or buy” choice. The “make” approach is construction of a new surgicenter. This can be a 100 percent surgeon-owned center, or a center that is co-owned with the local hospital or with a professional surgicenter developer. To participate in this type of transaction, the surgeon investor will normally be asked to make an initial capital contribution and sign an LLC Operating Agreement or other materials obligating the doctor to make additional capital contributions as needed. The Operating Agreement will also specify the terms for buy-out of an investor in the event of death, disability or other major event.
The “buy” transaction is a buy-in to an existing surgicenter. This will typically be structured as a purchase of shares in the surgicenter (if the surgicenter is a business corporation) or purchase of membership interest (if the entity is an LLC (limited liability company). Either way, payment is typically made by the new investor directly to the existing investors, either all cash, or part cash and part payment over time. The new investor then signs an addendum making him or her a party to the existing Shareholders’ Agreement (for a surgicenter that is a corporation) or LLC Operating Agreement (for a surgicenter that is an LLC).
Buy-In to Existing Surgicenter
The risks of the “buy” decision are generally lower than the “make” decision. In a “buy” scenario, the financials of the surgicenter are already established. There is a financial “track record” for the new investor to scrutinize as he or she deliberates the pros and cons of investing. The new investor can review numbers of cases performed at the surgicenter, annual revenues, reimbursement per procedure, payor mix and reimbursement policies, and so on. The identity and procedure volumes of the current investors are well established, thereby enabling the newcomer to assess the likelihood of a drop off in revenues due to surgeon investor retirement or disability.
If the surgicenter is operated by a professional ASC developer, the potential investor can also inquire regarding the developer’s management skills. Are the current investors satisfied with the “value added” equation (fees versus services provided)?
The next part of the financial review is to assess whether the purchase price to buy into the surgicenter is a reasonable one, given the existing and expected future profits, including the contribution of the new investor. While professional surgicenter companies such as Amsurg will pay five or six times “EBITDA” (earnings before interest taxes and depreciation) for an equity interest, surgeon investors who can contribute to volume should expect to pay a far lower “multiple” of earnings, generally two to three times existing earnings. A two- to three times multiple is equivalent to an expected rate of return of 33 to 50 percent on invested equity. Not bad, compared with returns on stocks and bonds in recent years!
Other factors to consider are the terms of the existing buy-sell agreement, to which the new investor will be become a party. In particular, the new investor should, with the assistance of legal counsel, carefully assess the following points:
· What are the terms for future buy-out of any one investor? When can a surgeon be forced to sell his or her shares? What rights does an investor have, if any, to sell his or her shares to a new investor, without approval by the group?
· What price must be paid for the repurchased equity? Does the price vary depending the circumstances of departure (e.g., expulsion versus voluntary departure, “bad boy”/cause termination scenarios)?
· Does the buy-sell agreement comply with the federal government’s “safe harbor” regulations?
· What are the voting rights of the various parties? Do any investors have special veto rights or other unique privileges? What is the scope of authority of the managing surgeon?
· What financial statements or other reports will be provided to the investors on a regular basis?
· Under what circumstances may the investor may be asked to “pony up” more money?
· Is there a prohibition on investment in other surgicenters in the area?
· Is there any provision addressing how new investors are to be brought in? Who makes the decision whether to admit the new investor? Who sells the equity to be purchased by the new investor?
· What happens if, within six months or one year after buy-out of a surgeon, the remaining investors sell the surgicenter for big dollars to an Amsurg or other institutional investor? Does the recently departed investor share in any of this “big buck buyout?”
If a professional surgicenter developer is managing the surgicenter, there will be a Management Services contract. Then have legal counsel review it for at least the following points:
· What is the fee for management services, and is it a fair one, in line with industry standards? Is there a separate fee for billing and collection? Is it fair?
· What is the scope of authority of the surgicenter manager? At what point does the manager need to seek authority from the investors?
· What are the rights of the investors to terminate the manager (i.e., “cause” termination)?
· If the manager is terminated, what price must be paid to repurchase the manager’s equity interest in the surgicenter? Are there other “damages” that must be paid in this circumstance?
· What financial statements and other reports must the manager prepare for investors? Are there any controls assuring the accuracy and truthfulness of these reports?
· Can the manager select its affiliated entities as vendors to the surgicenter? What controls are there on this selection process to obviate concerns over conflict of interest?
· Does the manager have the right to assign the management contract to a new manager, without the consent of the investors? Management companies typically view their management contracts as “assets” that can be assigned to a “buyer” (new management company) that will take over from the initially selected manager. Yet the investors may not feel comfortable with the manager’s designated replacement. Can they veto the assignment?
Buy-In to New Surgicenter
In the “make” approach, the risks are greater because the financial viability of the new entity is not well-established. Physicians considering such an investment should not proceed without extensive financial due diligence on the new entity. A pro forma should be prepared with all assumptions explicitly spelled out, in terms of expected numbers and types of cases to be performed at the center, and the average dollar level of reimbursement expected for each procedure. Start up capital costs and first year revenues and expenses should all be carefully delineated.
If a professional surgicenter developer is involved, due diligence on the track record of the developer is also needed. How many other surgicenters has the developer built? Is the developer experienced with the type of surgicenter being proposed, in terms of specialty (ophthalmology, gastroenterology, multispecialty etc.)? Does the developer have experience in the specific geographic market in question? (Goes to the developer’s knowledge of applicable reimbursement levels and contracting opportunities.) Is the developer promising non-recourse financing? If so, can this be verified?
The first step in due diligence in developer deals is to query the developer directly. The second step is to query surgeon investors in prior deals put together by the developer, and also the developer’s banks or other sources of financing.
After the financial due diligence, the legal review is critical. Carefully review the proposed documents on the issues bulleted above.
When performing due diligence, one very helpful document is a “PPM” or private placement memorandum. This document is sometimes, but not always, prepared in conjunction with the initial investment opportunity for a surgicenter that is not yet built. The PPM is not legally mandatory. However, it is frequently prepared for new surgicenters on the advice of counsel as an effective means of mitigating legal risk for the developer or organizer of the surgicenter; it serves to protect the developer/key player against securities law claims that the developer/key player failed to adequately disclose the financial and legal risks of the venture to the surgeon investors. It therefore discloses, in detail, all possible risks associated with the surgicenter, so that the investor cannot later claim to have been hoodwinked.
Generally, the PPM is prepared for investors in a surgicenter that is not yet built. It is not typically revised or updated when an initial investor sells out to a second generation investor. So it is of limited utility for investors who buy into existing, up-and running centers. By then the risks that were discussed in the PPM have either materialized or not materialized.
One final point. Never contribute money without execution of all relevant agreements, and never sign agreements on a verbal promise that “we can revisit the documents later.” Once the documents are signed, they are rarely changed, or at least not until later events uncover a major problem, and then it’s too late.
Daniel M. Bernick, JD, MBA is a shareholder in The Health Care Group and its affiliate Health Care Law Associates, P.C. in Plymouth Meeting, Pennsylvania.