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At yesterday’s session on Cost of Capital with Carol Carden at the BV Conference, one of my colleagues raised the question from the floor about whether “valuing the transaction” in healthcare constitutes strategic value. It clearly does not. Among the many aspects of the healthcare industry is the regulatory construct which requires fair market value as a standard in all valuation engagements. Therefore, one of the things that an appraiser must learn in practicing in the healthcare industry is how to apply the FMV standard of value to valuation models where someone unfamiliar with the regulatory construct might inadvertently develop strategic value – or, for fear of developing strategic value, default to valuing some “hypothetical” transaction.
“Terms Make the Deal” is a common cliché’ in transactions but it is not an indicia of strategic value. As a simple example, consider the value of a noncompete agreement as part of the enterprise value of a given medical practice. Assume that the seller has the ability and intent to compete post-transaction absent a contractual provision precluding that competition. A Hypothetical Buyer would pay less for the business – if pay anything at all – absent the noncompete, while a hypothetical seller expects to be paid for not competing in addition to being paid for the value of the other assets being sold. Thus, the noncompete has an identifiable value - that can be determined through a “with and without” analysis – and two different Fair Market Value prices would be determined for the Enterprise based upon the Terms of the Deal. The question is not whether the presence or lack of a covenant presents Strategic Value – it does not – the question is what Hypothetical Buyer and Seller would reach as a purchase price for the business with and without the noncompete.
The discussion cannot stop there. The Terms of the Noncompete itself determine its value. Thus, a noncompete with a geographic restriction of 10 miles might be expected to have a value less than one with a geographic restriction of 25 miles, assuming that the catchment area of the medical practice extended beyond 10 miles. The sale of the practice with a 10 mile noncompete provision versus one with a 25 mile noncompete provision would have two Different Fair Market Values! Nothing about the geographic range of the noncompete term represents strategic value so long as the Appraiser focuses his or her attention on what a Hypothetical Buyer and Seller would agree to as a transaction price.
As I responded in yesterday’s session, Appraisers need to focus on what actual assets are being transferred. One of the important lessons learned from the literature on FAS 141/142 and the focus on valuing the left – Asset - side of the Valuation Equation is that the Market Value of Invested Capital is the aggregate of the Assets of the Business. If the Transaction Documents pull out certain of those assets – like Accounts Receivable net of payables, for example, which is a common exclusion in a medical practice sale – a Hypothetical Buyer and Seller would and in fact must adjust the actual Transaction Price, notwithstanding any conclusion of MVIC – or, risk regulatory review due to paying for something you did not receive, a primary indicator that a prohibited buying-of-referrals motive was present.
As I further stated several times during the presentation, the 2008 Tax Court Case Derby makes it very clear that the Appraiser must – read that must – review the actual transaction documents specifically with respect to the post-transaction compensation and terms of the noncompete in order to determine the value of what was transferred. If the actual documents are not available, key assumptions such as post-transaction comp and noncompete terms must be obtained from the client and they should be 1) specified in the Report and 2) considered for a Representation Letter. This is a left-hand side or Asset approach to valuing transaction in contrast to the simpler, default right-hand or Invested Capital Approach. Assets have a Fair Market Value just as does Invested Capital and due to the Terms of the Deal, the two may not always be equivalent because either 1) some element of the Invested Capital is not transferred like working capital or 2) the terms of the transaction transfer more or less value that what the Appraiser’s generic concept of the transaction might be, such as a noncompete with a 10 versus 25 mile radius.
In healthcare transaction we encounter these nuances more often than not. We are expected under the regulatory standard of practice to assign value to these nuances, otherwise the transacting parties and the Appraiser risk civil or criminal prosecution.
As a final thought, real estate appraisal and transaction are no different! If a hypothetical buyer makes an offer on a home and the Building Inspection determines that the heating system is about to fail and will cost $10,000 to replace, one expects that the Hypothetical Buyer and Seller will make an adjustment to the Offer Price – or else a transaction will not take place. Simpler still, if there are two otherwise identical 4 bedroom homes located in the same neighborhood and one has been recently renovated with new kitchen cabinets, bathroom fixtures and a deck and the other requires updating, they will have two different prices. The reason is that the condition of the underlying component assets being transferred differs! The utility and the present value of expected future outlays by the owner to maintain House 2 are greater than House 1 making House 1 more valuable today!
Don’t fall victim to the tired argument that valuing the actual assets transferred in a transaction somehow constitutes strategic value. Only the Fool of Circus-man PT Barnum’s famous adage would pay $10 for a $5 bill.
AHLA/BVR’s Guide to Healthcare Valuation is now available. The Guide, edited by Mark Dietrich, is co-published by the American Health Lawyers Association and Business Valuation Resources. http://cpa.net/?page_id=427
Frank is one of the premier resources to CPAs in the healthcare consulting and valuation communities. He now has available at http://www.frankcohen.com/html/products.html the Top 50 CPT Codes by billed services utilization (count) frequency, charge frequency and others for 2009. I order this material from Frank every year and it saves countless hours of analysis - already have 2009 on hand. Good valuation work work requires CPT analysis, particularly with the Medicare Bonus of 10% to Primary Care Physicians based on specified CPT codes.
Healthcare Reform - The Inside Scoop: What it Means to You, Your Small Business and Individual Clients.
On October 20, I will be reprising my half-day Seminar on the Healthcare Reform legislation for the Michigan Association of CPAs, which has been updated to reflect the barrage of tax announcements and insurance regulations that have been issued since the presentation was first given in June. The venue is the Baronette Renaissance in Novi.
The Massachusetts Society of CPAs will run the Reform Seminar again on October 25 at the Crowne Plaza in Natick. A third presentation will take place in Stockbridge on January 21, 2011 at the Red Lion Inn.
This highly successful program offers attendees not only an update on tax issues but the unique perspective of a tax practitioner and healthcare industry consultant with extensive experience in negotiating insurance contracts on behalf of healthcare providers. Learn about how health insurance actually works and why the Reform legislation promises to drive up the cost of insurance for small businesses dramatically, even as it increases the out of pocket costs for individuals.
Program materials will include the Chapter on the Reform legislation from my new Guide to Healthcare Valuation, co-published by the American Health Lawyers Association and Business Valuation Resources.
In a report released September 2, 2010 - that I have been awaiting since 2007 - the Center for Studying Health System Change confirms what many observers including myself have independently determined about the Reform in Massachusetts that was used as the Model for the Federal Reform: 1) Massachusetts is an anomaly of limited relevance to the Nation - which itself is a series of anomalies. Academic Medical Center dominance along with specialist concentration and the highest per capita concentration of physicians in the country are at the core of that limited relevance as is a high per capita income; 2) the cost inflation in the small group insurance market as a result of merging that market with the individual market has been nearly DOUBLE that anticipated - and I would maintain from my personal experience that it is closer to FIVE times the level indicated in the HSC report; 3) Hospitals - the BIG winners in Massachusetts' Reform and again in the federal Reform - are driving the Cost Explosion Train; 4) reading between the lines, lack of Antitrust Reform, the threat of which was much ballyhooed during the purported debate on Federal Reform, has led to the ability of the provider community to raise rates willy-nilly (a technical term) which the Health Plans estimate contribute to 50% of the cost increase trend. The problem originates with the McCarran-Ferguson Act exemption for insurers, which led to provider consolidation in the 1990s and 2000's and the collapse of price competition; 5) MA Attorney General Martha Coakley - the victim of Senator Scott Brown's Senate Campaign - exposed the pricing anomalies in an incredibly detailed February, 2010 Report with data that only a government official with subpoena power or an experienced healthcare consultant could have obtained.
The mess created by 4 years of Reform in Massachusetts - which includes high unemployment unrelated to the Recession - finally required remedial action by the Executive and legislative branches in the last 6 months. Facing likely defeat in his reelection bid, the governor instructed his insurance commissioner to deny rate increases in the merged small group market of 10% to 30%, which were partially allowed in settlements reached between June and August. The legislature voted to permit small business to form purchasing cooperatives - or association health plans, which were banned by the state in 1996! - this past July.
Read the Report here http://www.hschange.org/CONTENT/1145/
Read about the nonpartisan Center for Studying Health System here: http://www.hschange.org/index.cgi?file=about which is funded by the Robert Woods Johnson Foundation.
Sometimes, the Truth hurts.
Larry E. Howard and Joan M. Howard, Plaintiffs v. United States of America, Defendant, U.S. District Court, E.D. Washington,2010-2 U.S.T.C. ¶50,542, (Jul. 30, 2010) is a new case re-emphasizing the factors established in Martin Ice Cream and Norwalk. Howard involved the sale of an incorporated dental practice whose owner (Howard) had, perhaps inexplicably, entered into a 3-year post-employment noncompete agreement with his corporate practice. The Court found that the goodwill of the practice was owned by the corporation, not Howard personally, and that the sale proceeds attributed to that goodwill resulted in a dividend to Howard and a tax of $60,129, together with interest of $14,792.
The Court stated "In order to resolve issues of tax liability arising from legal interests, the Court must look both to state law for the determination of the legal interest and federal law for the taxation of the interest." As I have maintained in the years since Norwalk and my articles in CPA Expert and BVR's Guide to Goodwill Valuation and various conference and seminar appearances, analysis of state law remains a critical component of any valuation of a noncompete agreement - whether it be for tax purposes, damages purposes or, in most circumstances, marital dissolution purposes. The new edition of AHLA/BVR's Guide to Healthcare Valuation includes several chapters written by me addressing both the valuation of enterprise and personal goodwill along with noncompete agreements, as well as damages from the violation of noncompete agreements. http://cpa.net/?page_id=427
I will observe that the Court cited "MacDonald v. Comm'r 3 T.C. 720, 726, 1944 WL 121 (1944), for the proposition that if an employee works for a corporation under contract and with a covenant not to compete with that corporation, as Dr. Howard did, then the corporation, and not the individual professional, owns the goodwill that is generated from the professional's work" a case that I would have regarded as "history" after Martin Ice Cream. The Court also discussd that "the Furrer court divided an employee's goodwill as goodwill for his company, and separately, goodwill for himself, “such as personal contacts … .” Furrer v.Comm'r 566 F.2d 1115, 1117-1118 (9th Cir. 1977).
Citing Norwalk, the Court observed "“In determining the value of goodwill, there is no specific rule,and each case must be considered and decided in light of its own particular facts. Moreover, in determining such value it is well established that the earning power of the business is an important factor.” This reminds us that cases are very fact-specific.
Finally, the Howard Court concluded "Bound by the covenant not to compete with Howard Corporation for a period of three years beyond when Dr. Howard no longer held Howard Corporation stock, which was until the dissolution of the Howard Corporation at the end of 2003 ( see Ct. Rec. 28, Ex A at 28), Dr. Howard could not have earned income from a competitive dental practice within fifty miles of Spokane (Ct. Rec. 28, Ex F). Therefore, even if the goodwill had belonged to Dr. Howard personally, it likely would have little value, because Dr. Howard could not have practiced within a fifty mile radius from his previous practice location for at least three years beyond the date of the Howard Corporation dissolution. Those prohibitions would likely discourage patients from following Dr. Howard to a new location."
The New AHLA/BVR Guide also addresses related reasonable compensation issues related to goodwill and the "independent investor" test of Exacto Spring (Seventh Circuit Ct. of Appeals, No. 99-1011 reversing T.C. Memo 1998-220)
Note: See also Technical Advice Memorandum 200244009.
I'll be speaking on Monday August 2 in Washington DC for CPA Associates Intl at their annual valuation conference on Medical Practice Valuation in the post-Reform era and on the incorrect use of the Cost Approach in valuing practices.
I'll be speaking at the BVR Divorce Summit in Chicago on September 14 on Reform's impact on the Valuation of Medical Practices.
I'll also be speaking at the Michigan Association of CPAs 2010 Specialized Business Valuation Workshop & Simulcast on Tuesday, October 19, 2010 at the Ford Motor Company Conference & Events Center in Dearborn. The following day - on October 20 - I will be reprising my half-day Seminar on the Healthcare Reform legislation for the Michigan Association, which will be updated to reflect the barrage of regulations that have been issued since June.
The Massachusetts Society has me asked me to present the Seminar on the Healthcare Reform again and that will take place on October 25 at a location to be announced, likely Framingham or Natick.
I'll be presenting two sessions at the AICPA National Healthcare Industry Conference in Vegas this November. One session will deal with antitrust issues in transactions and negotiations between physicians, hospitals and networks, with a focus on the new Accountable Care Organizations (ACOs) as well as what can and cannot be shared with respect to fees and how it is accomplished. My co-speaker will be healthcare antitrust attorney Jim Reeder of Vinson and Elkins' Houston office. The second session with my friend and colleague Tim Smith of Healthcare Appraisers will deal with Fair Market Value issues in healthcare valuation and compensation, again with a focus on ACO and other integration transactions. Time permitting, I hope to introduce a new Primary Care Compensation Model I am developing for the ACO market.
Finally - for now - I'll be speaking at the AICPA National Valuation Conference in Washington DC. I'll be sharing the session with my friend and colleague Carol Carden of Pershing Yoakley, who is also Chair of this year's Conference. The topic is Factors in Forecasting Cash Flow and Estimating Cost of Capital in Healthcare and will be based upon our joint paper in the June 2010 issue of Business Valuation Update.