Medical Practice Valuation: An Important Decision

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By Monica Kaden, MBA, ASA
Manager, Business Valuation
WISS & Company, LLP

Reprinted from M.D. News, May 2006

Valuations of medical practices are necessary for a variety of reasons. These include buying or selling a practice (or a percentage of the practice), divorce, litigation and estate planning. In ten years of performing business valuations, most of the medical practice valuations have been because of divorce or partnership changes.

The primary method of determining a practice’s value is to evaluate the cash flow and any risks of the practice. In order to evaluate the cash flow of the practice, a review of expenses is made to determine discretionary versus non-discretionary expenses. Discretionary expenses are those not required to maintain the practice. They include perquisites enjoyed by doctors such as cars and travel paid for by the practice. Non-discretionary expenses are those which maintain the practice, including employee salaries, rent and equipment purchases. Another important aspect of valuation is determining an appropriate “replacement compensation” for the owner physician. Replacement compensation is what the owner physician would have to pay another physician (usually younger, less experienced and less costly) to come in and perform the same function as the owner physician. There are almost always “excess earnings” between the owner physician’s salary and the replacement compensation. These excess earnings become the basis of calculating goodwill in the practice.

A practice’s reliance on managed care and third party insurance payers influences its market value. Boutique medical practices, which do not accept insurance and have a stable patient base willing to pay out of pocket for services, are more valuable because their earnings are protected from arbitrary decisions made by third party payers. Other factors affecting a physician’s practice investment include the presence of partners, local competition, property owned by the practice and the desirability of a practice’s location.

For practice sale purposes, real property owned by a practice, such as a building or condominium is usually valued separately from the practice. This is because the physician selling the practice may decide to keep the property and rent to the purchasing physician. Real property should be appraised separately by a certified real estate appraiser.

Medical equipment value is usually included in a practice’s value. The condition and age of the medical equipment is the most important determinant of value. If a buyer will need to purchase new equipment soon because the practice’s equipment is obsolete, then the anticipated costs of new equipment are included in the valuation. Alternatively, if equipment is new and the selling physician has not yet reaped the benefits from the equipment, then additional value can be added to a practice.

The three primary methods used to value a medical practice and any other businesses are 1) the income approach, 2) the market approach and 3) the asset based approach. These methods are generally accepted valuation approaches used by certified business appraisers. When a physician decides to have a valuation performed on a medical practice, finding a certified business appraiser is the next step. The most recognized credentials in business valuation are: ASA (Accredited Senior Appraiser), CPA/ABV (Certified Public Accountant Accredited in Business Valuation), CBA (Certified Business Appraiser) and CVA (Certified Valuation Analyst). An appraiser with one of these designations has had formal business valuation training, documented several years of experience and demonstrated competence in the field to peers.

There are scopes of engagement that an appraiser can provide. The American Society of Appraisers permits three different levels, a full appraisal, a limited scope appraisal and calculations. A full appraisal is the most extensive and correspondingly expensive approach. A full appraisal provides a complete report with all components of the valuation explained with schedules. This is the best support for negotiating purposes (i.e. buy, sell, merger, divorce, litigation). A limited scope appraisal encompasses the same analysis as the full appraisal, but the report is more limited and less expensive. Calculations are just that – calculations on schedules and sometimes a letter is attached.
After performing all of the approaches and analyzing the results, the appraiser concludes on a value. This process typically takes 5 to 6 weeks from inception to completion. Fees for a full appraisal are typically $10,000 to $15,000; the other more limited scopes would correspondingly be less.

Here are two practice valuation scenarios intended to provide a sense of the considerations taken when medical practice valuation is performed. It should be noted that the income approach is considered the method of choice for valuing medical practices. There are market transaction databases that reflect sales of practices, however, there is insufficient detail regarding the transactions, which is necessary for an appraiser to show comparability. Thus, most appraisers do not rely on the market approach to determine value. The market approach is a good “sanity check” to values determined using the income approach.

Scenario 1

Dr. A, a 58 year old internist and Dr. B., his 32 year old associate of three years are discussing partnership. Dr. A would like Dr. B. to buy 50% of his 20-year-old suburban practice. They have agreed that a buy in can occur over five years based on the fair market value determined today. The following is an income approach calculation to determine value:

Computation	Amount
Income of Practice (after physician salaries)	$150,000
Plus/Minus Adjustments (1)	25,000
Cash Flow of Practice	175,000
Capitalization Rate (2)	20%
Value of Practice	875,000
Plus/Minus Non Operating Assets (3)	42,000
Value on control, marketable basis	917,000
Pro Rata 50% interest	458,500
Discount for Lack of Control – 5% (4)	22,925 435,575
Discount for Lack of Marketability – 20% (5)	87,115
Fair Market Value of 50% interest on Minority, Non-Marketable basis	$348,460

1. Adjustments include depreciation, capital expenditures, reasonable compensation and perquisites.
2. The capitalization rate reflects the required rate of return on an equity investment in the practice.
3. Any assets or liabilities that are not related to the business of the practice (i.e. bank CDs, loans made), or brand new assets, such as machinery, that have not generated revenues.
4. A discount for lack of control is applied because a 50% shareholder does not have control of the practice.
5. A discount for lack of marketability is applied as the practice is not readily saleable like a stock which can be converted to cash in 3 days.

Scenario 2

Dr. A is getting divorced from his wife of 25 years, and a valuation of his one third interest in a urology practice must be performed. Dr. A’s share in the practice is considered a marital asset. In New Jersey, valuations for divorce or shareholder disputes must use the “fair value” standard of value. This is different from fair market value, which is inclusive of valuation discounts (when applicable). A valuation performed for litigation almost always commences with an analysis of the practice’s financial records and a review of expenses.

Computation	Amount
Income of Practice (after physician salaries)	$250,000
Plus/Minus Adjustments	35,000
Cash Flow of Practice	285,000
Capitalization Rate	19%
Value on Control, Marketable basis	1,500

1. No discounts for lack of control or lack of marketability are applied due to divorce case law in New Jersey.

Medical practice valuation is an important business decision made by a physician. This article is intended to enhance physicians’ understanding of the valuation process. Medical practices are unique and each requires an individualized approach from a skilled valuation professional. These professionals should bring a rational understanding of the marketplace to what is often an emotionally charged negotiation or litigation situation.

Monica Kaden, MBA, ASA is a Manager specializing in Business Valuation at WISS & Company, LLP. Ms. Kaden can be reached at 973-994-9400 or mkaden@wiss.com.

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