Measuring the Value of Healthcare Business Assets
By Christopher J. Evans, FACHE, CMPE
Published in Healthcare Financial Management Journal
April 2000
Abstract
Healthcare organizations obtain valuations of business assets for many reasons, including to support decisions regarding potential mergers, sale of business components, or financing; for tax assessments; and for defense against lawsuits. If compliance with regulations may be an issue, such as when a not-for-profit organization is involved in a transaction, healthcare organizations should seek an independent appraisal to ensure that applicable legal standards are met.
Whether or not regulatory issues are involved, however, an accurate and useful valuation of business assets depends on many factors. Financial managers must understand the purpose and function of the valuation, choice of appropriate valuation techniques, proper assessment of intangible value, use of realistic growth rates, appropriate emphasis on key focus areas of the valuation (eg, risk and future income streams), and an accounting of physician compensation.
Overview
Business valuation is a technical, professional specialty that serves a broad range of purposes, from helping for-profit buyers make informed decisions about how much to pay for a business to helping tax-exempt sellers determine the appropriate selling price. It is based on market-investment principles governing issues such as profitability, return on investment, and range of investor alternatives. These principles apply as much to a solo physician practice as to a 700-bed teaching hospital.
Business valuation, however, also is an imprecise art, involving, necessarily, an elementof subjectivity. Rather than attempt to arrive at exact determinations, therefore, valuation professionals seek to achieve a level of reasonableness when rendering an opinion of value. What is reasonable will depend on the unique circumstances of the valuation. Nevertheless, every valuation should be supported by facts, a clear understanding of circumstances, and cogent, logical decisions. A professional with the specific valuation skills recognized by the courts can bring context and practical experience, which case law has identified as a necessity for independent experts.
Purpose and Function of the Valuation
Healthcare organizations seek independent business valuations for a variety of reasons. The most common reason is to obtain support for decisions regarding potential mergers and consolidation and the development or divestiture of provider networks or other system components.Other reasons are to support the sale or purchase, financing, debt restructuring, or tax assessment of a business component, and to provide outside, expert testimony in support of litigation.
In addition,business valuation increasingly is being used to evaluate the ongoing strength and growth potential of business assets and product lines. Thus, a valuation may play a role not only in establishing monetary value in a proposed business transaction, but also in examining the financial and operational health of the entity in question.
When seeking an independent valuation, healthcare organizations should understand and communicate clearly both the purpose and the function of the valuation. The valuation professional then can determine which approaches and methods may be appropriate and what type of valuation report should be used.
In a business acquisition, for example, the purpose of the appraisal generally is to help the buyer decide whether to acquire the business, while the function of the appraisal usually is to assist in analysis of the business's performance and negotiation of the purchase arrangement. In more complex business arrangements, the purpose and function may be very different. In a joint operating agreement or joint venture, for example, the purpose might be to identify the new entity's debt capacity, and the function might be to provide analytical support of the debtcapacity. Valuation analysts must understand all aspects of the proposed business arrangement to apply valuation principles correctly and return a reasonable and supportable conclusion.
The purpose and function of the valuation also affect the value standard that will be required, the valuation premise, and in some instances, the level of value in question.
Value standard. The most prevalent standard of value in health care is fair market value, Fair market value generally is defined as "the price at which a willing buyer and willing seller would agree, neither being under any compulsion to buy or sell and both having a reasonable knowledge of the relevant facts."a
Other standards of value include strategic value and intrinsic value. These standards describe an asset's value in terms of an asset's benefit to a specific owner (or market), taking into account matters of preference (eg, discretionary positioning or handling of the asset), operational synergies (eg, enhanced operating performance in relation to other system assets), incremental benefit (eg, calculable increased performance levels above baseline), and related benefits of ownership. Although buyers often consider the strategic aspects of the transaction, paying for perceived strategic benefits is not consistent with the standard of fair market value, and in many instances, is illegal.
Valuation premise. The circumstances of the transaction determine the basis, or premise, of the valuation. For example, a hospital choosing to divest an unprofitable medical practice may be able to justify an appraisal of the practice for its liquidation value based on the premise that asset liquidation was necessary. Under a liquidation premise, an asset is deemed to require either orderly or forced sale due to imminent or actual closure of the business with which it is associated.
Lack of profits, however, does not necessarily mean a business is insolvent, and in some instances, a not-for-profit organization divesting an unprofitable business should have the asset appraised as a going concern at fair market value to ensure the transaction complies with tax-exemption regulations. For example, a hospital divesting a practice that is losing $50,000 would not be able to justify insolvency if the hospital is amortizing the practice’s purchase price over three years at an annual charge of $70,000. The reasonableness of losses (or need to finance) must reflect the reasonable prudent business decisions of the hypothetical willing buyer. Using a liquidation premise would artificially depress the sale price and potentially expose the seller to charges of unlawful private benefit to the buyer under IRS or fraud and abuse regulations.
Level of value. In assessing an asset's value, a valuation should account for the impact of control and marketability using investment-risk data derived from public capital markets. Most investors will pay a premium for control, and controlling positions are easier to sell. Investors often will consider a minority interest, however, if it is available, particularly if it supports their strategic growth or market position (eg, a hospital becoming a minority owner of a large medical group.)
Regulatory and Tax Issues
Noncompliance with regulatory guidance regarding the sale or purchase of assets can place a healthcare provider at risk of substantial civil and criminal sanctions, such as loss of tax exemption and Medicare provider status, and significant financial penalties. Obtaining an independent appraisal of an asset before a sale or purchase can help a healthcare organization effectively address fraud-and-abuse or tax-exemption issues that might arise. Tax-exempt organizationsmust ensure that they receive fair market value when divesting assets to avoid allegations that private individuals or entities have improperly profited from the transaction. In addition, independent opinions establish a basis for arms-length negotiations.
The IRS has published valuation guidance through its Exempt Organizations Continuing Professional Education Technical Instruction Textbooks (CPE texts) for fiscal years 1994 through 1996. Although this guidance does not carry the weight of precedence, it does shed some light on the IRS’s position, and generally supports sound business valuation theory. Moreover, November 1999 disclosures on safe harbor rulings indicate that fair market value will continue to be regarded as the standard for appropriate transactions.b
The need for a valuation to meet regulatory requirements is pertinent not only in business acquisitions, but also in other types of business arrangements, such as joint ventures between tax-exempt and for-profit entities to establish and document the fair market value of each party’s contribution to the venture. Minority interest acquisitions, joint-equity physician ownership arrangements, options to purchase, and rights of first refusal appraisals also must be held to standards of fair market value required by government regulators.
For example, most states require an independent valuation of charitable assets in not-for-profit hospital conversions to for-profit status to ensure that the state is not divesting itself of charitable assets at an amount below fair market value. Complex methods of physician compensation also frequently are referred to valuation analysts for conformance with fair market value.
The Hallmarks of Effective Valuation
Business valuation in the healthcare industry often strays from established valuation principles by incorporating implausible assumptions. An accurate and reliable assessment of the value of business assets will depend on the choice and application of the valuation approaches and methods, assessment of intangible value, use of supported and realistic growth rates, understanding of business risk, and accounting of physician compensation, where applicable.
Choice and application of the valuation approaches and methods. The three basic approaches to business valuation are the cost, income, and market approaches. The cost approach measures the value of a business in direct relation to the value of the business assets and the cost to recreate the business in the marketplace. The income approach measures the business's value relative to its earnings and the return on the buyer’s investment. Under the market approach, a business's value is directly related to other businesses that have been sold (ie, comparable sales). A variety of analytical methods may be used in each of these approaches. For example, the income approach may involve discounting a stream of income, as in a discounted cash flow analysis, or a direct capitalization method such as capitalization of earnings. Exhibit 1 lists various approaches and methods and gives examples of when each might be used.
An appraisal of business value should be based upon a consideration of all relevant methods, as directed by IRS Revenue Ruling 59-60, rather than on a single method. The view expressed by some valuation experts that a higher value is reached when a discounted cash flow method is used is misleading because only profitable businesses can be valued using income methods. In fact, profitable businesses often are more accurately appraised on the basis of the net present value of the anticipated future benefits, while unprofitable businesses may be more accurately valued on the basis of their net tangible assets.
Assessment of intangible value. In recent years, regulators have tended to closely scrutinize purchase arrangements in which a tax-exempt purchaser (eg, a hospital) offers to pay an entity that it wishes to acquire (eg, a group practice) for intangible value, often referred to as goodwill.
When evaluating the goodwill of a group practice, for example, it is important to understand that goodwill manifests itself in earnings above what a physician normally would expect to earn. A physician owner has no goodwillif a review and normalization of the physician's income and expenses shows that he or she is not able to earn total compensation in excess of the fair market value for the services he or she provided (both as a physician and as a manager of his or her own business). Moreover, even though the practice may demonstrate aspects of business value related to a going concern (the nature of the business being up and running with staff, equipment, and operating systems in place), these elements do not reflect goodwill.
The existence of goodwill preferably should be determined using the income and market approaches. The indication of value from these two approaches then should be compared with the value of the net tangible assets; any amount exceeding net tangibles may be allocated to goodwill. This process, called a "residual" method, is the preferred means to identify and value goodwill in purchase-price allocations for income-tax purposes.c It should be remembered, however, that a company's goodwill, like other aspects of valuation, depends on the company's unique facts and circumstances and cannot be determined by rule-of-thumb, surveys or other industry guidelines; rather, it must be demonstrated in earnings.
Use of realistic growth rates. A key consideration in valuing profitable businesses is establishing a plausible forecasted income stream. The projected level of revenue growth will help determine whether a business acquisition will return its investment within a reasonable period of time.
For many areas of the country, the long-term growth rates of most mature healthcare businesses are fairly low, perhaps in the range of 3 to 6 percent. The Balanced Budget Act of 1997 and the partial collapse of the physician practice management sector has dramatically increased the volatility of future income streams for healthcare organizations. Under current market conditions, the most reliable way to establish a realistic growth rate for a business, provided it has a documented strategic plan and signed provider contracts, may be to closely estimate each discrete period of income and then project a conservative long-term growth rate. Negative growth rates may be anticipated for many specialties and in areas of the country. Additionally, risk rates may be implausible if they are based on short-term investments rather than on appropriate market-based indicators (eg, basing risk rates on five-year U.S. government securities when basing them on a 20- or 30-year yield to maturity rate is the more accepted practice).
Payer-dominant environments require different strategies than provider-dominant environments. In addition to appreciating the quality and predictability of the income stream (which may be substantial if a provider receives direct payments from employers), appraisers also must the be aware of the accounting necessary to project capitated revenues affected by incurred-but-not-reported charges.The key is that assumptions must be reasonable and documented so they reflect the most likely scenario for a business in any given marketplace.
Whether the buyer is tax-exempt or for-profit should make no difference in determining risk rates. Under the income-based approach, for example, a valuation based on after-tax cash benefits should use a risk rate developed for after-tax revenue flow. Blending the corporate tax rate by presuming that one-half of buyers are tax-exempt is incorrect, mostly because it would be difficult to support the risk-rate development for such a half-and-half income stream. Moreover,most market data resources present data to be applied to after-tax benefit flows.d
In many instances, market-observed multipliers applied to an income measure of the subject company, referred to as value multiples, cannot be supported by projected income streams. With few exceptions, business values resulting in price/revenue multiples above 0.70 will not support the debt service for most mature and stable entities unless rapid growth is anticipated. In such instances, analysis of the transaction probably will show that fair market value was overstated because the appraisers set unrealistic growth rates. Many group practices, for example, have been purchased at high price/revenue multiples suggestive of unrealistically strong projected profit growth. Such inflated values result in transactions that appear to exceed fair market value. Therefore, all valuations that suggest intangible value should be subject to a justification-for-purchase test to assess the reasonableness of the purchase price. This test, highly regarded by small business appraisers, measures debt capacity based on projected income stream over a prudent buyer’s reasonable payment period.
Understanding of business risk. When appraising profitable entities, a key element to consider is risk. Risk is embodied in the capitalization rate, as a reflection of the asset’s return on investment, and is tied to the quality and predictability of the projected income stream as the primary basis for sustainable growth. Given current market forces and income fluctuations due to BBA, a direct capitalization method usually is inappropriate for appraising a profitable business. In general, the focus of a valuation of a profitable business should be about 10 percent on assessing past performance, 70 percent on assessing projected performance, and 20 percent on reconciling the difference.
Since unprofitable businesses are valued on the basis of their net tangible assets only, general business risk would consider the likelihood of future losses and, in general, on the suitability of the acquired assets for future business use.
Accounting for physician compensation. Valuations of business assets are based on how a prudent businessperson would operate a business. This normalized benefit stream most often includes owner discretionary cash and earnings (typically earnings before interest, taxes, depreciation, and amortization [EBITDA] or debt-free net income), which should represent the cash that can be taken out of the business without impairing operations. When adjusting, or normalizing, the financial statements of a group practice, owner compensation is adjusted to reflect the necessary salary paid at fair market value to a physician for his or her clinical services, plus a reasonable amount, if applicable, for practice management. The remaining income, which should include all owner discretionary expenses that a new owner would control, becomes the basis of the probable, expected future earnings of the business, and the source of goodwill.