by Keith Borglum CHBC
There are many occasions when knowing what your practice is worth is important information. The most common reasons for getting a practice valuation has always been for purposes of practice sale, buy-in, pay-out or for marital divorce. Most of the debate about the value of medical practices settles around "goodwill" value.
The Goodwill Registry published by The Health Care Group is the leading database in the country on the value of goodwill in physician practices. It is a resource often quoted and used in practice appraisals, court cases, mergers, buy-ins and pay-outs, specifically in the Market-Comparison Approach to value.
The Goodwill Registry is a tool, like a scalpel. It has value when used correctly, but can be harmful when used incorrectly. The purpose of this article is to help you use it correctly.
The Goodwill Registry reports goodwill as a percentage of revenues (ie “collections”). Per the Goodwill Registry, “in a commercial context, goodwill is "the likelihood that old customers will return to the old place," as well as a sometimes separately identified "going concern" value. In a professional practice, these values may exist but may account for little "goodwill." As we see it, professional practice "goodwill" is a combination of practice intangibles varying, on a case-by-case basis, as to existence and value. That combination might include location, use of a practice's or individual's name, patient information (embodied in the clinical record), a favorable leasehold, a covenant not to compete, compensation for past (or future) management and entrepreneurial services, payments made for referral to an associate or recommendation of a successor, patient lists, credit records, patient care and/or employee contracts, as well as assignments of future income.”
“The Goodwill Registry does not attempted to distinguish these practice values. While an allocation among these practice intangibles is often negotiated in an outright sale, usually no distinction is made in co-ownership arrangements, mergers, divorce evaluations or similar transactions. The Goodwill Registry reports the sum total of practice intangibles under a term of convenience, as ‘goodwill’. Information from the Goodwill Registry report is intended to be used as benchmark data.” (italicizing mine, you’ll see later why this is important).
Other entities have different definitions for goodwill, which causes confusion. For example, the new Small Business Administration (SBA) definition for bank loans as of March 2009 is “Selling price minus the sum of the book value of all assets being purchased” in an asset sale, but “Selling Price minus [the sum of the book value of all assets being purchased minus the sum of all liabilities that are being assumed]” for stock sales. Most practice sales are “asset sales” so that the buyer doesn’t inherit the malpractice liability of the seller. Most buy-ins to groups are stock sales. State divorce courts often have even different definitions. Other experts opine that goodwill is what is left over after subtracting all the other tangible and intangible assets and liabilities.
The printed The Goodwill Registry report identifies the value of Goodwill as a percentage of annual revenues, but this view can be very misleading to the uninformed reader relying on it for valuation. Acquiring the underlying The Goodwill Registry Toolkit database allows the professional analyst to view the data in various ways comparing revenues, goodwill, earnings, location, year, etc. It is important to note that The Goodwill Registry also includes non-sale data that should often be excluded in a valuation of a practice for sale or buy-in, like valuations for taxes, estate-planning, and divorce, other undisclosed non-sale reasons, none of which reflect actual sales or buy-ins. Some submissions are merely one appraiser’s opinion with no transaction or verification applied.
The The Goodwill Registry reports data over the past 10 years as a goodwill of the past year's collections at median, mean, low, high, and zero goodwill. This simple “median” or "average" view of Registry data does not identify trends –up or down, nor does it differentiate between subspecialty, cash, or multispecialty practices. Practice size ranges from thousands to millions of dollars. One extraordinary outlier submission at 10x the value of any other submission-ever, can greatly affect the average values presented.
Many specialties that are heavily dependant on Medicare –and PPOs that base reimbursement on a percentage of Medicare– have been hurt by broad reimbursement cuts since 2004, which are likely to continue. In addition; specific code reimbursement –like what has happened in dermatologic Mohs surgery– further reduce reimbursement and profits. In the meantime, overhead continues to increase. It is erroneous to think that current business value in a market that has fallen has the historic 10-year average or median value. For example –using the stock market as an illustration– a stock whose value has fallen from $10 to $3 over the past decade does not currently have the average or median value of around $6. It has a current value of $3.
Upon close scrutiny, we can find that a mere application of the median or average goodwill value of the past decades' transactions to gross revenues has minimal relevance to a specific practice situation. As an extreme example for illustration; blindly applying a median goodwill-to-revenue ratio of 25% to two practices, each with $1,000,000 in collections, with one being a well managed cash-practice in an excellent location with a $500,000 profit, and one a poorly managed Medicaid practice in a terrible location with a $100,000 loss, yield the same goodwill value; which is clearly illogical. Using a similar example with $1,000,000 revenue each, with $500,000 profit each, but one being general surgery and the other general surgery specializing in bariatrics, using the general practice sale to value the bariatric practice wouldn’t be right, nor vice versa.
You see now why I italicized the The Goodwill Registry statement: ."Information from The Goodwill Registry report is intended to be used as benchmark data”. That means you have to adjust the benchmark data to your specific practice situation; large or small, general or subspecialty, or all-cash, location, profitability, year of sale, and unique situation.
According to the IRS Business Valuation Guidelines: "The three generally accepted valuation approaches are the Asset-based Approach, the Market Approach and the Income Approach. Consideration should be given to all three approaches.” IRS Revenue Ruling 59-60 states that earnings are preeminent for the valuation of operating companies. Earnings-driven methods therefore are most important for the appraiser to consider. Most appraisers favor the Income Approach in valuing small, privately-held professional services businesses, as it best reflects the impact of profit or dividends rather than just gross collections”.
Accessing the The Goodwill Registry Toolkit underlying database finds reported “earnings” as "seller's discretionary earnings" (ie “SDE”) which includes the owner's salary, profits, retirement plan contributions, personal insurances, excess CME in exotic locales, over-payment of family members, personal automobile expenses, etcetera. We don’t know if the appraiser found, correctly included, and reported those expenses, as many business-owners hide them from view.
Use of SDE provides a different perspective that what is commonly used in the “Income Approach” in appraisals which excludes compensation for labor in finding "dividends". Dividend paying capacity is determined through the use of the net cash-&-benefit flow to ownership after subtracting the equivalent market-rate compensation of one owner as if the owner were employed, and the remaining cash flow was available to shareholders/investors. This is a major reason that you can’t use the same goodwill-to-revenues ratio on both general and subspecialty practices, since they have different earning potential.
This makes sense as it is the income available to a buyer above what they could earn in simple employment that is used to pay off the purchase price or buy-in. Without a way to earn back the purchase price, a knowledgeable buyer would otherwise just take employment and invest their money elsewhere.
According to a leading industry resource: "Probably the most common mistake made by those familiar with medical practices but new to valuation is failing to choose a reasonable earnings-comparable from the available statistics. Assume the subject has productivity and compensation in the 75th percentile. Is it reasonable to assume that one could hire a replacement physician to perform 75th percentile workload for a median salary? I think not. " (per Dietrich, Medical Practice Valuation Guidebook 2001-2002, p470)”A weakness in the The Goodwill Registry data when using SDE, is that the owner's work-hours are not identified; ie the owner might work 0 hours per week or 60 hours per week – we can't tell. Nor can we tell if they employ other MDs, PAs or NPs.
What this means is that you can’t competently use the The Goodwill Registry report by itself to value a practice for sale or buy-in by just adding the goodwill value to the tangible assets value. It is part of only one of three approaches in determining value. You have to consider all the facts, not just one.
The right way to use the The Goodwill Registry is as a tool within the Market Approach in giving perspective from a proper selection of individual transactions that are similar in size, time and place to the subject; then comparing the results to what is found in an Income Approach and Asset Approach.
With so many practices in the country looking for an associate or buyer, and so many candidates interested in practice-ownership, if you don’t properly set the price for sale or buy-in, you will likely be left out of the competition in recruiting, as you have to assume that the buyer will have all the facts, knowledgeable advisors, and a choice of opportunities.
Reprinted with permission from CALIFORNIA MDs BUSINESS ADVISOR.
Phone 1-707-546-4433 for consulting and appraisal information.
Author Keith Borglum CHBC is a consultant, medical practice appraiser, and licensed practice broker with Professional Management and Marketing, 3468 Piner Road, Santa Rosa California 95401.
Member or former member of the National Society of Certified Healthcare Business Consultants, Society of Medical Dental Management Consultants, American Medical Association's Doctors Advisory Network, American Academy of Family Physician's Network of Consultants, California Academy of Family Physician's Consultants on Call, and the Institute of Business Appraisers.