Health Care Valuations
"Fair Market" valuations still dominate the
highly regulated health care industry. Where are "Fair Market" valuations
needed? Physician practice mergers, physician/hospital joint ventures,
buy/sell agreements, entity sales, medical directorships, consulting thought
leaders, management agreements, equipment leases, staffing, etc.
As used herein, the term fair market value is "the value in an arm’s length
transaction, consistent with the general market value.” General market value
is the price that an asset would bring as the result of bona fide bargaining
between well-informed buyers and sellers who are not otherwise in a position
to generate business for the other party or the compensation that would be
included in the service agreement as the result of bona fide bargaining
between well-informed parties to the agreement who are not otherwise in a
position to generate business for the other party, on the date of
acquisition of the asset or at the time of the service agreement. Usually
the fair market price is the price at which bona fide sales have been
consummated for assets of like type, quality and quantity in a particular
market at the time of acquisition or the compensation that has been included
in bona fide service agreements with comparable terms at the time of the
agreement, where the price or compensation has not been determined in any
manner that takes into account the volume or value of anticipated or actual
referrals. (Federal Register Vol. 69, No. 59 Section 411.351)
With respect to service agreements described in Federal Register Vol. 72, No. 171 Section 411.351, fair market value can be derived from applying a commercially reasonable methodology that is appropriate under the circumstances. Previously, the regulations of Federal Register Vol. 69, No. 59 had allowed for safe harbor calculations of fair market value for such arrangements. Further, the Federal Register Vol. 72, No. 171 states that “references to multiple, objective, independently published salary surveys remains a prudent practice for evaluating fair market value.” Federal Register Vol. 72, No. 171 goes on to state, “ultimately, the appropriate method for determining fair market value for the purposes of physician self-referral law will depend on the nature of the transaction.”
Under IRS final regulations concerning excess benefit transactions (67 Fed. Reg. 3076 (January 23, 2002), the term "fair market value" means, with respect to both the transfer and the right to use property, the price at which the property or the right to use property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy, sell or transfer property or the right to use property, and both having reasonable knowledge of relevant facts”). Furthermore, such IRS regulations also provide, with respect to services provided, that the fair market value of services is the amount that would ordinarily be provided for like services by like enterprises (whether taxable or tax-exempt) under like circumstances (i.e., reasonable compensation).
There are many factors that must be considered in the valuation of a business enterprise. Among them is the pattern of historical performance and earnings, the practice’s competitive market position, experience and quality of management, marketability and others. These factors are embraced by the Internal Revenue Service’s Revenue Ruling 59-60, which outlines relevant considerations to be used as a valuation guideline:
- The nature of the business and the history of the enterprise from its inception
- The economic outlook in general and the condition and outlook of the industry in particular
- The book value and financial condition of the business
- The earning capacity of the practice
- Whether or not the enterprise has goodwill or other intangible value
The factors, guidelines, techniques and considerations outlined in Revenue Ruling 59-60 are often categorized into three distinct approaches for valuing companies. Accordingly, the development of a fair market value opinion is based on the utilization of three basic approaches to value; namely, the income approach, which uses the capitalized net excess cash flow or discounted future cash flow methods; the market approach, which utilizes the guideline practice method; and the asset based approach. Value indications derived through the applicable methods under each approach are then analyzed in association with specific entity, economic, and industry data to formulate an objective opinion as to the fair market value of the particular subject business.
For this valuation, a combination of the income, market and asset methodologies will be utilized. The income approaches are based upon the present value of future benefits of ownership (discounted future cash flow) and this historical capitalized net excess cash flow of the practice, and the market approach is a comparison of similar practices that have sold and for which a price is known. The valuation results will include an estimated total value of the practice.
Guideline Practice Method
Data on actual arm’s length transactions generally provides the most direct, objectively determined evidence of a practice’s fair market value. As such, the value of an asset is often defined in terms of what it is sold for in a cash transaction. This same value should apply not just to the asset being sold, but also to all similar assets. Therefore, a practice’s value can sometimes be determined based on what similar or comparable practices have recently been sold for in cash transactions. The value of a practice can be accurately determined by reviewing the values of similar medical practices in the marketplace.
Capitalized Net Excess Cash Flow Method
This approach relies on the ability to obtain financial data for a representative period of time. In addition, this approach normally produces an estimate of the value for the entire practice. However, to be truly considered a control value, the net excess cash flow to be capitalized should be representative of “normalized” cash flow. That is, the cash flow should represent the amount that a control owner would expect to receive. The capitalized net excess cash flow method is a more appropriate valuation method when it appears that a medical practice’s current operations are indicative of its future operations (assuming a normal growth rate). As such, this approach includes a risk premium associated with the uncertainty of the continuation of the trend in net excess cash flow.
Asset-Based Approach
The asset-based approach includes estimation of the reproduction cost of the assets comprising the practice. In this approach, the tangible and intangible assets of the practice are valued individually on a going-concern basis and then aggregated to indicate total value. Unless otherwise noted, we utilize balance sheet data as of a specific date. The components of the business enterprise value include net working capital, which is defined as current assets less current liabilities plus fixed and intangible assets.
Discounted Future Cash Flow Method
This approach is used to estimate the value of the anticipated cash flow to an investor looking for a specified rate of return. This valuation method is generally only as reliable as its two primary components: the projection of future returns (including the terminal value) and the discount rate. This method tends to be more appropriate over the capitalized net excess cash flow method when future operations are expected to be substantially different from current operations. As such, this approach includes a risk premium associated with the uncertainty of the anticipated cash flow and an additional premium equal to the assumed rate of growth used to determine the expected future cash flow.
Members of Somerset's Litigation & Valuation Team and Health Care Team are very experienced in all types of health care valuations. Please contact us when you need expertise in this area.
This newsletter is provided by
Somerset for our clients and other interested persons upon request.
Since technical information is presented in generalized fashion, no
final conclusion on these topics should be made without further review.
For additional information on the issues discussed, please contact
Steve Riddle,
Tom
Thieme,
Rex Collins or
Doug
Ayres
of our
Litigation & Valuation Team.
This document is not intended or written to be used, and cannot be used,
for the purpose of avoiding tax penalties that may be imposed on the
taxpayer.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
