When a physician gets divorced, the value of his or her ownership interest in the practice is often included as an asset for property distribution purposes. Additionally, the income generated from that practice is likely to be utilized in the determination of support. Because valuation is an art (that requires a skilled hand), not a science, it makes the task of valuing a medical practice more difficult (and more likely to be disputed) than valuing the marital residence or a spouse’s retirement plan.
In the BVR/AHLA Guide to Healthcare Industry Finance and Valuation, contributing author Stacey D. Udell, CPA/ABV/CFF, ASA, CVA, dives into how the value of a physician practice is based on the valuator’s informed judgment applied to the specific facts and circumstances, and different assumptions lead to different conclusions of value, any of which may be reasonable. Some of the major issues that must be considered are:
- Standard of value;
- Premise of value;
- Valuation date(s);
- Buy/sell agreements;
- Goodwill; and
- “Double dip.”
Standard of Value
Standards of value differ among the various states and jurisdictions, and the valuator must utilize the appropriate standard of value for the jurisdiction. As it is a matter of law, the family law attorney should inform the valuator of the applicable standard of value. Reliance on an incorrect standard of value could lead to an incorrect value conclusion, your report and testimony being excluded as evidence and possibly becoming the basis of a malpractice suit.
Arkansas and Louisiana have statutes precisely defining the standard of value to be used in divorce. In other states, the standard of value is often left undefined. To confuse matters even more, many state statutes refer to “value” or “net value” without any further clarification or definition. Many states inconsistently apply standards of value to arrive at an equitable result. There is no case law or statutes in Alabama or Georgia discussing the standard of value to be used in matrimonial litigation. Therefore, determining the appropriate standard of value can be a perplexing problem for the valuation expert to resolve.
The standards of value utilized in the valuation arena are fair market value, fair value, intrinsic value, and investment value. The chart below reflects the states that are fair market value states, either explicitly or by application.
Premise of Value
The International Glossary of Business Valuation Terms defines premise of value as “an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation.” The two recognized premises of value are going concern and liquidation.
The going-concern value assumes the business will continue operating into the future. This results from having such things as a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place. Unless otherwise excluded from the marital estate (by statute, for example), goodwill is included under the going-concern premise of value.
Liquidation value can be defined as the amount that would be realized if the business was terminated. Liquidation can be either “orderly” or “forced.” An orderly liquidation would generate higher proceeds and results when the business is terminated and the assets are sold piecemeal. In a forced liquidation, the assets are sold as quickly as possible and lower proceeds are usually generated. Liquidation value is applicable when a controlling interest is being valued because a minority (noncontrolling) owner may not compel the sale of the business. Furthermore, the liquidation value would be pertinent only if it is greater than the value an income or market approach determines.
State law reflects the appropriate date to value the practice for divorce purposes.
- Fourteen states require the use of a date as close as possible to the date of trial;
- Fifteen states and the District of Columbia require the use of the date of complaint;
- Nineteen states suggest using the date of divorce; and
- Two states mandate the use of the date of separation.
When the use of a trial date or dissolution date is required, often the state laws suggest the use of a current date. The chart below reflects each state’s requirement.
Often physicians are party to a buy-sell agreement. These agreements are typically utilized in situations of death, disability, retirement, or withdrawal of a partner. While these agreements may set a value and be binding for transfers of an ownership interest, disagreements exist as to the use of these values or formulas in the context of marital dissolution because the nonphysician spouse is not party to the agreement and no change in ownership is occurring.
The courts have recognized that often values included in these agreements contain artificially low values. However, some states consider the agreement value the sole indicator of value, concluding that the amount in the agreement is the only amount the owner will ever receive and it would be inequitable for the nonowner spouse to receive more than the owner spouse.
The majority of states follow West Virginia’s ruling in the case of Bettinger v. Bettinger, 396 S.E.2d 709, 714 (W.Va. 1990), wherein the court opined that the value pursuant to the buy-sell agreement should be considered along with any other relevant evidence regarding the value and weighted accordingly. Additionally, the physician’s age may be a consideration. A value an agreement sets may be more relevant in the case of a 58-year-old physician subject to mandatory retirement at age 60 who is nearing the end of his professional career than the case of a 38-year-old physician subject to the same agreement when sale or retirement is not imminent.
In addition to the value of the tangible assets a medical practice owns, the value is also comprised of intangible assets such as goodwill, patient lists, medical records, and covenants not to compete. The value of the intangible component is often greater than the value of the tangible component.
Goodwill, an intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified, can be viewed as the ability to earn a return over and above the return earned on the tangible assets. Once it has been determined that goodwill exists, it must be valued. Goodwill is often valued to compensate the nonphysician spouse for his or her marital contribution.
Two types of goodwill may be associated with the value of a medical practice. Personal (or professional) goodwill is attached to the individual and his or her unique abilities and characteristics. Practice (or entity) goodwill is attached to the medical practice and is not associated with the physician’s unique abilities and characteristics.
Personal goodwill presumes that a practice has a higher value as a result of the particular professional’s knowledge, experience, and reputation. Personal goodwill is that which would make a doctor’s patients follow him even if he or she changed his location, staff, and phone number. As such, personal goodwill is difficult to transfer, but it may be done with advance planning and cooperation between the buyer and the seller. However, would a hypothetical buyer pay anything for personal goodwill (under the fair market value standard of value)?
Practice goodwill is associated with the practice as a unit, including its location, systems, operating procedures and policies, staff, an established client base, and patient records. Another indicator of practice goodwill is a telephone number. Assume a family practice has a telephone number of 808-555-1212. As a patient of that practice who needs an appointment, you will call that number and ask for an appointment with Dr. A. If Dr. A is not there, you still are likely to see whatever doctor is available at that telephone number.
A distinction must be made between personal goodwill and professional goodwill because the majority of states do not consider personal goodwill a marital asset. A minority of states, shown in the chart below, ruled that all goodwill is marital property, whether it is personal goodwill or practice goodwill.
The “double dip” dilemma exists when the same income stream is used for multiple purposes—for example, when the income stream of a business is utilized to value a practice and that same earnings stream is used as the basis for support.
An important task for an appraiser of a professional practice is to determine the distinction between the return on labor and the return on equity. This is done by utilizing normalized compensation to determine the value of a practice. It represents what the owner physician would have to pay another physician to come in and perform the same function as the owner physician. Often, the determination of reasonable compensation is the most disputed part of the valuation.
The actual compensation, which is usually greater than the normalized compensation, often includes discretionary personal expenses that the business pays, such as automobile expenses, dues and subscriptions, household expenses, meals and entertainment, retirement plan contributions, telephone, and travel. The use of normalized compensation for valuation purposes increases the value of the practice. At the same time, actual compensation is often used as the basis for support. For example, assume the following information for Dr. A:
Assuming a capitalization rate for net income of 20%, the value of the practice using normalized compensation is $900,000. The spouse’s alimony will be calculated based on the physician’s compensation of $490,000. Therefore, the spouse is receiving the double benefit from the normalized earnings utilized in determining the value of the practice and the actual compensation the physician takes. As is the case with determining the applicable standard of value, the states’ treatment of the double dip varies.
Successful valuation engagements require sound judgment, and valuation professionals must be confident that the conclusions reached are reasonable based on the unique facts and circumstances of the case and that the value is reasonably defensible. With the majority of the issues discussed on the topic of valuing a physician practice in the event of divorce, the courts have looked to previous decisions not only in their own state, but often in other states as well.
For more on this topic, download the complete chapter from the BVR/AHLA Guide to Healthcare Industry Finance and Valuation and add the complete publication to your library to learn more important topics such as the healthcare marketplace, regulatory considerations in healthcare valuation, valuing physician practices, and much more.