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Key issues in merging medical practices

By Daniel M. Bernick, JD, MBA.

Medical practices can achieve a number of major, long term benefits through merger. But many potential mergers never happen because the parties lack sufficient guidance to plow through and resolve the many decisions that need to be made. This article is designed to assist physicians in identifying and resolving the key business and legal issues.

Objective. What are the anticipated benefits of merger, to this specific group of doctors? Potential benefits include greater leverage with payors; pooling of financial and human resources; more efficient use of expensive resources (e.g., new associate physician); expanded opportunities for cross-referral of patients and capture of ancillary revenues; and greater attractiveness to physician recruits. The basic point is to be clear what the benefits are, so that the parties can remind themselves periodically and thereby generate sufficient continuing motivation to “get through” the pre-merger meetings, make the hard decisions and absorb the short term costs of merger.

Relationships. How well do the parties know each other? Merging is an act of faith. Each physician must trust that he will be able to get along with his future merger partners. Some of the fears about mergers can be mitigated through various legal provisions, discussed below. However, bottom line, no one can be sure how things will work out. Thus, prior relationships are key to providing the reassurance needed to “take the plunge.”

Par or non-par? Generally, the merger parties need to be on the same page in terms of par or non-par status with Medicare and other key insurances. If not all physicians accept the same insurance, patients will be confused and annoyed, and cross coverage, patient scheduling, marketing and operations may all be impeded.

Compensation Formula. The parties should address this early on, as differences here can be deal killers. Is it “eat what you kill” or equal sharing, or a combination? Are any major changes in compensation expected as a result of the move to a new formula? Transition provisos may need to be established.

Malpractice Insurance. It is awkward to have different carriers insuring different physicians within a consolidated group. Some carriers will not provide insurance at all in this situation, and others will refuse to insure the entity. Neither is desirable.

Retirement Plans. Merger generally means adopting a single retirement plan. Thus, the physicians must agree on the terms of the new plan, which can be the same or different from either of the pre-existing plans. Once the plan features are agreed, the accumulated assets from each pre-existing plan can be transferred into the new plan (without tax).

Equipment, Staffing, and Space Needs. There will likely be duplication of existing resources in these areas, between the merger parties. Which of these resources will be retained, and which let go?

Legal Structure of Merger. Assume that the merger will involve two PCs. PC 1 is owned 50/50 by two shareholders. PC 2 is likewise owned 50/50 by two shareholders. There are two basic options in terms of forming a single entity.

· Merge PC 1 into PC 2. PC 1 goes out of existence. Its medical practice becomes a part of PC 2, which is the “surviving” entity. PC 2 has all of its pre-merger assets and liabilities, plus those of PC 1. The shareholders of old PC 1 exchange their shares of stock in PC 1 for stock in PC 2. All former shareholders of PC 1 and PC 2 now own equal 1/4 shares in PC 2.

· Start a “fresh” PC 3. PCs 1 and 2 distribute their equipment and charts (but not their receivables or liabilities) to their shareholders. The shareholders then transfer the equipment and charts to new PC 3, together with a working capital infusion of cash, in exchange for an equal 1/4 stock interest in PC 3. PCs 1 and 2 collect their remaining pre-merger receivables, and use the proceeds to pay off their pre-merger liabilities and make final distributions to the physician owners. PC 3 uses the capital infusion from the shareholders to cover expenses until monies from post-merger receipts begin to come in.

The appeal of the latter approach is that it arguably allows the doctors to “start fresh,” in terms of liability for past malpractice, reimbursement issues, and so on. Theoretically, shareholders of PC 2 need not worry that association with the PC 1 doctors will expose them (the shareholders of PC 2) to unknown contingent liabilities of PC 1, such as a Medicare audit of prior claims, tax problems or sexual harassment claims. Similarly, shareholders of PC 1 need not worry about old, unknown liabilities of PC 2. However, it is questionable whether the formation of a new PC will in fact provide this liability shield. It can surely be expected that any plaintiff desiring to sue PC 1, for example, will sue PC 3 as well, claiming that PC 3 is the “successor”to PC 1 and should be held responsible for PC 1’s liabilities, particularly if PC 1 has since dissolved or is an empty “shell,” having previously collected its old receivables and distributed the proceeds out to its shareholders.

There are two other concerns with the “start fresh” approach. First, on the reimbursement side, new provider numbers need to be obtained for PC 3. Depending on the number of carriers involved, this may be an onerous administrative task. Also, delays in obtaining the new numbers may impede the cash flow of the new entity during the vulnerable, start-up phase.

The other concern with the “start fresh” approach relates to taxes. The distribution of equipment and charts out of the old PCs is viewed by the IRS as a deemed “sale” of these assets, and therefore may trigger taxes at both the corporate and individual level.

For these reasons it may be preferable to opt for the first approach outlined above, namely, outright merger of the PCs. This is perhaps less satisfactory from a liability perspective, since all liabilities of the prior entities are clearly inherited by the new consolidated entity. However, PC 1 shareholders can mitigate this risk by doing pre-merger due diligence on PC 2 (review old financial records, ask questions regarding potential malpractice claims or prior audits, look at chart documentation and coding patterns), and PC 2 shareholders can do the same on PC 1. Further protection can be obtained through appropriate provisions in the merger documentation; PC1 shareholders agree to indemnify PC 2 shareholders against any negative financial effects from old PC 1 liabilities, and vice versa. With these precautions, the liability risks of outright merger can be managed.

Outright merger of the two PCs is generally free from tax as a “reorganization” under IRS rules. In addition, on the reimbursement side, there is a significantly reduced burden in terms of getting new provider numbers. PC 2 as surviving corporation can use its old numbers to bill out all post-merger services of all physicians. (The individual provider numbers from PC 1 shareholders would be reassigned from PC1’s old corporate number to PC 2’s corporate number.) Finally, the merger should not create concerns with bankers and landlords of PCs 1 and 2, although of course the physicians should check their loan documentation and office leases for “change of control” provisions.

Equalization. Some groups, when they merge, “equalize” assets contributed. In other words, each merger party is responsible for bringing to the table an equal amount of assets (net of associated liabilities). This certainly makes sense for cash and debts, but may need to be carefully reviewed with respect to other items which have a less easily identifiable value, such as equipment. Further, if there is duplication of equipment items, some will need to be discarded, and the party discarding them should not be penalized by excluding them from the equalization calculation.

One way of side-stepping the equalization dilemma is to provide that if one party contributes more equipment than the other, that will be reflected in any future buy-out. In other words, a physician who contributes less equipment is not required to make up the difference with cash, but if he should leave the merged practice in the future, his buy-out will be smaller than someone who contributed more equipment.

NonCompete Provisions. Generally all merger parties should be subject to non-compete provisions, or none should. Probably it is best to start without non-compete provisions, since the parties are typically reluctant to bind themselves in this way, not knowing how the merger will play out. A non-compete provision can be inserted later, perhaps after three or four years, when the merger partners have a greater confidence in each other as long-term partners.

A less restrictive alternative to a non-compete clause is a simple limitation on future buy-out. An unhappy merger partner can leave and compete, but there will be a price to pay in the form of a reduced buy-out to the competing doctor. This permits the competition, but discourages it, so as to incent the doctors to stay together.

Bail Out Clause. This helps alleviate pre-merger “jitters.” The provision effectively allows either merger group to “unwind” the merger in their first year or 18 months, if they feel the merger is not working out for any reason. The concept is that each merger party is restored to as close to its pre-merger position as possible. The single merged PC or other entity will be split into two (hopefully qualifying as a tax-free reorganization under IRS rules), and equipment and intangibles contributed are restored to their former owners. Items acquired jointly, post-merger may be handled via a “shootout” provision, in which one party makes a cash offer for a desired item, and the other party can either accept that offer or is required to buy the item at the proposed price.

Typical bail out provisions address the allocation or handling of the following items: patient lists, charts, phone numbers, leaseholds, staff, equipment, and corporate name and entity.

Governance. There needs to be agreement on who will manage, and what percentage vote will be needed to approve group decisions. Typically, majority rules, but oftentimes there are some issues that require unanimous approval, such as sale of the merged practice, dissolution, taking on bank debt or purchasing an expensive item, opening or closing an office, or admitting a new partner or terminating an existing one.

Future Buy-Sell Arrangements. Does one group have a set of documents that is acceptable to the other merger party, so that those prior agreements can be used? That will facilitate the process, and eliminate any issue, in terms of drawing up arrangements from scratch. Address whether the newly merged entity has new needs in terms of buy-out triggers and valuation formulas.

Pre-existing Buy-In. When the merger occurs, there may be a buy-in in progress, within one of the merger parties. How should this be handled? Typically, buy-ins in progress are continued, so that the senior physicians who negotiated them can continue to benefit. Possibly, the buy-in may be modified, if there is going to be significant change in the underlying compensation formula, as a result of the merger.

These are some of the major business and legal issues to be dealt with on the road to medical practice merger. With proper planning, these issues can be successfully negotiated and resolved. If so, the parties are on their way to a potential fruitful alliance, and more enjoyable future practice life.

Daniel M. Bernick, J.D., MBA is an attorney/consultant with The Health Care Group, a health care law and consulting firm in Plymouth Meeting, Pa. specializing in physician practices.

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