EDGEMONT CAPITAL BLOG
10 Financial Considerations in Sales and Strategic Partnerships for your Medical Practice
Written by Jeff Swearingen, Managing Director
Like it or not, healthcare consolidation is a fact of life for medical professionals. The pressures driving this trend are real and unrelenting. They include the increased complexity and uncertainty around reimbursement, a desire among providers to move away from administrative duties and return to the practice of medicine, and changing models of care delivery that require financial resources and an investment of capital unavailable to most physician practices.
The required investments in technology can be daunting. Data from a recent survey of approximately 100 physician groups indicate that groups must have at least 200 physicians to be able to finance information technology (IT) investment for MIPS participation of $500,000 or greater, and that only 19% of respondents are confident or very confident in their MIPS capabilities.
Add to this a generational shift in physicians’ perspectives on owning their practice (versus being employed by the practice), the attractive valuations being paid for practices and the tax arbitrage opportunities (long-term capital gains versus ordinary income) and you have the conditions required to drive consolidation for the foreseeable future across physician specialty groups and the payer-facility continuum.
In the past 10 years, more than 500 hospitals have merged into a larger health system. More than $100 billion has been spent on hospital consolidation in the last six years alone. The top three publicly traded payers have a combined enterprise value of more than $350 billion, providing scale, significant negotiating leverage and almost unlimited access to capital.
As a result, more and more medical professionals have sold or are considering selling/merging their practices or pursuing similar partnerships involving substantial investment. For those weighing the costs and benefits of this decision, here are 10 factors to consider:
- How much is your practice worth?
The payment received by the seller generally reflects the expected earnings over time. This figure is then given a multiple — x times earnings — to arrive at a practice value. The multiple is determined by several factors, including the type and scope of practice, rate of revenue/industry growth and the needs of the buyer/investor. There may be various incentives and milestones built in as well. This upfront payout, in turn, reduces future expected compensation for the seller. As a seller, you are effectively accelerating future income while reducing business risk and still maintaining a “market” level of compensation based on continued clinical productivity.
- Cash versus accrual accounting
Accounting methods can make a difference in how earnings are calculated, affecting the valuation. Factors to consider include revenue timing and capital expenditures (typically equipment and information technology systems).
- How do you get paid for the transaction?
The buyer/investor may seek to pay the seller in various ways, including cash, stock in the platform management company, ongoing profit participation and earn-outs. A transaction may include a mix of all of these — some cash, some stock and an earn-out pegged to post-transaction performance. It is important to assess how these factors affect the value of the transaction, including which income is guaranteed.
- Medical malpractice
Provisions should be made for potential tail insurance costs. This often requires a conversion from a claims-made policy to an occurrence policy. A tail policy may need to be purchased at the time of the transaction. If so, both parties will have to decide who will bear this significant cost, the buyer/investor or seller?
- Accounts receivable
Does the buyer/investor or the seller get the accounts receivable and other working capital assets and liabilities? How is this factored into the practice’s valuation?
- Post-closing obligations
Selling physicians need to be aware of clinical and practice leadership responsibilities that will be required after the transaction is completed.
- Sharing the practice sale proceeds
There may be non-owners (partner-track physicians and others) who are instrumental in the success of your practice or individuals who have been with you for many years whom you want to reward. If, when and how these individuals will receive a portion of the proceeds from a sale should be determined up front as part of the negotiations with the buyer/investor. Often a buyer/investor will create equity incentive pools that provide clinicians and even practice administration leaders with the opportunity to earn additional equity over time or by achieving specified operating targets.
- Real estate owned
What, if any, real estate is owned by the selling practice? Is it included in the transaction and if not, are there “arm’s length” leases? Typically, the owner of a practice and real estate has the opportunity to create lease/rent payments that are at the high end of market rates for tax purposes. An arm’s-length lease means adjusting rates and terms to a market level standard rent, which provides more cash flow to sell and more reasonable rents post-transaction.
What are the buyer’s plans for investing in the practice? Is there a potential to increase revenues through investment in ancillaries (equipment or service expansion) or expanding through add-on acquisitions and new office openings? If so, who benefits? How do you, as a practice, make sure you capture post-closing value?
- Taxes matter
The transaction should be structured to maximize tax efficiency, while meeting the legal and tax structuring requirements of the buyer/investor. Typically, the purchase price is paid at closing, with the majority of proceeds treated as long-term capital gains, which is taxed at a lower rate than ordinary income. This may be especially important in states with substantial state and local taxes (SALT), as these deductions are capped at $10,000. The top federal rate on ordinary income is 37%, while state and local taxes can collectively push this above 50% in some regions. Long-term capital gains are taxed at 20% (plus state capital gains taxes, where applicable).
The Amazon effect
The rationale behind healthcare mergers and acquisitions is straightforward: fundamental reimbursement changes are driving a search for scale among providers and payers, which means more money for technology and systems and bigger investments in infrastructure. Not everyone will have the resources to manage this, but those practices that fail to keep up may find themselves at a competitive disadvantage.
This so-called “Amazon effect” has rippled through much of the U.S. economy. It was only a matter of time before it hit healthcare as well, as can be seen in recently announced transactions such as the CVS-Aetna deal. Shrinking margins and rising costs reward size. In response, payer and provider organizations have focused on increasing physician networks, expanding geographic reach and diversifying offerings. Absent major alterations in current law, this trend will likely continue.
Medical practices must be aware of these seismic influences sweeping over the industry. Every practice needs to be examined in light of these macro-economic shifts. If, and when, the decision is made to sell or pursue a strategic partnership/investor, understanding both the broad market dynamics, and your interests as an owner of a medical practice, will be vital in maximizing value.
Let us help you educate your practice on current market dynamics, and address how M&A may affect your practice or your local competitive landscape. For more information please contact Jeff Swearingen at Jeff@edgemontcapital.com