Practice Pricevs.Practice Value David L. Broussard, MBA, MTax National Society of Certified Healthcare Business Consultants Annual Meeting – Atlanta, Georgia Keynote Address June 22, 2006
Practice Price vs. Practice Value What is Practice Price? What is Practice Value? Why does it matter to know the difference? When is it important to know the value? When is it important to know the price? How is Price determined? How is Value determined? Of Price and Value: Which is more important? Why?
Value Standard of Value: Fair Market Value Market Value Fair Value Investment Value Collateral Value Premise of Value Going Concern Liquidation
Unique Characteristics of a Medical Practice The practice provides primarily a service delivered by the owner physician(s), There is a relationship of trust and respect between the patient and the doctor, The practice or physician often relies on referral sources for patients, Extensive training and knowledge beyond a college degree are required, A license to practice medicine in the State is required, The physician may become Board Certified in a specific area of medicine, The physician must complete a rigorous credentialing process to have hospital privileges and to be a participating provider with an insurance carrier, Family member’s not licensed physicians may not inherit the practice, In many cases a third party pays for a large portion of the care provided, In many areas of specialty, there is an over supply of physicians, and The medical economic marketplace is increasingly competitive
What Does the IRS Say?Revenue Ruling 59 - 60 Regulation Section 20.2031-1(b) defines “Fair Market Value” as: “the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state, in addition, that the buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such a property”.
Revenue Ruling 59-60, 1959-1Cumulative Bulletin 237, states: “the purpose of this Revenue Ruling is to outline and review in general the approach, methods and factors to be considered in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes. The methods discussed herein will apply likewise to the valuation of corporate stock on which market quotations are either unavailable or are of such scarcity that they do not reflect the fair market value”.
The Market Approach value is found in the sales price of other enterprises1. Rules of Thumb Method2. Direct Market Data Method3. Multiple of Discretionary Earnings Method
The Asset Approach value is found in property1. Net Asset Value Method2. Excess Earnings Method3. Liquidation Value Method4. Asset Accumulation (Cost-to-Create) Method
The Income Approach value is found in earning capacity1. Yield Capitalization Method2. Direct Capitalization Method
Income Approach In actual practice, the Income Approach to valuation results in the possible use of two methods, namely, The Direct Capitalization Method - based on a single-period estimate of expected economic income applying a capitalization rate, or The Yield Capitalization Method – based on a multiple-period estimate of expected economic income applying a discount rate. Often the terms capitalization rate and discount rate are used interchangeably, but in reality they have different meanings and are not used in the same way when valuing a business enterprise.
Discount Rate The discount rate is used to identify the present value factors that are used to discount a multiple-period benefit stream to a present value. Therefore, present value is a financial term that is used to describe what something received tomorrow is worth today. For example, if you are to receive $100 in two years from an investment and your expected return is 6% given the risk level, the present value (today) of that future benefit would be $89.00. In fact, $89.00 x 1.06 = $94.34 and then $94.34 x 1.06 = $100.
Capitalization Rate The capitalization rate is used as divisor or multiplier to compute the value of a single-period benefit stream. For instance, assume a business has a capitalization rate of 20% and net earnings of $30,000, the enterprise would then be valued at $150,000. The actual calculation could be made one of two ways; first, $30,000 ÷ .20 = $150,000 or second, $30,000 x [1 ÷. 20] = $150,000. The first calculation being a divisor application and the second being a multiplier application.
Rate Relationship The Discount Rate and the Capitalization Rate have a relationship the basis of which is the assumption the business has a perpetual life and its annual growth will be constant over time. With that connection in mind, the relationship is presented as follows: Capitalization Rate = Discount Rate – Growth Rate The expected annual Growth Rate for the business includes two components, namely, 1) price increases (relating to inflation) and 2) volume growth.
Direct Capitalization MethodThe Direct Capitalization Method is most useful when: The economic income of the business is highly predictable, The business has attained a certain degree of maturity, The business has significant intangible value, Expected growth rates are modest and predictable, The business adds significant value to its services through labor and intangibles, Current earnings levels are expected to approximate future earnings.
Yield Capitalization Method Generally speaking, the Yield Capitalization Method would be utilized if: An enterprise maturity level has not been attained as measured by the level of client development, service(s) mix, or anticipated revenues, It is not reasonable to assume a single long-term growth estimate, or Earnings for recent periods are not good indicators of future earnings.
Which Method to Use?1. Yield Method Multiple Periods Discount Rate2. Direct Method Single Period Capitalization Rate
Direct MethodCapitalization Rate for a Benefit Stream?New Year Benefit Stream: Cap Rate = Discount Rate – Growth RateCurrent Year Benefit Stream: Cap Rate =(Discount Rate – Growth Rate) (1+Growth Rate)
Calculating the Discount RateDiscount Rate = Risk Free Rate + Equity Risk Premium + Size Premium + Company Specific Risk Premium
Which Benefit Stream?Normalized Net Earning vs. Net Cash FlowNormalized Net Earnings+ Noncash Charges- New Property, Plant and Equipments- Cash for future Working Capital+Projected Increased Debt= Net Cash Flow to Equity (Net of Debt)
Example Calculation New Year Net Cash Flow = $100,000 Capitalization Rate: Discount Rate = 42% Growth Rate = 2% Therefore, Cap Rate = 40% Practice Value = $100,000/.40 = $238,095
Mathematical WeightingWhen assigning a relative appropriateness to each of the valuation results, the following four factors were considered:1. The nature of the business and its assets,2. The purpose of the valuation and the definition of value,3. The premise of value and ownership characteristics, and4. The quantity and quality of date available.
Adjustments to Value Control Premium Minority Interest Lack of Marketability
What is a Buy/Sell Agreement?A Buy/Sell agreement is a contract that places restrictions on the ability of shareholders to freely transfer their ownership interests.The contract provides that an owners interest will be sold (or offered for sale) at a specified price to the other owners and/or to the business entity itself upon the occurrence of identified triggering events.
Common Types of Buy/Sell Agreements1. Redemption Agreements – • Between Owner and Entity1. Cross-Purchase Agreements – • Between Owner and Other Owners1. Wait & See Agreements – • Option to Owners, Practice and then Owners1. Third-Party Agreements – • Owners and Outside Parties
Trigger Events1. Death2. Disability3. Divorce4. Departure With Cause Without Cause Retirement1. Dissolution Partial Total
How To Buy Into A Practice?Options: Stay an Employee. Pay Cash. Earn In.Strategies: Big Purchase Price Small Purchase Price Equitable Terms