7 Tips for Valuing—and Designing—Buy-In and Buyout Agreements for Medical/Dental Practices

One of the most common forms of valuation engagements involves valuing an equity interest for a buyout of or a buy-in to a professional practice or other small business. More often than not, the equity interest being valued is a noncontrolling interest and therefore requires consideration of lack of control and lack of marketability discounts—that is, of course, unless the shareholders’ agreement, operating agreement, or similar document provides guidance or rules for the valuation analyst to follow.

Healthcare valuation expert Mark Dietrich, who has more than 40 years of experience designing and valuing buy-in and buyout agreements, recently wrote an article for the Business Valuation Update identifying a number of best practices for both valuation analysts and consultants with respect to these matters. Here, we explore seven of his top tips. Be sure to download the complete article for more.

1. Agreement basics

   Noncontrol interests contemplate lack of control and marketability discounts. However, most physicians and dentists do not understand that and believe that their interest is worth a pro rata share of the control value of the entire practice. More importantly, perhaps, many attorneys who draft these agreements do not understand the term “fair market value” when they use it. Thus, as a threshold matter, any agreement should specifically state whether or not “fair market value” is determined at the: (1) control level pro rata; (2) control level with consideration of lack of marketability; (3) noncontrol level without regard to marketability; or (4) noncontrol level with consideration of lack of marketability.

2. Level of value basics

   Clearly, the valuation analyst has to read and understand the level of value the agreement requires. Some of the valuation considerations to explore include:

   • Pro rata control value. This is the most simple and straightforward level of value and eliminates the need for any discounts. It is also what most physicians contemplate when they sign such an agreement.
     
     
   • Unmodified control value. In this scenario, the agreement specifies that value is at the control level but without mention of marketability one way or the other. Thus, the valuation analyst is required to consider whether any discount should apply to the pro rata share of control value. This consideration may be easily disposed of if there have been historical transactions where lack of marketability was or was not considered.
     
     
   • Noncontrol value without a marketability discount. Here the agreement specifies the value level is noncontrol and the valuation is not to consider lack of marketability.
     
     
   • Noncontrol value. Here, the valuation analyst is required to consider whether any lack of marketability discount should apply, in addition to the obvious lack of control discount. Yet again, other documents found in the typical medical or dental practice have a significant impact on the appropriateness and amount of any lack of control discount.
     
     
3. Elements of practice value

   Different medical and dental specialties have specific types of underlying value drivers. For medical practices, the appraiser should focus on professional component income under the resource-based relative value scale, or RBRVS (modifier -26 where appropriate), and technical component income (modifier -TC) as a key element of distinguishing return on labor from return on capital. A few examples include:

   • Primary care medical practices. Health insurers widely favor primary care—especially adult primary care—in terms of payment rates and potential incentives. In many cases, the availability of incentives is a function of relative contracting strength, which is typically not held directly by the individual practice but rather by a network, independent practice association (IPA), or similar entity that the practice is a member of.
     
     
   • Dermatology practices. Perhaps the “hottest” thing in medical practice today, dermatologists have a variety of means of generating income. With two generic service lines—medical dermatology and cosmetic dermatology—these are the most popular targets for private equity and public-company buyers. Dermatology offers the availability of the use of advanced practice providers as well as specially trained nurses or technicians who can do such tasks as CoolSculpting.
     
     
   • Orthopedic surgery. Orthopedics is characterized by increasing specialization such as hand, back and spine, shoulder and elbow, arthroscopy, knee and hip replacement, foot and ankle, and sports medicine, to name a few. As with dermatology, orthopedists have been very successful in the use of advanced practice providers—primarily physician assistants—to increase their productivity in both the office and the operating room. Since PAs require physician supervision, one can debate the extent that the net income derived from those PAs represents a return on the surgeon’s labor or a return on trained workforce.
     
     
   • General dentistry. Perhaps the finest example of deriving profits from “midlevels” are dental hygienists, one of the primary value drivers of a general dental practice. Although supervision is required, hygienists spend most of the time alone with the patient, aside from the dentist coming in near the end of the cleaning. The patient base and its recurring need for services is also a valuable asset.
     
     
   • Dental specialties. There are many of these, of course, but some rely more heavily on referrals from general dentists, while others, such as periodontists, may develop a recurring patient base due to the use of periodontal hygiene. A prosthodontist, implant specialist, or oral surgeon will have a primary asset of a referring dentist base, versus a patient base.
     
     
4. Technical component and other facility value

   Under RBRVS, there is a practice expense component (relative value unit, or RVU) designed to compensate for ownership and maintenance of the equipment, employment of technicians to operate it, and other associated costs. This revenue stream is distinct from that for professional services. Imaging centers have technical component revenue, especially for high-tech imaging. Other examples of technical component revenue include pathology labs and even certain ophthalmic tests. Surgery centers have a separate facility fee that is almost always distinct from the payment for the services of the physician doing the procedure; it is always separate for Medicare, for example.

5. Employment contract 

   This is the document that governs distributions. The typical medical practice has an employment contract or similar agreement, e.g., professional services agreement, with its owners and nonowner physicians. There are a variety of regulatory reasons for this, such as an assignment of the right to bill for services to Medicare and other insurers for services or language declaring that no payment is being made in exchange for referrals under the Stark law or Anti-Kickback Statute.

   A well-operated practice will include in its employment or similar agreement the compensation methodology the practice uses to allocate available income to the physicians and other providers. Often, the methodology will be fairly complex, tracking not only individually generated revenues, but also individually incurred expenses such as for travel, health insurance, continuing education, and similar discretionary expenses.

6. Use of deferred compensation 

   Many medical practice buy-ins and buyouts are undertaken with compensation shifts such that the payments for what otherwise might be labeled “goodwill” are made with pretax dollars. This is especially true when the new owner is stepping into a productivity-based compensation plan where he or she will be allocated 100% of his or her production—reiterating a focus on return on labor versus return on capital. Similarly, some portion of the income advanced practice providers generate is attributable to physician supervision.

   Because these payments are taxable as ordinary income to the recipient and deductible by the payer rather than being taxed as capital gain and not deductible, they constitute an effective discount. As such, additional valuation discounts would be duplicative.

7. Working capital
   Perhaps the most commonly overlooked adjustment in the valuation of a medical or dental practice is the reconciliation of actual working capital to “normal” working capital. Normal working capital is typically expressed as either a percentage of revenue or a number of days’ collections based upon the accounts receivable aging. Other measures are also possible.
   
   Virtually all professional practices of the type discussed here file their tax returns on a cash basis. Very few will have accrual basis financial statements, unless there is some requirement by a lender, for example. As such, it is incumbent on the appraiser to obtain sufficient data in the valuation process to measure actual working capital and then reconcile that value to normal working capital as contemplated by the valuation, such as the capitalization of cash flows or discounted free cash flow methods.

Conclusion

Professional practice buy-ins and buyouts require significant expertise if the fair market value is to be determined correctly. To read about more best practices in the area of buy-in and buyout agreements in medical/dental practices, download the complete article from Mark O. Dietrich, CPA/ABV, in the Business Valuation Update.