Transcript 2 Key Valuation Issues The Value of Shares for Physician

2 Key Valuation Issues
I. The Value of Shares for Physician Buy-in and
II. Valuing Compensation Relationships in Under Arrangement
Models
14th Annual Ambulatory
Surgery Center
Conference
October 20, 2007
Presented By:
Stephan Peron, VMG Health, LLC
Curtis Bernstein, HealthCare Appraisers, Inc.
Definition of FMV
In Revenue Ruling 59-60, the Internal
Revenue Service defines fair market value as
“the amount at which property would
change hands between a willing seller and a
willing buyer when the former is not under
any compulsion to buy and the latter is not
under any compulsion to sell and when
both have reasonable knowledge of the
relevant facts.”
Valuation Guidance from the IRS
Revenue Ruling 59-60 also states that all relevant
factors should be considered, including the following:
The nature of the business and history of the enterprise
from its inception;
The overall economic outlook, and the condition and
outlook of the specific industry in particular;
The book value of the stockholders’ equity and the
financial condition of the business;
The earning capacity of the company;
The dividend-paying capacity of the enterprise;
Sales of the stock and the size of the block to be valued;
and
The market price of publicly traded stock of
corporations in similar industries or lines of business.
Basic Valuation Theory
Time Value of Money
If I invest $1,000 today at 10% annually, I
will earn $100 next year, $110 in year 2,
etc.
The inverse is true – if I expect to earn
$100 next year, $110 in year two, etc. from
an investment in which I expect to earn
10%, I would be willing to pay $1,000
today for that investment
Conversion to a Multiple
The current FMV of a non-controlling
interest in an ASC is currently trading
between 3.0 and 4.5 times adjusted* EBITDA
less debt.
Reconciliation to “Basic Valuation Theory”
An investor would expect a 22% to a 33%
return annually on an investment in a noncontrolling interest in a particular ASC.
*Adjusted based on post DRA revenue
The Value of Shares for Physician
Buy-in
Considerations Selling Equity to Physicians
 Current ownership structure
 Percentage equity available for sale
 Availability of existing shares for sale
 Sale of new shares
 Maximum and minimum percentage available per
physician
 Return on investment (ROI) of equity investment
 OIG and IRS regulatory requirements related to valuation
 ASC safe harbors of the Anti-Kickback Statutes
 Term of existing operating agreement
 Management of partnership
 Buyout provisions and covenants not to compete
 Value of equity at minority and control level
Valuation Issues
 Regulatory requirements for valuation (OIG and
IRS)
 Fair market value opinion vs. pricing analysis
 Pricing analysis using limited valuation methods
 Fair market value opinion using complete valuation
process
 Timing and cost considerations
 Reasonable consideration of non public minority
level equity
Valuation Issues Specific to ASCs
 Physician ownership makeup or lack thereof
 Physician risk is the most important risk factor in
ASC valuation
 Case volume, mix, and reimbursement
 Change in volume and reimbursement per case
 Diversification (e.g., # of surgeons, number &
type of specialties, payors)
 Nature of payor contracts – “out of network”
business
 Market reimbursement risk analysis
 Ability to generate sustainable cash flow and
distributions
Valuation Issues Specific to ASCs
 Financial leverage, working capital, and capital
expenditures
 Quality and age of facility and equipment
 Opportunity for expansion (rooms, surgeons)
 Competent management
 Barriers to entry (e.g., CON)
 Terms of operating agreement
 Divesture required upon retirement, relocation, and
inactivity
 Restrictive covenants
Valuation Methodology
Decision Tree
ASC
Unprofitable
Profitable
Profitable
Attributes
Going Concern Risk
Stable Earnings
Trending Earnings
Income approach
Income approach
Capitalization of earnings
Discounted Cash Flow
Asset approach
Compare value to market transactions
Adjust for atypical working capital
Use asset approach to establish floor of value
Depending upon standard of value, apply discounts
Valuing Minority Interests
 Simply states: Interests providing absolute control (i.e.,
greater than a 50% interest whereby key aspects of
control are not diminished by governing documents or
otherwise) are worth more than interests which do not
have the same control rights
 Control granted by the governing documents (examples
on next slide)
 Concept of “effective” control – physicians control with
their feet and their hands
 Valuation Guidance: absence of control adjustments in
financial projection (preferable approach) or application
of minority interest discount (reliance on published
studies or other more difficult to quantify and support)
Valuing Minority Interests
Matters Subject to Control
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Capital calls
Admission of new investors
Borrowings greater than a certain amount
Acquisition of equipment greater than a certain amount
Selling, assigning or otherwise disposing or
encumbering assets
Entering into material contracts
Management agreement contracts (assigning/cancelling)
Selling, liquidating, or merging the entity
Changing the core governing documents
Typical ASC ownership agreement are very friendly to
the minority shareholder
Note: Physicians display a certain level of control
regardless of ownership interest level
II Under Arrangements –
Compensation
Stark - Phase III
• Centers for Medicare and Medicaid Services (“CMS”)
posted the final Stark Phase III on August 27, 20007 (Federal
Register September 5th)
• With respect to indirect compensation arrangements, CMS
explains in the final rule that the relationship between the
physician and his or her physician organization is
disregarded and the physician “stands in the shoes” of his
or her physician organization.
• CMS states, “many arrangements that may not have met
the definition of an ‘indirect compensation arrangement’
under the Phase I and Phase II analysis will constitute
direct compensation arrangements that must satisfy the
requirements of an exception in order for the physician to
make DHS referrals to the entity furnishing DHS.”
• RESULT: Consult your regulatory attorneys to assist with
the legal issues associate with an under arrangement
structure
Case Study: “Under
Arrangements” Business Model
• Primary Model, can vary depending upon desired structure and
state-specific regulations
– Hospital contracts with a separate legal entity formed to provide
turnkey surgical management services to Hospital’s outpatient
department (i.e., separate legal entity is not an outpatient
surgical center, but rather, a management company)
– Management company, “NewCo,” can be jointly owned by
Hospital and Physicians or 100% physician owned
– NewCo would provide facility services to the hospital pursuant
to a written agreement
– The Hospital would bill for those services under the Hospital’s
name and provider number
– Hospital directly compensates NewCo for its services in an
amount that is reasonable based on the going rate charges in the
community to other entities that provide comparable services
Case Study: “Under Arrangements” Business
Model - Advantages
 Allows hospital to offer seamless outpatient surgical services to
patients in collaboration with physicians within the community,
enhancing quality of care and patient satisfaction
 Increased efficiency & cost controls: MDs generally have a
demonstrated ability to offer cost-effective services on an outpatient
basis
 Creates an alternative mechanism for hospitals and physicians to
offer outpatient services to patients beyond the standard freestanding, independent surgery center
 Preserves hospital’s ability to leverage upon existing payor contracts
 Expansion of current services through access to needed capital:
allows hospital to preserve capital for other equally important
projects
 Creates a mechanism to recruit and retain physicians
 Creates an opportunity for physicians to participate with hospital
and earn economic returns in exchange for assuming certain
business and financial risk
“Under Arrangements” Business
Typical Model
HOSPITAL OUTPATIENT
DEPARTMENT
•Maintains patient relationship, QA,
and Medical Records
•Holds managed care contracts and
performs billing & collection function
•Contracts with NewCo for the
provision of “turnkey” services
•Pays NewCo a management fee
“NEWCO” JOINT VENTURE
•Purchases equipment and supplies;
employs staff
•Can be jointly owned by hospital and
physicians or 100% MD owned
•Contracts with hospital for the
provision of “turnkey” outpatient
surgical services
•Receives
management
fee
from
hospital, which is comprised of
reimbursement of reasonable and
necessary operating costs as well as a
market rate of return
Case Study
Facts:
Small rural area of about 50,000
population;
One local hospital with outpatient surgical
volumes of approximately 4,000 annually;
Estimated income to hospital - $1,00,000
annually;
Physicians threaten to start own ASC;
Case Study
Freestanding ASC model
 Hospital and physicians joint venture the ASC.
 Who determines who gets what percent?
 Hospital is required to over build to meet the
needs of certain physicians (“politics” says
Hospital’s CEO)
 New Center is required to get new Medicare
number and negotiate new payor contracts
 Center and Hospital compete in same market –
increased competition leads to ASC getting lower
reimbursement than Hospital.
 Resulting income = ($350,000) in year one and
making a slight profit by year four
Case Study
Under Arrangement Model
 Hospital owns department;
 Hospital and physicians joint venture management company;
 Hospital outpatient department already build out – no
additional build out capital expenditure necessary;
 Hospital contracts in-place – no delay in payments and no
renegotiation;
 Hospital continues to earn a significant profit, actually
exceeding historic profits from its outpatient surgery business
by year four;
 Under arrangement company only earns a 10% profit but
returns to investors equal to 30% annually.
 Result: Hospital retains income that can be used to fund nonprofitable business such as the ED, Labor & Delivery, etc.
 Result: Physicians have their ownership in outpatient surgical
business and make profit similar to that made in their own
business.
Methodology for Establishing FMV
 Clearly define which entity will provide which service
 Determine Managers estimated cost of providing the turnkey
service; differentiate fixed from variable; perform sensitivity
analysis over a relevant range of volume assumptions
 Mirror costing assumptions to proposed level of payment (i.e., one
weighted average per case fee vs. payment designed around specific
procedures)
 Research similar arrangements in the marketplace; research market
rates of return for comparable operating entities and leasing
companies; apply operating margin return to manager’s fully
loaded cost per case figure (example on next page)
 Examine rates of return for each party to the agreement over a
relevant range of volume assumptions; assess for reasonableness
and equity
Methodology for Establishing FMV
Per Case Fee Calculation (Simplified Example)
Assume: fully loaded cost per case (including debt service on equipment) =
$1,000 / case
Assume: Market research indicates that profit margins reasonably range between
20% and 30%
Per Case Fee calculated as (Cost Per Case) / 1 – Operating Margin)
Low: $1,000 / ( 1 - 0.2) = $1,250
(i.e., $250 represents a 20% operating profit margin on $1,250 in “revenue” to manager)
High: $1,000 / (1 – 0.3) = $1,429
(i.e., $429 represents a 30% operating profit margin on $1,429 in “revenue” to manager)
Depending upon scope of services provided, look at RBRVS reimbursement as a
measure of reasonableness
CANNOT BASE “PER CASE” PAYMENT ON HOSPITAL’S
REIMBURSEMENT: FMV WOULD DICTATE THAT HOSPITAL
PAY A MARKET RATE OF RETURN FOR SERVICES
PURCHASED AND NOTHING MORE . . . .
Stephan Peron, AVA
VMG Health, LLC
Three Galleria Tower
13155 Noel Road, Suite 2400
Dallas, Texas 75240
(214) 369-4888
[email protected]
Curtis Bernstein, CPA/ABV, CVA, MBA
HealthCare Appraisers, Inc.
858 Happy Canyon Road, Suite 240
Castle Rock, CO 80108
(303) 688-0700
[email protected]