The Practice Buy-Sell Valuation Conundrum

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A buy-sell agreement is a necessity whenever a physician joins a medical practice in an ownership capacity. To avoid future pain, special attention needs to be paid to the formula you use to value the practice.

A buy-sell agreement is a necessity whenever a physician joins an entity in an ownership capacity. While hopefully crafted with great attention at the outset of the practice, the agreement generally is only pulled from the drawer when a triggering event occurs. This is when some practices will experience pain.

While the agreement typically will contain many important sections, special attention should be focused on one particular area: The section dealing with how the practice is to be valued upon the death, disability, termination, etc., of a partner can have an incredibly important effect on the future of the partner and the practice.

As the economics of medicine continue to evolve at warp speed, it is important to periodically review the valuation formulae in these agreements to ascertain their application in the current and ever changing environment of medicine. Unfortunately, this is not always done, since the business of keeping up with the business can take precedence over practice matters which are not immediately pressing.

Let’s say a partner approaches the managing partner of a practice and tenders his resignation, effective in 60 days. Around this occurrence, or shortly thereafter, a demand for payment of his or her equity interest through redemption will be made. Characteristically, at that time the practice will open the drawer and blow the dust off the buy-sell agreement. Included in the termination section will hopefully be some formula which describes in detail the calculation of the value to be paid the departing physician.

Buy-sell agreements can include several different types of formulae for the determination of the value of a departing owner’s interest:

Fixed Formula. This offers a value based on a multiple of a practice metric (for example, three times the prior year’s profit or x% of book value, etc.).

Flat Dollar. Under this arrangement, the value of the interest is already determined by a stated fixed amount.

Valuation Formula. The value of the interest is determined by preparation of a business valuation of the practice by a qualified business appraiser. In some agreements, to provide comfort to the parties that the result will be unbiased, each party (the practice, and the departing shareholder) select a qualified business valuator. The two selected valuators agree on a third valuator to perform the actual practice valuation.

Of these three types of value calculations, only the valuation formula has the best chance of capturing the value of the practice.

Generally, a medical practice will be valued using an income approach. Within this approach, the generally applicable recognized methods of valuation are the capitalization of excess earnings method (“COEE”), or the discounted cash flow (“DCF”) method.

The COEE method makes a presumption that the practice’s past earnings are representative of its future earnings. Once the earnings stream is determined, and appropriate adjustment is made for earnings on the value of assets, the remainder is subjected to a capitalization rate. The result of this computation represents the value of the “intangible asset” of the practice. The fair market value of the practice’s assets is added to this amount. The total of these two amounts represents the value of the practice.

The DCF method presumes past earnings of the practice are not sufficiently relevant for the valuation, and instead, requires a projection of future earnings of the practice for a number of years. These future earnings are then utilized to determine the value of the practice.

While there are other ways to value a practice, these are the most common found in agreements. Each has its benefits and drawbacks, but with careful attention paid during the drafting of the agreement -- and periodic reviews -- a buy-sell agreement can be a very beneficial document for the practice and its owners.

Make sure your buy-sell agreements appropriately address the valuation issue. Once they do, review them periodically to make certain the formulae are still valid in the ever changing landscape of the profession.

Joel Charkatz, CPA, CVA, CFE, and Melissa Pitchford, CPA are shareholders at KatzAbosch P.A., in Timonium, Md., a leading provider of accounting, tax and consulting services to the medical community. Joel and Melissa can be contacted at jcharkatz@katzabosch.com and mpitchford@katzabosch.com, or call (410) 828-6432.

KatzAbosch is also a proud member of the National CPA Health Care Advisors Association. HCAA is a nationwide network of CPA firms devoted to serving the healthcare industry. Members provide proactive solutions to the accounting needs of physicians and physician groups. For more information contact the HCAA at info@hcaa.com.