If you are ready to make a graceful exit and want to ensure that you are compensated appropriately for the business you have built the first step is to quantify the value of your practice. When valuing a business you must choose a valuation method that will hold up in court against both the IRS and other interested parties. The practitioner and his advisors must understand the strengths, weaknesses, and suitability of each valuation method not only to arrive at the highest dollar amount but also at the strongest argument for value after the fact. In the words of The Treasury, fair market value (FMV) is,
"the net amount a willing purchaser...would pay for the interest of a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts" See IRC Reg. Sec. 20.2031-3.
Key words being, " reasonable knowledge of relevant facts".
When arriving at fair market value and the disclosure and communication of relevant facts there are legal and Treasury precedents established. According to the IRS, FMV is arrived through an analysis of the Business Enterprise's Value (BEV). BEV is typically derived through the market approach, cost/ assets based approach, and income approach.
This is least defendable approach to valuing your business. The market approach relies on comparables. Similar to a real estate transaction, when valuing your business though the market approach you are comparing your practice the readily available value of similar businesses. However, there are no publicly traded physician practices and, therefore, to arrive at a valid valuation your practice would need to be based on long term service arrangements where you can quantify the cash flow of similar businesses. This type of valuation bleeds into the income approach which will be discussed later. Additionally, until recent Medicare reimbursement disclosures became accessible by the public, most physicians keep information on net sales confidential and have reduced the ability to establish a precedent. Unless you have a materially similar practice in your geographic location with a similar demographic client base sell within a short time horizon to your agreement it will be difficult to substantiate the comparability of your businesses value.
While the market approach is a clumsy way to establish a true BEV for the practice as a whole it is certainly appropriate for certain assets. For instance, if the practice owns the real estate in which it operates a FMV for the real estate itself must be established assuming the physical structure of the practice comprises a portion of the consideration in the agreement.
Cost/ Assets Based Approach:
The cost approach is based on dollar value to replace or reproduce an asset of the company while taking into account deterioration, obsolescence, and depreciation. The practice we need to value assets based on the cost to reproduce, replace, the actual cost of an asset, or the depreciated cost of an asset.
Reproduction will typically provide the highest cost for an asset. Consider an practice's building built 60 years ago with a plumbing and electrical infrastructure of nearly 100% copper. To reproduce the weight of the copper in today's current value would cost a literal fortune. In this case, applying the reproduction method of valuation to the practice's assets would result in a higher valuation.
Replacement cost is based on the fair market value of an asset in use (FMVIU). FMVIU accounts for the obsolescence of a practices machinery and medical equipment. Similar to a depreciated valuation, the replacement cost will discount assets for the value of their usefulness in the current market environment. However, unlike depreciation, there is no designated scale for the reduction of cost. The valuation encompasses a comparison of the original purchase price, the current price of similar equipment, and a reduction in value for estimated use.
Similar to FMVIU, the asset is based on the original purchase price. Unlike FMVIU it does not account for functional obsolescence and is typically used for older equipment that will reduce the "turnkey" ability of the acquiring practice to put the asset into productive use.
This approach typically results in the lowest value and is seldom used when the seller values the practice. Depreciated cost will result in the actual cost reduced by the IRS schedule for an asset's useful life.
The income approach attempts to measure the value of the stream of income stemming from business activities. The income approach is, in essence, a combination of the Discounted Cash Flow method (DCF), the Capital Asset Pricing Model (CAPM), and Weighted Average Cost of Capital (WACC). Without a deep background in valuing companies this discussion will be lost on most individuals outside of the mergers and acquisitions community. What is most important to a medical business owner is ownership and discount rate.
The difference in ownership between payor and physician will play a material role in the value of future cash flows. A managed care practice is dictated by the payor. A fee for service model will command a much higher value for the volume, number, and per capita revenue per relationship.
Discount Rate & Capitalization Rate:
The key step to a DCF analysis s the assumed discount rate. A discount rate represents the rate of return a prospective buyer would accept for the risks and opportunities presented by a business's client base, assets, and reputation. For the purposes of this series we will abandon the actual mathematical equations used to derive WACC and CAPM. Instead, we will utilize James H. Schlit's, "A Rational Approach to Capitalization Rates for Discounting the Future Income Streams of a Closely Held Business" (The Financial Planner, January 1982). According the Schlit, medical practices fall into the 26 -30% discount rate category of, "small one-person businesses of a personal service nature where the transferability of the income stream is in question".
The capitalization rate refers to the combined company growth rate in conjunction with the discount rate. If a company has grown at 8% for the past three years and the discount rate is 28% then the true capitalization rate would equal 20% (28% Discount rate minus 8% growth rate).
The point being that, through the DCF model, the lower your discount rate, the higher the value of your business is based on projected and historical income.
Conclusion: Spend the Money to Value Your Practice
If the aforementioned valuation synopsis was Greek to you then valuing the actual company might give you an intellectual hernia. Point being; pay someone. The relative expense to appraise versus value derived in conjunction with the confidence you will bring to the bargaining table will be well worth the expense.
Click Here to read Lesson 1: The First Rule of Owning a Business is Always Be Prepared to Sell.
Click Here to Read Lesson 3: Well, I’m in the Market…and That’s Scary
Samuel P. Boyd is a CFP® and registered investment advisor based out of Capital Asset Management Group’s Bethesda, MD headquarters specializing in retirement planning, risk management, and succession planning for closely held business owners. He can be reached via email at email@example.com
Securities licensed associates of Capital Asset Management Group Inc. are Registered Representatives offering securities through Cambridge Investment Research, Inc. A Broker/Dealer. Member FINRA/SIPC. Licensed administrative associates do not offer securities. Investment advisory licensed associates of Capital Asset Management Group Inc. are Investment Advisor Representatives offering advisory services through Capital Investment Advisors, Inc. A registered investment advisor. Capital Asset Management Group and Capital Investment Advisors are separate and unrelated companies from Cambridge.