Group Practice Buy-Outs: What’s Fair? What’s Affordable?

By Daniel M. Bernick, Esq.

Many physicians in private group practices are alarmed by news of health care reform and other developments affecting their practice finances.  Some physicians have responded by abandoning private practice in favor of hospital employment.  Other physicians still want their autonomy, and are committed to private practice.  But they wonder: are the documents that they signed years ago are still reasonable in light of all that is happening in health care?  Will they remain reasonable if reimbursements go down, or expenses go up, or both?

There is no question that the challenges to physicians in private practice have been coming fast and furious in recent years (higher associate physician salaries, Stark, HIPAA, anti-markup, elimination of consult codes, EHRs, etc.) and show no signs of letting up.  At the same time, it is important to remember that physicians have a wonderful “franchise” in the form of their medical licenses.  The system cannot function without doctors and in many regions and specialties they are scarce.  Further, demand for medical services is only going to grow as the huge baby boom generation ages and medical and pharmaceutical technology advances.

So there is no need for panic.  At the same time, private practice physicians cannot remain complacent.  And part of staying on top of things is making sure that old contractual commitments are still appropriate.  Here are some basic guidelines.

First, the buy-out arrangement must be in writing.  This may seem obvious, but not infrequently we encounter situations where partners have never “gotten around” to signing a buy-sell agreement, or “couldn’t agree on what it should be.”  This is a disaster waiting to happen.  The best example of such a disaster is the death of a partner.  Now the remaining partners must negotiate a reasonable buy-out value with the grieving spouse, who may mistrust them or harbor ill will due to prior inter-doctor conflicts involving the deceased.  Such a spouse may also lack knowledge of the Practice’s finances, or valuation concepts, or both, leading to wildly exaggerated ideas of what the Practice (and the buyout) is or should be worth.

Assuming that the buy-out is in writing, the next step is to make sure it is valued and structured appropriately.  There are three basic values that should be priced:  equipment and supplies (net of debt and other liabilities); accounts receivable; and goodwill/intangibles, including such various items as going concern value, patient loyalty, charts and patient lists, workforce in place, phone numbers, and all systems in place and ready to operate a medical practice.

In a typical, incorporated medical or dental practice, the nominal stock buy-out price in the Shareholders’ Agreement is based on equipment and supplies only (net of debt).  Traditionally, receivables and goodwill are generally not factored into the stock buy-out.  Instead, they are reflected in separate “deferred compensation” or “severance” payments.  This structure has a beneficial tax result, from the perspective of the group: the non-deductible portion of the payment (stock) is kept low, since it reflects the more moderately priced “hard asset” values.  The severance payment delivers the remaining, more substantial values (receivables, goodwill) in a tax-efficient (deductible, pre-tax) manner.

The stock portion of the buy-out may be valued at tax book value, or tax book value with adjustments (to better approximate true economic value.)  Regardless, it is generally not a contentious item, and its payment does not (generally) threaten the ongoing finances of the group or the incomes of its remaining partners/shareholders.

The severance payment, however, may be a contentious item.  Payout of personally generated receivables is generally accepted without fanfare, but additional monies based on intangibles values may generate heated conflict.  Intangibles are hard to value, and are often substantial.

Let’s assume that goodwill is factored into the severance payment.  How should it be priced?  One method is to attach a fixed value to it (e.g., $300,000), and then say that the departing physician is entitled to a portion of this total value based on his percentage stock share.   A similar approach is to use a formula, such as a specified percentage of the Practice’s average annual total revenues, as they exist in the year or two or three prior to buy-out (e.g. 30% of gross revenues of $1 million is a goodwill value of $300,000).  Again, the departing physician receives a portion of this total value based on his percentage stock share.

This percentage-of-gross-revenues method has been used in severance formulas for years.  Its advantage is that it is easy to use, and it self adjusts to practice growth, yielding a larger goodwill value as the practice expands.  However, it has some vulnerabilities, most notably that it does not reflect changes in Practice overhead over time.  Such rising overhead can erode profitability, which in turn depresses goodwill values.

For this reason (and others), the physician group should consider a more recent, alternative approach.  The severance payout is based on prior physician W-2 earnings, rather than on gross revenues.  For example, a physician’s severance payment might be one times his last complete year’s W-2 earnings (or his average annual W-2 over the past two or three years).  Typically, such a “one-times-net” payout includes the physician’s interest in both receivables and intangibles; such a severance payment is sufficient to cover both values.

Thus, if earnings decline over time, whether due to loss of revenue or increased overhead, the severance payout automatically adjusts.  The document sits unread in a desk drawer for years, yet there is a very good chance that when it is brought out again (because a physician has died, or is retiring), the amount owed to the doctor under the W-2 based formula in the document will still make sense in light of then existing finances.

Whatever the amount of the buy-out, the departing doctor would prefer that it be paid as quickly as possible, to maximize time value of money, and avoid future risk of default.  Yet it is more important that the group be given adequate time to comfortably make the payments.  It makes no sense to “kill the goose that laid the golden egg” by overburdening the remaining partners with an accelerated payout.  A too-fast payout may trigger a destructive “race for the door”, as group members worry that only the doctor who leaves first will get full payment.

Thus, for a one-times (1x) W-2 severance payout, we typically recommend an extended 60-month payout, without interest.  This generally yields a payment plan that the remaining partners can comfortably sustain, while still getting the departing doctor his funds on a reasonable schedule.

Several other buyout provisos are important.  For example, what if the departing physician is leaving to set up shop across the street?  Should he still receive a full payout?  Most groups would say no, at least with respect to that portion of severance which is based on intangible values, and possibly with respect to receivables as well.  The departing physician is damaging the group through his or her competition, and should not be rewarded with a big payout.

Another question is whether a physician who is terminated for cause should get a full buyout.  Most or many groups would again say “no.”   Physician groups are reluctant to terminate shareholders, even when justified.  Thus, a physician who actually is dismissed for cause must have done something extraordinarily bad, and that bad thing likely hurt the group in some way.  For example a physician who loses his license or hospital privileges may have hurt the group’s reputation with referrers or patients.  A physician who sexually harassed a staff member may have created huge legal liability for his group practice partners.

Other groups take the view that differentiating the buyout amount based on “cause” versus “without cause” termination is invitation to litigation.  Whether there is “cause” may not be clear, but if hundreds of thousands of dollars depends on the answer, the parties may seek to manipulate the facts, and this in turn may lead to a court battle.

Groups rightly worry that a post-departure decline in group reimbursements may make a previously “reasonable” payout become burdensome.  A good way to mitigate this risk is to incorporate a limit on payout payments in any single post-departure year.  For example, a typical proviso would be that the total severance payments in any given year to all departed doctors may never be more than 3-6% percentage of the practice’s receipts in that payment year.  To the extent that the payout exceeds such limit, the excess is carried forward and tacked onto the back end of the severance payment plan.  The basic idea is that with such a limit, the payout can never be more than a modest overhead line item for the Practice.

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Daniel M. Bernick,, Esq., M.B.A. is an Attorney and Principal of  Health Care Law Associates, P.C. and The Health Care Group in Plymouth Meeting, Pennsylvania.  He can be reached at 610.828.0360.