Common Misconceptions Regarding Healthcare Entity Valuations

Five Remaining Leading Misconceptions (Part II of II)

The following discussion summarizes and responds to common misconceptions many analysts have with regard to the valuation of healthcare entity property and/or services transfers. These analyst misconceptions typically involve a misunderstanding of one or more of the relevant regulatory provisions. These analyst misconceptions typically relate to an erroneous understanding that “the Service only accepts this” or “the Office of Inspector General doesn’t accept that.” These analyst common misconceptions are addressed from the perspective of the regulatory compliance of the valuation analysis. In Part II of II, the article covers the remaining five of the 10 leading misconceptions.

In the first part of this two-part series, five of the top 10 leading misconceptions regarding valuation of healthcare entities where presented.  In this second part, the remaining five leading misconceptions are discussed.

 

There Should be no Patient Relationships Value Included in the Health Care Valuation

Often the same analyst who excludes goodwill value will also exclude the value of any patient relationships-related intangible asset from the health care valuation.  This procedure (or lack of performing a procedure) is particularly important when the analyst uses the asset-based business valuation approach (and, specifically, the asset accumulation method) to value the health care property transfer.

 

First, the statutory and regulatory prohibition relates to any health care provider (tax-exempt or otherwise) paying for patient referrals to the acquirer entity.  Second, there is no prohibition of a health care acquirer paying for the current patient relationships (not the patient referrals to the acquirer) of the target health care entity.

 

In virtually any industry or profession, a good part of the value of a target business relates to the income earned from the entity’s current customer (in this case, patient) relationships.  The value of these current patient relationships is often measured based on the expected future income from the current patients returning to the current health care services provider.  That value does not (and should not) include the expected future income from the future referrals of current patients to the acquirer health care entity.

 

No Health Care Entity Can Pay Reasonable Compensation Over $1 Million per Individual

Some analysts erroneously believe there is an arbitrary dollar amount (say, $1 million per year) of reasonable compensation above which health care regulatory authorities will not accept.  These analysts may also erroneously believe there are arbitrary “ceilings” on fair market value compensation for different professional positions—for example, a chief executive officer, chief medical officer, chief research officer, operating room director, emergency room director, etc.

 

The fact is, there are no such arbitrary limits on the fair market value level of compensation—either in the relevant statutes or in the relevant regulations.

 

There are numerous factors an analyst should consider in assessing the fair market value of a health care entity executive or professional compensation.  Likewise, there are numerous factors an analyst should consider in assessing the fair market value compensation-related contract terms for health care entity contractors.

 

All of these factors are consistent with the overarching consideration with regard to the fair market value of either employee or contractor compensation: the compensation should be commensurate with the compensation levels paid to similarly qualified individuals performing similar functions at similar organizations.

 

The Analyst Should Not Use For-Profit Organizations as Comparables in a Fair Market Value Compensation Analysis

Some analysts erroneously believe that for-profit business entities do not provide meaningful guidance with regard to the fair market value compensation assessment of a tax-exempt entity employee or contractor.  As mentioned above, the general regulatory guidance with regard to fair market value compensation is that the analyst should consider comparable individuals in comparable situations at comparable organizations.

 

First, with respect to providing empirical evidence regarding market-derived compensation levels, tax-exempt health care entities and for-profit health care entities are comparable in at least one important respect.  Both types of health care entities are subject to the Medicare fraud and abuse statutes and regulations.

 

Therefore, ignoring income tax status considerations, neither type of health care entity may seek reimbursement for employee or contractor compensation expense in excess of fair market value compensation levels.

 

Second, health care entities and many related industry entities are comparable in at least one other important respect.  That is, they all compete for the same pool of executive and professional talent.  Health care providers, insurance companies, pharmaceutical companies, research institutes, universities, and other organizations all are competing to recruit the same pool of executive, technical, and professional talent.  In addition, when a health care entity employee or contractor decides to change jobs, he or she can interview with all of these related-industry entities.

 

Employers will recruit—and compensate—the most talented employees (even if that means recruiting an employee from a related industry).  Likewise, employees will interview with—and work for—the highest-paying employers (even if that means working for an employer in a related industry).

 

Therefore, in a fair market value compensation analysis, the analyst should consider the “big picture” with regard to compensation paid by competing employers and compensation received by competing employees.  With regard to the supply and demand for executive, technical, and professional talent, comparable organizations can be: (1) either for-profit or not-for-profit, and (2) in related industries.

 

A Services Supplier Cannot Earn Excess Profits on a Fair Market Value Compensation Services Contract

Like the fair market value of employee and contractor compensation, the general rule with regard to the fair market value of supplier contract price is that it should be supported by empirical market data.  That is, the subject health care entity contract price should be comparable to prices paid by comparable entities for comparable contract services.

 

Similar to employees offering their employment services, service providers are free to offer their services to both for-profit entities and tax-exempt entities.  Service providers are also free to offer their services to entities in related industries.  Accordingly, for-profit entities and related industry entities may provide a source of empirical data for assessing the fair market value of market-derived contract services prices.

 

Further, there is no statutory or regulatory prohibition that an efficient services provider cannot earn a profit margin (even a high profit margin) providing services to a health care entity.  Rather, the services providers must charge fair market value prices for the services they provide to the health care entity.  Excess earnings methods and profit split methods may have certain applications in health care property valuation circumstances.

 

However, neither of these methods are used to measure the fair market value price for professional, administrative, technical, or other contract services provided to a health care entity.

 

Analysts Should Only Consider Data from For-Profit Acquirers in Health Care Property Valuations

Some analysts erroneously believe they should only consider valuation variables extracted from empirical data with regard to for-profit buyer transactions.  Such valuation variables may include discount rates, capitalization rates, pricing multiples, etc.

 

These analysts erroneously believe this procedure will prevent the subject health care entity (particularly a tax-exempt entity) from paying more than fair market value for property or services.  Presumably, this belief is based on the erroneous premise that tax-exempt buyer transactions (related to property or services) include some amount of price premium associated with the buyer’s tax-exempt status.

 

In other words, this belief is based on the misconception that tax-exempt entities generally pay more than a fair market value price for purchased property or services.

 

It is possible that any buyer (health care or otherwise, tax-exempt or otherwise) could occasionally pay more than fair market value for property or services.  Likewise, it is possible that any buyer could occasionally pay less than fair market value for property or services.

 

However, there is no empirical evidence to indicate that any class of buyer (and particularly health care buyers or tax-exempt buyers) consistently pay more than (or less than) fair market value for property or services.  Therefore, there is no empirical or theoretical reason to exclude a tax-exempt health care property or services transfer from the analyst’s data gathering or valuation analysis.

 

Paying a Fair Market Value Price is the Same as Having a Commercially Reasonable Purpose

To comply with federal statutes and regulations, health care entities (and their legal counsel) often ask the analyst to opine both that a pending transfer: (1) is priced at fair market value, and (2) is commercially reasonable.

 

Some analysts erroneously believe proving one of these propositions (i.e., the transfer is priced at fair market value) also provides the second of these propositions (i.e., the property or services transfer is commercially reasonable has a valid business purpose).  That analyst belief is a misconception.

 

A proposed property or services transfer could be priced at fair market value—and still there is no valid business purpose for the proposed transfer.  In other words, that transfer would not be commercially reasonable.  Likewise, there could be a perfectly valid business purpose for the health care entity to enter into the proposed property or services transfer—yet the transfer could be priced at above fair market value.  In other words, that transfer could still be commercially reasonable (even though it was not priced at a fair market value price).

 

Each of these two opinions (i.e., fair market value price and commercially reasonable purpose) deserves its own individual consideration and analysis.  And, each of these two transfer transaction opinions can be reached by the analyst independently of the other opinion.

 

Summary and Conclusion

This discussion considered common misconceptions with regard to the fair market value analysis of health care entity transfers.  Each of the above-listed analyst beliefs is considered a misconception when it is compared to the professional guidance provided by the relevant statutory authority and regulations.

 

There are, of course, valid analyst beliefs with regard to health care entity fair market value valuations.  First, in the valuation of any health care property transfer, the analyst should understand the transfer transaction.  For example, the analyst should understand if a pending health care entity transaction will be the purchase of the entity assets or the purchase of the entity equity.

 

Second, in the health care property transfer valuation, the analyst should consider both the payment price and the payment terms.  For example, the analyst should investigate if there is any seller financing.  And, the analyst should investigate whether the property purchase price will be paid in cash at the closing—or whether there will be a series of payments over a time period.  If there are payment terms, the analyst should assess whether those terms are at fair market value.

 

Third, the analyst should consider if there are several contracts being entered into as part of the health care property transfer.  For example, the analyst should consider whether there are earn-out provisions to the health care property transfer transaction.  And, the analyst should consider whether there are employment agreements, noncompete agreements, intellectual property licensees, lease transfers, or other agreements that are part of the overall transaction.  If so, the analyst should assess the fair market value of the total (multi-contract) transaction.

 

Fourth, the analyst should consider whether the health care transaction includes both a property transfer and a services transfer.  And, the analyst should consider the direction (i.e., from whom to whom) of both the property transfer component and the services transfer component.  Both components of the health care transfer have to be at fair market value if the total transaction is considered to be a fair market value transaction.

 

Finally, this discussion considered both analyst misconceptions and analyst correct perceptions with regard to the fair market value analysis of a health care entity property transfer or services transfer.

Robert Reilly is a managing director of Willamette Management Associates and is based in Chicago. His practice includes business valuation, forensic analysis, and financial opinion services. Mr. Reilly is prolific writer and thought leader that can be reached at: (773) 399-4318 or at: rfreily@willamette.com.