Understanding the difference between the value of a practice and the price received upon completing a sale.

1. Practice Price
vs.
Practice Value
David L. Broussard, MBA, MTax
National Society of Certified Healthcare Business Consultants
Annual Meeting – Atlanta, Georgia
Keynote Address
June 22, 2006

2. 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?

3. Value
 Standard of Value:
 Fair Market Value
 Market Value
 Fair Value
 Investment Value
 Collateral Value
 Premise of Value
 Going Concern
 Liquidation

4. 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

5. 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”.

6. Revenue Ruling 59-60, 1959-1
Cumulative 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”.

7. The Market Approach
 value is found in the sales price of
other enterprises
1. Rules of Thumb Method
2. Direct Market Data Method
3. Multiple of Discretionary Earnings
Method

8. The Asset Approach
 value is found in property
1. Net Asset Value Method
2. Excess Earnings Method
3. Liquidation Value Method
4. Asset Accumulation (Cost-to-Create)
Method

9. The Income Approach
 value is found in earning capacity
1. Yield Capitalization Method
2. Direct Capitalization Method

10. 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.

11. 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.

12. 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.

13. 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.

14. Direct Capitalization Method
The 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.

15. 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.

16. Which Method to Use?
1. Yield Method
 Multiple Periods
 Discount Rate
2. Direct Method
 Single Period
 Capitalization Rate

17. Direct Method
Capitalization Rate for a Benefit Stream?
New Year Benefit Stream:
 Cap Rate = Discount Rate – Growth Rate
Current Year Benefit Stream:
 Cap Rate =(Discount Rate – Growth Rate)
(1+Growth Rate)

18. Calculating the Discount Rate
Discount Rate =
 Risk Free Rate +
 Equity Risk Premium +
 Size Premium +
 Company Specific Risk Premium

19. Which Benefit Stream?
Normalized Net Earning vs. Net Cash Flow
Normalized 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)

20. 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

21. Mathematical Weighting
When 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, and
4. The quantity and quality of date available.

22. Adjustments to Value
 Control Premium
 Minority Interest
 Lack of Marketability

23. 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.

24. Common Types of Buy/Sell Agreements
1. Redemption Agreements –
• Between Owner and Entity
1. Cross-Purchase Agreements –
• Between Owner and Other Owners
1. Wait & See Agreements –
• Option to Owners, Practice and then Owners
1. Third-Party Agreements –
• Owners and Outside Parties

25. Trigger Events
1. Death
2. Disability
3. Divorce
4. Departure
 With Cause
 Without Cause
 Retirement
1. Dissolution
 Partial
 Total

26. How To Buy Into A Practice?
Options:
 Stay an Employee.
 Pay Cash.
 Earn In.
Strategies:
 Big Purchase Price
 Small Purchase Price
 Equitable Terms