Selling a business and relinquishing autonomy is a tough decision for a business owner, and most believe they will be offered a significant purchase price for their ownership stake. However, a high purchase price up front might not be possible if the former owner is going to receive compensation from the business following the transaction, resulting in the business not generating any positive cash flow.
In the healthcare industry, this scenario most commonly occurs when health systems acquire medical groups. Once the transaction is complete, the health system often transitions the group’s physicians to its compensation plan, which results in an increase in physician pay and, conversely, a negative cash flow at the practice.
But what about practices that have been around for many years, building strong reputations in their communities and strong relationships with their patients? Can they expect to be monetarily compensated for those things?
While no one would argue the value those assets bring to any transaction, from a valuation perspective, paying for goodwill is most often not supportable.
Defining Intangible Assets
To understand the reasoning for this, we must first define some key terms. In general, intangible assets are those items or concepts that are not physical assets that can be recorded on a company’s balance sheet. From there, intangible assets can be broken out into two categories: identifiable intangible assets and goodwill.
- Identifiable intangible assets are company assets that, while still not physical assets, can be separately identified and valued, such as patents, copyrights, trademarks, and software. These items can be sold or licensed, and as such, can generate revenue for a business.
- For example, buyers may be willing to pay to license the name of a business with a strong brand name, such as Mayo Clinic, since they know they will most likely generate value from associating with the brand.
- Intangible assets that cannot be separately sold or licensed are considered goodwill and include items such as the company’s reputation, workforce, customer base, etc.
- When a transaction occurs, the Financial Accounting Standards Board (FASB), an independent organization that establishes accounting and financial reporting standards, defines goodwill as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.”[1]
- Put simply, goodwill value is an excess value that remains in the business after tangible and identifiable intangible assets are deducted.
Valuing Intangible Assets
To reiterate, when businesses have identifiable intangible assets, they can ascribe value to them. This is most often done via the income approach, which estimates the future economic benefits that could be generated from the asset. However, to value an asset this way, the business needs to actually have positive future cash flow from the asset.
That can be hard to do when valuing a physician practice. Often physician practices have no cash value beyond the fixed—that is, tangible—assets because the business will not generate a positive income stream once the post-transaction physician compensation changes are accounted for. In addition, physician practices usually do not have a stronger brand name than the company acquiring them and do not have any identifiable intangible assets to sell.
It is important to note that the cost approach is an alternative way to value intangible assets, which would consider the cost to recreate the asset. However, this would call into question why, if the overall business wasn’t generating income, would the buyer pay to recreate that asset absent of the opportunity to gain referrals. From a Stark law perspective, it is hard to justify paying for a money-losing asset without considering the potential for referrals.
In our experience, the two most common intangible assets that health systems and physician practice owners want to be valued during a practice acquisition are the assembled workforce and noncompete agreements. The following sections provide further clarification on when these assets can and cannot be valued.
Assembled Workforce
Sellers often expect to be compensated for the value of their workforce to account for the time and effort spent recruiting and training these employees. However, according to the FASB, workforce is not considered a separately identifiable intangible asset; instead, it falls under the category of goodwill. And in order to value goodwill, a business must demonstrate a positive income stream.
If a business does not generate any income after considering all post-transaction expenses, including physician compensation, the workforce should not be valued. After all, the workforce could leave tomorrow and cannot be separately sold the way fixed assets can. If there is no positive business enterprise value from the income or market approach, then there is likely no goodwill value.
However, there may be some instances where it makes sense to value the workforce. Each analysis is highly dependent on the specific facts and circumstances at hand. For example, if the physicians will maintain some ownership of the practice after the acquisition and only receive their compensation through distributions, there could be a significant income stream to value. In this case, the buyer should ensure the ownership percentage and expected distributions are in line with the market or else the physicians likely will not continue to be as productive as they have been historically.
Noncompete Agreements
Organizations also frequently wonder whether it is possible to appraise the noncompete agreement as part of the intangible assets. The noncompete would be valued using the income approach, which would entail estimating future cash flow with the noncompete in place versus not in place. No value can be assigned to a noncompete agreement if the business does not generate positive income. Moreover, some noncompetes are extremely restrictive or occur in states where they are not enforceable, essentially rendering them valueless.
However, if any of the below factors are true, an organization might be able to ascribe value to a noncompete.
- The new employer pays the organization that holds the noncompete to release the affected employee if it can be proved the organization receives economic benefit from having the noncompete in place.
- There is no referral relationship between the parties that are exchanging cash for the noncompete.
- The noncompete is enforceable.
Finally, health systems often wonder if they can pay a physician for signing a noncompete within an employment agreement. The short answer is no; however, the system could include a sign-on bonus instead, as long as it ensures the total compensation is consistent with fair market value.
The Golden Rule
Transactions in the healthcare space are complicated, and there can sometimes be misconceptions about which assets hold value. As discussed, more often than not, paying for goodwill cannot be supported from a valuation perspective when there is no value from an income approach. However, there are instances when intangible assets and goodwill might have value; but the buyer should ensure there is an approach that can support the value before promising to pay for any of the seller’s nonphysical assets.
Edited by: Emily Johnson
This article was originally published by the American Association of Provider Compensation Professionals in the AAPCP Bulletin.
Footnotes
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