Goodwill

Why it Shouldn’t be A Dirty Word in the Valuation of Physician Practices

The topic of goodwill in a physician practice acquisition continues to be hotly debated. There are very different viewpoints from reputable appraisers on how to value physician practices and whether hospitals can pay for goodwill in an acquisition. I often hear healthcare professionals involved in acquisitions say, “Hospitals can’t pay for goodwill.” However, there is no legal or financial reason why goodwill cannot be considered in a physician practice acquisition. This article discusses the merits of considering and including goodwill in the valuation of a physician practice.

[su_pullquote align=”right”]Resources:

Healthcare 101 For the Valuator

How to Value Physician Practices

Don’t Stumble Coming Out of the Gate—The Top Ten Issues to Address in Physician Practice Acquisition and Valuation

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Goodwill—Why it Should Not be a Dirty Word in the Valuation of Physician Practices

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The topic of goodwill in a physician practice acquisition continues to be hotly debated.  There are very different viewpoints from reputable appraisers on how to value physician practices and whether hospitals can pay for goodwill in an acquisition.  I often hear healthcare professionals involved in acquisitions say, “Hospitals can’t pay for goodwill.”  However, there is no legal or financial reason why goodwill cannot be considered in a physician practice acquisition.

In negotiations, physicians receive value through either the upfront purchase price or ongoing compensation.  Oftentimes, hospitals are putting more value into ongoing compensation.  However, goodwill and other intangible assets are an important part of a physician practice as it is the goodwill and other intangible assets that drive the income of the practice.

In reality, there is no legal constraint for paying for goodwill, it is not paying for referrals, and can be beneficial from the perspectives of both the buyer and the seller.  Paying upfront for goodwill rather than through increased compensation can positively affect ongoing future cash flow.

Historical Trends in Physician Practices and Acquisitions

To better frame the discussion about goodwill, it is important to understand the trends in physician practice transactions and how we arrived at the point we are today.

Prior to the 1980s, the number of physicians numbered around 150 per 10,000 people.  Physicians were able to simply “hang up a shingle” and thanks to overwhelming demand and a limited supply of physicians, they largely succeeded.  Physicians did not acquire practices because there were not any practices for sale.  Then by 1985, the number of physicians grew to more than 240 per 10,000 people.  In fact, from 1960 to 1988, the physician population grew three and a half times faster than the general population.

But, as the supply of physicians increased, it generated a greater interest in acquiring practices rather than starting from scratch because of the lower costs of acquiring a practice.  The payment for goodwill as part of a physician practice acquisition was part of those transactions.  In fact, many physicians who are now selling their practices paid goodwill when they acquired their practice.

In 1990, concern over growing healthcare costs grew, as did discussion about regulation.  PPOs and HMOs developed rapidly, and the acquisition of physician practices increased along with their prices.  As with most businesses, as the demand businesses grows, so does price buyers are willing to pay and the corresponding fair market value (FMV).

In the decade that followed the year 2000, utilization and the cost of healthcare grew rapidly.  Questions about whether the physician practice acquisitions were causing cost increases were raised.  In addition, regulators called into question whether the payment for goodwill was payment for referrals in physician practice acquisitions.  So, health systems and their legal counsel started to scrutinize the goodwill amount in transactions.

However, these concerns did not decrease physicians’ expectations about the value of their practices.  To get a deal done with the concern on the price of the practice, more value was going to physicians in the form of compensation rather than purchase price.  This often did not change the overall cash going to the physician, but changed how and when the physician was paid, and the payment was no longer called “goodwill.”  The payment, however, was likely due to the success of the physician’s practice and was really related to the “goodwill” developed in that practice.

Regulations and the Effect on Physician Practice Transactions

To try and stem the growing healthcare costs, increased regulations occurred.  Whether these regulations did decrease the cost of healthcare is up for debate.  They did push the growth of physician practice acquisitions and decrease the price paid for practices due to the price concerns being raised.  However, they also decreased the competition and increased physician compensation paid by health systems to the point where average physician compensation is now higher under a health system compared to an independent practice.  The regulations around FMV affecting this trend included the Stark and anti-kickback regulations and the definition of FMV and commercially reasonable within these regulations.

The federal physician self-referral law, or Stark Law 1, was passed in 1989.  It prohibits physician referrals for designated health services for Medicare and Medicaid patients if a physician has a financial relationship with the entity, unless the payment is at FMV and compensation is established in advance and not determined based on volume or value of referrals.  The Stark law was further revised four times in 2002, 2004, 2007, and 2009 with additional language and noted exceptions.  However, the same concept prevailed.  The Stark laws were implemented to ensure payments for certain healthcare services or transactions between physicians and hospitals did not factor in referrals to the hospital to induce more procedures and the payment between physicians and hospitals had to be at FMV.

The Anti-Kickback Statute promulgated by the Office of the Inspector General (OIG) is an important federal fraud and abuse law affecting healthcare entities.  It prohibits the knowing and willful offer, payment, solicitation, or receipt of remuneration to induce or reward referrals of services reimbursable by a federal healthcare program (such as Medicare or Medicaid).  Therefore, if payments are above FMV, the OIG assumes the action is fraudulent.

Arrangements between hospitals and physician practices must also be commercially reasonable, an element of key compensation exceptions to the Stark Law and one that differs from the concept of FMV.  An agreement is considered commercially reasonable if it makes good business sense (a sensible, prudent business agreement from the perspective of the parties) and if any entity would be willing to enter the same agreement absent potential referrals.  The concept of commercially reasonable is different from FMV as an arrangement could be at FMV, but not be commercially reasonable or not be a “normal” arrangement that other individuals would enter without the potential referrals.

All these regulations were implemented because of the concern over the growing cost and utilization of healthcare.  The question raised was whether these arrangements between hospitals and physicians created incentives for increased volume of services performed (labs, x-rays, etc.) and increased the price of those services.

However, the concern is more closely correlated to how physicians are compensated after they are employed than the one-time payment for goodwill.  Payment for goodwill in an acquisition is not directly tied to any service performed at the hospital or any revenue generated prior to the acquisition.

Since 2010, Stark violations relating to physician compensation have become more prevalent because of growing physician compensation.  If you look at the current scrutiny of compensation, health systems should spend more time scrutinizing compensation arrangements established as part of an acquisition.  If health systems want to grow their business lines and need to be cautious about compensation, and if physicians want to receive a fair value for their practices, goodwill and other intangible assets is a consideration to get a deal done that meets the FMV standard of “willing seller” and “willing buyer.”

Fair Market Value: Breaking It Down

As we look to support a price between a hospital and physician that is FMV, it is important to understand what FMV means.  FMV as defined by the IRS is:

“The price at which the property would change hands between a willing buyer and a 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.”

The definition of FMV is very similar under Stark, but the concept of “compulsion” is replaced with language such that market value does not factor in referrals or the ability to “generate business for the acquiring party”.

In most business situations, FMV is arrived at by a buyer and seller negotiating a price they feel is reasonable and meets their expectations.  Normally the seller wants to sell at the highest price possible and the buyer wants to pay the lowest price possible.  As they negotiate, they arrive at a price they both can agree to.  That price is what would be considered FMV.  For healthcare transactions, appraisers often get involved in setting the price to ensure referrals are not factored into the price a hospital is willing to pay.  The FMV from an appraiser should still be the same as what the buyer and seller would otherwise negotiate, without factoring in referrals.

To arrive at the FMV, appraisers will use the Cost, Income, and Market Approaches to value.  However, many appraisers have very different ideas on which methods are most appropriate for calculating FMV and these approaches may yield very different results.

As appraisers, it is our job to put ourselves in the shoes of the buyer as well as the seller and arrive at a value the buyer and seller would agree to, without the compulsion to buy or sell, and without consideration for value or volume of referrals.

To do so, consideration should be given to the price that is paid between willing buyers and willing sellers that do not refer business and consider the economics of the deal to both the buyer and seller.  Part of the considerations buyers make in their decisions is how much it would cost to start up a comparable business or the future cash flow difference of buying an existing practice compared to developing one from scratch.  These considerations can be assessed using the market and cost approaches to value.  The Income Approach is important as well but may consider the income “with” the practice and the income “without” the practice, without factoring referrals into the equation.

By performing all those approaches, in my opinion as an experienced appraiser of healthcare practices, paying for goodwill and intangible assets in a physician practice acquisition can be supportable as FMV and commercially reasonable. 

Goodwill in Physician Practices

The practice of paying goodwill in other small businesses draws comparisons with paying goodwill in physician practices.

In small businesses of a size like a physician practice that generate comparable income for the owner, goodwill is often paid when all the compensation goes to the owner, as it does in physician practices.  Interestingly, of the 259 asset purchase transactions in the online database Pratt’s Stats, with one million to five million dollars in sales and discretionary earnings of less than $200,000, over 80% of them included intangible assets in the purchase price.

In addition, healthcare practices that are not being purchased by hospitals and are not concerned with Stark Laws and the Anti-Kickback Statute, such as dental, optometry, therapy, and chiropractic practices, continue to receive payment for goodwill.

In many healthcare valuations today, value is placed on workforce in place.  Placing value on workforce in place is further support goodwill is part of a physician practice.  For financial reporting purposes, payment for workforce in place is treated as goodwill, under the AICPA fair value standards.

Prior to hospitals getting involved in physician acquisitions, payment for goodwill in a physician practice in the 1990s was very common.  This can be seen by reviewing transactions in the Goodwill Registry, a publication by The Health Care Group that includes information on the prices and goodwill being paid for physician practices.  The Goodwill Registry has over 10,000 transactions, with more than 5,000 involving primary and secondary physician practices as well as dental, therapy, or ASC transactions.

Paying for Goodwill is a Smart Move

Goodwill can be supported through reviewing past transactions of physician practices not involving hospitals, small business transactions, and practice transactions for which referrals are not a concern.

In addition, while there are several Stark legal cases involving healthcare facilities and FMV, the large majority did not relate to the purchase price or goodwill but rather were related to annual compensation being paid to the physician.  Tying compensation to production has historically created more scrutiny by regulators than payment for goodwill in acquisition price (paying for what was built in the practice, not referrals).  Therefore, more concern should be focused on the compensation piece than the purchase price.

The goodwill and other intangible assets in a practice are important assets that are purchased in a physician practice acquisition.  It is not the tangible assets such as desks, exam tables, or supplies that create value in a physician practice, it is the goodwill and other intangible assets that create value as they drive income.  Physician practice buyers would agree the value lies in the trained workforce, patient base, systems in place, location, and established practice.  These are all intangible assets/goodwill.  Therefore, value should be placed on the assets that create the most value to the buyer.

Another reason paying for goodwill is the right decision is that it may cost the buyer less in the long run.  If more dollars are included in the ongoing annual compensation to the physician, that number does not normally decrease in the future.  Therefore, if instead of paying someone $500,000 upfront, you pay an additional $100,000 in compensation, after five years you have paid more for the practice.  The obvious cost savings is the reason many buyers will pay for goodwill and other intangible assets in an acquisition.

Goodwill Should Not be a Dirty Word

Paying for and characterizing goodwill in a transaction is legal and can be beneficial to both parties.  While not all acquisitions warrant value for goodwill, goodwill should be considered part of the transaction if the cash flow and practice characteristics warrant it.

The same considerations that are factored into any small business under FMV standards should be factored into a valuation of a physician practice being acquired by a health system.  By assigning value for goodwill in a transaction, physicians receive value for something they have built, and health systems may pay less in the long run.

Lisa Cribben, CPA, ABV, ASA, is a Partner with Wipfli LLP in their Valuation, Litigation, and Transaction Services Group. She assists Wipfli LLP’s clients all over the United States with their valuation and purchase and sale transaction support needs. With over 10 years of operational and 18 years of valuation experience, she can provide expert advice with an understanding of client needs.

Ms. Cribben can be reached at (920) 662-2897 or by e-mail to lcribben@wipfli.com.