Succession Planning and Valuation

March 20, 2018 | Featured Articles

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In addition to providing excellent care, successful medical practices have three things in common: a clear valuation formula, straightforward succession plan, and detailed outlines of shareholder compensation. Insightful practice leaders know better than to kick the proverbial can down the road on preparedness issues; and being proactive starts with a fair, clear shareholder agreement.

Medical practices need to be able to convey their business frameworks in a simple manner for physicians who might consider coming on board, and have everything in place should there be a sudden death, divorce, or other unforeseen circumstance. My rule of thumb: If you can’t explain your frameworks in more than a minute or two, it’s more complicated than it needs to be.

In any business, success starts with preparation.

In early January 2000, my father Buzzy Vanchiere, MD, FAAP, was serving as managing partner for an 18-provider pediatric practice in Southwest Louisiana. The practice was detail-oriented and highly organized, with a clearly drawn up succession plan and shareholder agreement. At the time, my father and his partners were in the midst of finalizing the buyout of the practice’s senior partner, which was a streamlined process due to the business’ concise processes and expectations.

Then disaster struck. As his partner’s final day approached, my father had a massive stroke. The practice was suddenly faced with two simultaneous buyouts: a potentially detrimental financial blow for the remaining six partners. But not for this practice, which had readied itself for the unpredictable.

After the initial shock subsided, the practice was able to quickly proceed with the plan that they already had in place. The buyout of the senior partner was unaffected while the life insurance the practice had purchased on each of the shareholders provided the liquidity to buy out my father’s interest in the practice. Since the pending buyout of the senior partner could have provided a timely reference for my father’s buyout amount, it was reinforced with a solid shareholder agreement.

The most notable item in the shareholder agreement related to updating the practice’s value each year. My father and his partners reviewed the valuation formula annually, discussed any necessary adjustments, and signed off on updated values. In the case of a disagreement, the last agreed-upon valuation served as the amount for any buyouts over the next year. This process was particularly helpful in the case of my father: Planning ahead allowed his partners to address the issues at hand as objectively as possible.

It is not uncommon that without clear and understandable shareholder agreements, individuals on each side of the transaction are prone to place their own personal interests ahead of the practice. Some practices simply pay out the departing partner (or his or her estate) a percentage of the remaining accounts receivables, while others account for any accumulated assets and incurred liabilities. In all situations, it ultimately comes down to a dollar amount that all parties can agree on.

As such, The Verden Group and Pediatric Management Institute are often called in to review such situations to help find a fair position for both sides of the transaction to ensure that the practice emerges as financially viable coming out of the negotiations as it was going in.

Don’t rely on accountants to determine your value.

Most practices rely on accountants to tell them the value of their practices. While this is helpful in some ways, it can also be dangerous. Too often, accountants rely on “book value” (assets minus liabilities), along with the shareholders’ total income and practice revenue stream, to determine a valuation. Such an approach can be disastrous: I once worked with a client who had eight providers generating more than $4 million in revenue each year: book value would indicate that with all that money coming in, the practice was worth millions. Guess what? It’s not.

Practices face significant financial stress because they do not plan for the exact scenarios mentioned. The most effective way to avoid negative consequences from such events is to determine the actual value of the practice in advance, much like a prenuptial agreement determines the financial considerations in the event of a divorce. Because it is a certainty that every partner in a practice will need to be bought out at some point if the practice continues to operate, it is prudent to plan ahead for that inevitability.

Smart practices conduct annual updates to practice value. The process to do so should be quick and easy. Shareholders can take time each May (after filing the previous year’s tax return) to collectively update the valuation formula and make any necessary adjustments. Having a solid formula in place allows for quick and easy updates to the valuation.

Philosophy, formula and adjustments play into your practice’s valuation.

A common practice valuation approach seeks to establish the added benefit of owning the practice instead of being employed. For example, if a shareholder makes $250,000 for a given year and an employed physician at the same practice makes $180,000, the added benefit for owning the practice is $70,000. After applying a multiple to this number, adding the practice assets and deducting the practice liabilities, one should have a good handle on what the practice is actually worth, per shareholder. And that’s why you will want to value your practice in this way; you are dealing with buy ins and buy outs of shareholders, rather than looking to sell your practice to a venture capital company for profit maximization. (If that opportunity comes along, go back to the book value approach your accountant may recommend.)

If the practice has more than one shareholder and one or more employed physicians, the process to determine the value is rather simple:

1.Determine the average of the shareholder earnings;

2.Compare shareholder earnings with the average compensation for the employed physicians in your practice (if all physicians are shareholders, find regional or national averages for comparison);

3.Multiply the valuation basis times the number of years of projected earnings. This amount can vary from one to three years based on a variety of market conditions.

There are a number of changes to the formula that can be made from there, including:

  • Taking the average shareholder salary for the previous two or three years;
  • Adjusting average shareholder compensation based on whether monies have already been received, or if shareholders have previously taken lower salaries to fund practice projects that are expected to generate additional earnings in the future;
  • Adjusting the years of projected earnings or average shareholder compensation to account for upcoming large capital expenditures;
  • Adjusting for a variety of nuances in the shareholder compensation formula.

Your practice’s value may be different when it comes to selling to a hospital.

In the event that a practice is looking to sell to a hospital (or any non-profit entity), the value of the practice is very different. Gone are the days where hospitals hand over blank checks like they did back in the 1990s. Today, thanks to federal Stark Laws, hospitals are limited and usually offer to purchase the tangible assets of the practice and provide salary guarantees for the physicians.

Assets valuation can be as simple as the book value (total assets purchased minus accumulated depreciation), or a physical count of everything minus an amount for wear and tear. Salary guarantees are usually limited by a percentage of national salary benchmarks such as MGMA, along with standard benefits package offered to all employees of the organization. Many hospitals will claim to offer flexible negotiation terms, but larger organizations usually have standard contracts with very little leeway to address specific concerns you may have, and many are underpinned by strict regulations.

Shareholder agreements should be decided by advisors and shareholders.

Seasoned consultants, attorneys or accountants who understand the nuances of medical practices can guide you and your partners to develop an appropriate formula. But while practices often have competent legal advisors putting together such agreements, they occasionally lack the “real life” experiences to include how common situations will be handled. Shareholders can use their own priorities to determine specifics that work for them. In this process, be careful to address the following details:

  • Personal responsibility for coding audits: To avoid improper coding or documentation penalties and recoupments from affecting the entire practice, include a stipulation that providers are responsible for their own coding and documentation—as well as for error penalties. Neglecting to address this issue can spell disaster! In addition, include “clawback” provisions specifying how potential recoupments will be handled after a shareholder is bought out or leaves a practice. Such provisions must be included in the employed provider’s employment agreement.
  • Spouse approval: To avoid any potential conflict after a shareholder dies or goes through a divorce, it is important that shareholders’ spouses sign the shareholder agreement. Crafted properly, this eliminates potential challenges to the practice valuation and buyout process. Such a requirement is quite effective when facing buyout opposition from an estate or soon-to-be-ex-spouse.
  • Personal guarantees for financing: Shareholder agreements often have generic language about how personal guarantees for practice loans are handled. Address whether such guarantees are on a pro-rata basis and if shareholders will indemnify each other’s allocated guarantee. Whatever language you decide on needs to be correlated to the final loan agreements, which will likely take precedence over the terms of your shareholder agreement.
  • Consecutive days out of office: A practice retains a certain amount of overhead regardless of whether a shareholder is actively seeing patients. A shareholder who is away for an extended length of time can complicate a practice’s ability to keep up with such costs. Determine up-front how many days a shareholder can be away before enforcing an alternative compensation formula or buyout.
  • Disability: The best shareholder agreements include a clause that compensation will continue at the usual rate until a shareholder’s disability policy kicks in. This requires shareholders to carry some sort of a disability policy that begins 45 to 60 days after the beginning of a disability. This provision minimizes the financial impact to the practice during a time when additional expenses may be incurred. Those shareholders who can’t obtain disability insurance may seek a variety of ways to escrow a portion of their salaries each year for such contingencies or provide an alternative compensation formula for them.
  • Mediation or arbitration clauses: It is advised that a practice includes a mediation provision in case of stalemates over major decisions. Shareholders may call upon a neutral third party to facilitate a resolution in such instances. The agreement should further state the issue will be resolved by binding arbitration should mediation not work. These terms motivate involved parties to come to a consensus in the mediation phase. Without such verbiage, the mediation phase will lack the teeth needed to motivate a resolution.
  • Medical malpractice tail coverage: The agreement should address how the tail coverage for a departing physician will be paid and whether or not this amount will be deducted from the buyout price. Tail coverage can be very costly, depending on how long the departing provider has been on the policy as of their last date with the practice, and whether it is a claims-made policy.
  • Force out provision: Assuming the shareholder agreement contains the explicit formula to value the practice, there should be a premium allocation (10 to 25 percent) to be paid should a majority of shareholders wish to buy out a particular shareholder. This provides a financial incentive to carefully select partners aligned with the shareholders before adding a new partner. More importantly, it provides some motivation for all the partners to weather challenges.
  • Failure to plan provision: Practices should have as much notice as possible of individual shareholder retirement plans, due to the time and expenses related to recruiting and grooming another shareholder. The agreement should stipulate that the buyout amount is discounted by 25 percent in the event of a physician not providing at least two or three years’ notice of retirement. Obvious exceptions would apply for disability and death. Consideration should also be given to scenarios in which a shareholder loses his or her ability to be covered by medical malpractice, retain board certification, or remain on provider panels.
  • Pledging of assets: The shareholder agreement should specify that individual shareholders cannot collateralize stock ownership; specifically, they cannot pledge stock in the practice as guarantee for any personal loans or the like.
  • Personal bankruptcy: Practices should seek legal counsel concerning how to minimize impact resulting from a shareholder filing for personal bankruptcy. The last thing a practice needs is third-party meddling.
  • Future expansion and financing: Consider the following scenario. Two physicians invest $100,000 in a new location. Instead of taking a loan, they reduce their income for the year by $50,000 each. One of them dies during the next year and a significant portion of the valuation formula takes into consideration the “benefit of owning the practice.” How do you compensate the heirs for the reduced income in the previous year and loss of benefit from that investment? While every situation is different, one way to mitigate this problem is to obtain outside financing to fund expansion efforts. While this does not mitigate all the issues, it does address one part of the equation. Similarly, care needs to be taken to avoid a scenario where a shareholder reduces his or her earnings in a given year in order to fund the acquisition, yet is bought out before the investment is recouped.

If you have concerns about your current agreements and / or lack of succession plans, there is no better time than now to begin to address those. Start by reviewing your partnership agreements. Run scenarios such as described throughout this article: if your senior managing partner had a heart attack tomorrow, are their plans in place to quickly and deftly manage their departure? Don’t wait until you need a plan; get your plan in place well in advance of disaster and your partners will thank you for that in the future.