“I only want you to tell me what the doctor’s practice is worth. I will worry about her salary. Why do you care about compensation anyway?”
This is a common response from clients when we ask for post-acquisition physician compensation as an input to determine fair market value of the physician’s practice in a potential acquisition. Hospitals sometimes try to compartmentalize physician practices by looking at the value of the business apart from the value of the physician’s services. Because medicine is a service-based industry, however, value is largely dependent on income from physician services, and physicians expect compensation for such services. Therefore, you cannot consider the value of a physician practice without considering the value, or cost, of its primary income generator, the physician.
The impact of physician compensation on the physician practice is most recognizable when considering the business value from an earnings perspective. Earnings are the result of two primary drivers – revenues and expenses – and typically, physician compensation makes up a significant portion of a practice’s expenditures. A change in physician compensation has a direct impact on a practice’s net earnings and, consequently, cash flows, which translates into a change in practice value. If the physician also owns the practice, his or her historical compensation typically reflects both income for services provided as well as a return on owner investment. For this reason, historical physician compensation may not be a reasonable proxy for post-acquisition physician compensation.
After the physician practice acquisition is complete, physicians are typically compensated by the new owner under an employment agreement as an employee or a professional services agreement as an independent contractor. Assuming the purchaser is a hospital to which the physician can refer federal healthcare patients, physician compensation must be representative of fair market under either type of arrangement.
If the purchaser has not determined post-acquisition physician compensation prior to engaging a valuation analyst to determine the fair market value of the practice, the analyst can determine fair market value physician compensation in conjunction with the practice valuation. If the analyst determining the practice’s value is different than the analyst determining fair market value physician compensation, the two analysts must communicate assumptions used in the valuation models. The assumptions used in the analysis of future physician compensation and those used in the valuation of the practice should be similar, and post-acquisition compensation to be paid to the physician should be communicated to the business valuation analyst as a factor in the income approach in assessing practice value.
In many cases, the fair market value of physician compensation can be expressed as a range of values. This, along with the relationship between compensation and practice value, can provide the parties with some flexibility in the negotiation of practice value and compensation. Absent an asset-only purchase, if the physician prefers to receive maximum employment compensation post-acquisition, the value received for the practice at the time of sale will be lower than if the physician agrees to receive compensation in an amount less than the established maximum.
When entering into negotiations for the purchase of a physician practice, it is important to remember the practice’s dependence on the physician and make sure consideration of value for the physician’s services and the valuation of the practice are evaluated together rather than in isolation. This is one of many reasons to engage valuation analysts experienced in healthcare appraisal.