Physician Practices Sales – Advanced Concepts

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“I’m altering the deal, pray I don’t alter it any further.” – Darth Vader [iStockPhoto]

During the sale of physician practices, purchase agreements and employment arrangements are negotiated and executed concurrently. There is a fluid give and take relationship between the practice purchase price and forward-looking physician compensation.  Not being able to explain how purchase price affects physician compensation can be a real deal killer.

Since 2008, there has been a marked increase in the sale of independent physician practices to hospitals and health systems.  Compared to the physician employment trends of the 1990s, buyers have generally paid much less for physician practices during the last six years.

The main reason for these lower sale prices is that buyers have more carefully considered the relationship between physician compensation and the business value of physician practices.  The figure below graphically illustrates how physician practice profit is usually reclassified as physician salary expense.  This reclassification adjustment eliminates business value because there is no left-over cash flow (no profit) to value.  When this approach is applied, physician practices usually sell for the value of their equipment and furniture.  Physicians enter into employment agreements and receive very little for the business sale component of their practice.

Typical Physician Practice Sale Adjustments

However, there are several circumstances when physician practices do have business value.  For these types of sales, it is important to understand how the business value and employment offer are related.

A Growing Practice

Let us assume that further examination of the same practice reveals that it has actually grown 10% per year for the past three years in a row while maintaining the same profit margin.  The development of a future projection for the practice shows that the practice will likely grow 10% per year for the next four years as well.

Historical Trends & Projection for Same Practice

For physician practices with growth trends such as this one, depending on how future physician compensation is set, there is clear evidence for business value.  In Chart 2 below, you can see that physician compensation is set at the 2013 level.  Therefore, because physician compensation is semi-fixed, future growth in revenues creates profit for the buyer.

Fixing Physician Salaries at 2013 Level

The tricky part is that any change to the proposed compensation plan, or business valuation, directly effects the other component.  In the tax court case Derby v. Commissioner the court determined that for transactions involving both a practice sale and a compensation offer, the same post-transaction compensation offer should to be factored into the business valuation.  This means that each and every possible adjustment discovered during due diligence process could possibly have an effect on both the practice sale price and the proposed compensation.

Here are three examples.

Example #1:

During due diligence, several discretionary and one-time expenses are identified that can be removed.  These include (a) one-time attorney expenses to review all the practice’s policies and procedures, (b) consultant expenses related to the sale, and (c) discretionary travel expenses for sending staff to certain conferences.  The removal of these items reduces the practice’s total annual expenses by $100,000.

This extra $100,000 in profitability can be credited to the business value or be considered an extra $100,000 in annual physician compensation under the future plan.  Or the extra $100,000 could be split with $60,000 being credited to the business value (perhaps increasing sale price $180,000 with a 3.0x multiple) and the other $40,000 being applied to the annual physician compensation plan as an increase.

Example #2:

The physician owners are close to retirement and the practice sale price is a higher priority to them than the future compensation proposal.  During due diligence, the parties decide to split the practice into two businesses.  One business is the professional physician practice and the other business is the in-office MRI business.  The owners/sellers would rather have an extra $200,000 of their practice’s overall profit be realized as MRI business value rather than personal compensation because the 4.0x multiple on the MRI business yields an additional $800,000 on the sale price ($200,000 x 4.0  = $800,000).  While the three owners’ compensation will be $200,000 lower per year during their employment contract, they prefer the upfront payment because they do not intend to work much longer.  The buyer is equally amenable to this arrangement, because after the owners retire in 3 years, it can replace them with younger, less costly physicians.  The current owners will stay on for a three year employment contract to help with the transition to the new physicians.

Example #3:

During due diligence, it is discovered that Medicare reimbursement for in-office imaging will decrease next year, resulting in a $100,000 decrease to revenues.  This $100,000 adjustment to revenue will have to manifest as an adjustment to the business value, or annual physician compensation, or split between the two.  If business value is more important to the physicians than future compensation, the three owner/sellers may waive the proposed compensation for their three directorships to keep the projected profit margin budget neutral and maintain their sale price.

Selling and buying physician practices can be a tenuous process.  As much research and preparation as possible should be conducted before putting an offer on the table because adjustments discovered during due diligence can create the appearance of a “bait and switch” tactic that is frustrating to both parties.