Urgent message: Despite the fact that underlying principles are the same as for other settings, it behooves the urgent care operator to consider factors unique to the urgent care arena when determining the value of the practice.
By Keith Borglum, CHBC
How much is your practice worth?
This is a simple question with a complex answer. There are many books on the topic—and a fair amount of debate—and the answer differs depending on the particular situation of the seller and buyer.
There are many reasons to value a practice, the most common being marital dissolution (the rules of which vary by state), but we will ignore valuation for courts in and concentrate on “buy-sell” situations.
Usually in a buy-sell situation, both parties are interested in fair market value, with both hypothetical parties having all the relevant facts, and under no duress to act. There are laws that govern the definition of fair market value that can affect medical practices, as well as other requirements—especially if the buyer is a hospital, outside practice (e.g., orthopedics or imaging), or a non-physician.
Section 1877(h)(3) of the Social Security Act defines fair market value for purposes of Stark regulations as “the value in an arm’s length transaction, consistent with general market value.”
Specifically, the regulations (420 CFR 411.351) state:
This can have impact especially in relationships where referrals occur. Sometimes, an ancillary service revenue stream has to be excluded in order to remain compliant.
Approaches to Valuating Practices
According to the IRS Business Valuation Guidelines, the three generally accepted valuation approaches are:
• the asset approach
• the market approach
• the income approach.
As their names indicate, the asset approach looks at assets, the market approach at the comparable market sales, and the income approach at the income available to the owner. An appraiser should consider all three approaches in valuing a particular urgent care center, even if one or more is ultimately used, or rejected. Professional judgment will be needed in selecting the correct approach for the situation.
For example, the asset approach is rarely dominant for urgent care practices, but more commonly important for asset-intensive practices like radiology. An exception would be a brand new center not yet having revenues, or one with very weak, substandard income.
The role of earnings
IRS Revenue Ruling 59-60 states that earnings are preeminent for the valuation of operating companies. Earnings- (or income-) 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. (In other words, how much income or profit you keep is more important than just how much you can collect!)
There is some confusion surrounding the definition of earnings—or income—used in the name of the “income method.” Such words have included earnings (which excludes cash flow), cash flow (which excludes pure earnings), discounted cash flow, returns, benefits, economic income, etc. In the end, however, it is dividend paying capacity which is encouraged in Revenue Ruling 59-60.
Different income streams use different methods to determine value. Most clinics are S-corporations, partnerships, LLCs or LLPs, have deductible benefits to the owner, and need the income stream “normalized.”
The most appropriate income stream to consider is dividends, or normalized net pre-tax cash flow after considering the equivalent market-rate compensation of the owner as if the owner were employed, and the remaining cash flow was available to shareholders or investors. This provides a perspective as if the owner were instead an employee, and the balance was a return on investment (ROI) to ownership.
Another way to look at this is: The result is the income available to the owner on his or her investment in the practice if the owner couldn’t work and had to hire an equivalent, licensed professional replacement to see the patients. This is the income stream that a buyer uses to pay back the purchase-loan and get a return on investment.
The dividend is multiplied by a capitalization, or cap rate, to find the value. A cap rate includes the return needed for an investor to put capital in the ownership of a business. The cap rate differs from an interest rate in that interest is a return on debt, rather than equity. In other words, this formula takes the return and figures out how much a buyer needs to invest to get that return. To determine the cap rate, we examine the rates of return on other investments competing for the investor’s dollars, and determine what rate of return will be required for this investment. This rate is calculated by “building-up” rates of risk and return, from the lowest/safest (often 20 year Treasury bonds) to the risk-adjusted level of risk in the particular investment. The high risk of small businesses requires high returns.
Risks inherent when investing in urgent care centers include reduced reimbursement by insurance companies, changes in worker compensation laws, loss of local business clients, and economic recession. Appraisers can quantify anticipated future changes in return by modifying revenue and cash flow assumptions appropriately or, in the absence of adequate information about a proposed change (like future Medicare or worker compensation reimbursement levels), by modifying the risk premium when developing a discount/cap rate.
Put more simply, as risk increases, so does the ROI demanded by investors. That’s why investments in public stocks usually pay more than savings accounts, and why investments in urgent care centers should pay more than investment in public stocks.
The ‘value’ of goodwill
Most clinic owners wonder about the value of the intangible goodwill of their practice. Goodwill value is not separately valued in the income approach, as it might be when taking other approaches to valuation. The underlying concept is that when using income of the business as the approach for valuation, that income results from the value of the tangible and intangible assets together. The investor cares less about the mix of assets and more about the ROI.
The Market Approach
The market approach is easier for most urgent care clinic owners to understand, but it can be less reliable as an indicator of value. This approach simply compares the value of the subject to other practices that have sold. The difficulty is finding appropriate comparable sales. Rarely are there comparable sales available that are at the same time recent, nearby, similar in size, have the same payor contracts, and offer the same services. In addition, there are fewer urgent care centers than there are more common specialties like family practice or internal medicine. Even if there were some very similar sales nearby, the transactions are private and the underlying factors and data are rarely available to the appraiser.
Therefore, the market approach is usually not as good as the income approach, and is either weighed less in the final result, or even rejected.
The Income Approach
The simplest legitimate rule of thumb for valuing an urgent care center is using a grossly simplified income approach; this is the primary approach per IRS Revenue Ruling 59-60. This approach looks at the ROI (i.e., dividends) to the buyer after market-rate compensation of one working owner. Remember, the following is a rough estimation without considering the variables of the particular practice:
1. Add back to salary and profit all the economic benefits the current owner receives (like auto, life insurance, health insurance, etc), plus depreciation, Sec 179 expense, and interest (assuming the seller will pay off any loans with the proceeds from the buyer).
2. Subtract the cost of employing a substitute person for the owner, as if the owner were disabled and had to hire a replacement person to do his job. This may or may not include seeing patients.
3. Multiply the remainder by 2 to 2.5 (by 2 to 2.5 if dependant on insurance reimbursement, or by 2.25 to 2.5 if a cash-only practice.
The result is the approximate value, excluding cash, accounts receivable, and other liabilities such as accrued and unpaid employee benefits. You will notice that the 2 to 2.5x means an ROI of 40% to 50%, which you might consider extraordinarily high. However, it’s not that high when you consider that professional service businesses based on cash – e.g., attorneys, CPAs, architects and engineers – historically have had cap rates of 25% to 35%. Most professionals in the urgent care arena would probably agree that urgent care clinics based on insurances and government intervention are riskier than those other professions.
Obviously, there are many other details that impact the value for a particular clinic. Most appraisers will apply at least one or two other approaches, weigh the answers, then apply a “reality check” to the answer.
The Asset Approach
In the asset approach, the tangible contents of the practice are inventoried and valued. This may or may not include tenant improvements, and usually excludes cash and accounts receivable. If the value of the assets is more than the value found in the income or market approaches (i.e., in weak clinics), then the asset approach prevails.
Advice on Choosing a Medical Practice Appraiser
Medical practice valuation is not a licensed activity in most states, so competency varies considerably. Florida is a notable exception, wherein appraisal without a Florida license may be a felony. Generally, good reports contain background information and documentation so the client (you, in this scenario) can see that the protocols followed are clear and data can be confirmed.
Demonstrating bias or favoritism in a valuation is considered a breach of ethics. The objectivity of an appraiser can often be determined by a close evaluation of his report, especially in comparison to other reports by the same appraiser. Ask the attorney if they would have a different opinion working for a buyer versus a seller. If they answer “Yes,” find someone else.
Appraisals should be based on facts. Since most general business appraisers may not have a firm understand of Stark regulations, corporate practice of medicine prohibition laws, Medicare fraud and abuse laws, and fee splitting laws; it is wise to work with someone with experience in medical practice valuation. You should demand to have the appraiser present the resources-used, the currency of his/her databases, and the assumptions underlying the opinion; 10-year-old databases have little relevance in light of today’s values.
Some so-called appraisers appear to base their valuations on hearsay, with little or no substantiation of their opinions. However, a reputable appraiser will make it clear how an opinion was reached, accompanied by transparent math. A respected colleague once commented to me that “appraisals are 90% research and 10% reporting.” As in responsible medicine, good research is evidence based.
The importance of working with an ethical appraiser who has experience in the medical field cannot be overstated. Even the most honest, competent general business brokers may know nothing about medical practice. Conversely, a general medical management consultant or hospital accountant may know nothing about the valuation process. This was proven to me not long ago when a business broker told me that she arrived at the exorbitant value she placed on a medical practice based on “that’s what the seller wants.” In my experience, I have seen an urgent care practice priced millions of dollars above what could logically and financially be supported by a thorough appraisal. Assume that the other party to your transaction—whether buyer, seller or associate—will have access to competent counsel. Starting with a faulty appraisal makes the owner/seller look bad, and the deal look suspect.
There are a few professional associations, so the most common way to find a medical practice valuation specialist is to search for “medical practice valuation” on your favorite internet browser(s), then check the credentials of the appraiser to verify that he specializes in medical practice valuation and belongs to a professional appraisal association. Urgent care will likely fall within the experience of such an individual. Be aware, however, that it is unlikely that an appraiser will work exclusively in the urgent care marketplace because the market is simply too small at this time.
It is important to note that “valuation” is not the same as transaction consulting or brokerage. Consulting on practice sales, buy-ins and payouts—unlike valuation—is a licensed activity in many states, and it’s easy to cross the line unknowingly. Be vigilant; you wouldn’t go to an unlicensed doctor, so don’t work with an unlicensed broker or consultant.
A Note on Value vs. Price
An appraiser’s opinion of value is like using the Kelly Blue Book™ for used cars; it’s just an expert opinion. A particular buyer and a particular seller may logically agree on a price different from the value, just like for a used car. For example, an ill or desperate seller may sell for a price below the market value, and a public company might pay more than fair market value because of strategic leverage they bring to the acquisition.
When you ask “What is my urgent care practice worth?”, a definitive answer may be elusive. Using common sense, professional judgment, and bona fide statistical analysis can result in a usable estimate, however.
• The Medical Practice Valuation Workbook, by the author of this article, is written for the do-it-yourself owner, or to use to perform a “reality check” second opinion on an appraisal report.
• Medical Practice Valuation Guidebook 2001/2002 by Dave Dietrich goes into far more detail on alternative approaches and issues in all types of medical practices.
• Valuing Small Businesses and Professional Practices by Shannon Pratt is one of the bibles of the appraisal profession, allowing the reader to compare medical practices to other professions.