Introduction
Due in large part to concerns over healthcare reform and declining reimbursement rates, physicians are increasingly looking for opportunities to sell their
practices to hospitals and work as employees. Similarly, hospital systems are interested in acquiring key practices to solidify or expand their provider networks. These transactions are clearly subject to the regulatory restrictions of commercial reasonableness and Fair Market Value ("FMV") imposed by the Stark Law
1 and the Anti-Kickback Statute ("AKS")
2, as well as the Internal Revenue Code Section 501(c)(3) regulations if the hospital is a not-for-profit entity.
Many practices have very low or sometimes negative projected posttransaction earnings after adjusting for the physician's anticipated posttransaction compensation. Accordingly, an Income Approach valuation methodology, such as the Discounted Cash Flow ("DCF") method, will generally result in zero or a very low value for the practice. In such cases, the Cost Approach will be utilized instead. However, the problem arises when the Cost Approach results in substantial values being attributed to intangible assets,3 such as physician workforce, that are not supported by an appropriate level of net cash flow needed to provide an economic return to the hypothetical buyer.
This paper addresses the appropriateness of assigning substantial value to intangible assets such as physician workforce, under the FMV standard, and going concern premise of value, without such amounts being appropriately supported by net cash flow under the Income Approach. The paper first defines the key terms used and describes typical intangible assets, then looks at the theoretical underpinning of the Cost Approach as described in accepted valuation texts and court cases, then examines, critiques and ultimately dismisses the sole use of the Cost Approach to value physician workforce as both a violation of professional standards and the regulatory structure for FMV.
Key Concepts & Definitions
The following key concepts and definitions are important for understanding the analysis and conclusions expressed in this paper.
Commercial Reasonableness Transactions between hospitals and physicians with the ability to refer designated health services ("DHS") must be commercially reasonable. The Stark regulations explain commercial reasonableness as: "An arrangement will be considered commercially reasonable, in the absence of referrals, if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician of similar scope and specialty, even if there were no potential designated health services referrals."4
Accordingly, the commercial reasonableness requirement means the transaction must make good business sense without the potential of future referrals from either party.
Fair Market Value The most widely used definition of FMV is: "The price at which property or service would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of the relevant facts."5
The Stark regulations define FMV similarly as: "The value in arm's length transactions, consistent with the General Market Value." General Market Value ("GMV") is defined as: "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 compensation that would be included in a 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 the acquisition of the asset or at the time of the service agreement."6
Strategic Value In contrast to FMV, strategic value is the value to a particular buyer rather than to a hypothetical buyer. There are a variety of strategic considerations that a specific buyer may employ in determining strategic value, some of which would likely not violate the Stark Law and others of which almost certainly would. For example, a tax-exempt hospital would have access to tax-exempt bonds to acquire a practice, providing a low cost of capital and a correspondingly higher multiple of value. It would also not pay any income tax on income from the practice if the transaction were properly structured resulting in a higher cashflow and strategic value. Although they do not violate the Stark law, these two items likely violate the anti-inurement rules. When compared to a hypothetical nonhospital buyer, a hospital obtains various inpatient referrals from a physician practice, of course, but consideration of these referrals directly or indirectly is prohibited.
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Reed Tinsley, CPA, is a Houston-based CPA, Certified Valuation Analyst, and healthcare consultant. He works closely with physicians, medical groups, and other healthcare entities with managed care contracting issues, operational and financial management, strategic planning, and growth strategies. His entire practice is concentrated in the health care industry.
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