Measuring the intangible: Valuation issues in health care transactions
In the highly complex and heavily regulated world of health care, business valuations can be particularly challenging. Last year’s U.S. Tax Court decision in Derby v. Commissioner illustrates this point.
Looking at the history
Derby involved the sale of a medical group to a not-for-profit health care organization that was part of an integrated delivery system of hospitals and medical practices. The group contended that the value of the assets it transferred — including goodwill and other intangibles — exceeded the value of what it received in exchange. The group’s members, therefore, claimed charitable tax deductions for their shares of this excess value.
The Tax Court denied the deductions, concluding that the physicians were unable to show that the value of what they received was less than the value of what they transferred. The lack of noncompete agreements with the physicians and the lucrative bundle of benefits they received played key roles in the court’s decision.
Spreading the risk
In Derby, physicians who were part of an independent practice association called United Health Medical Group Inc. (UHMG) became affiliated with a larger health care organization so that they might better manage risk and take advantage of specific efficiencies and economies of scale.
Ultimately, UHMG settled on Sutter Health, a regional health care system that operated group medical practices through its not-for-profit subsidiary, Sutter Medical Foundation (SMF). These group practices, along with Sutter’s affiliated hospitals, formed an integrated delivery system.
Sutter’s primary objective in integrating medical groups was to gain immediate access to a roster of patients for its clinics and hospitals, but for legal and financial reasons it was unwilling to pay the UHMG physicians anything for goodwill or other intangibles.
On the advice of a health law attorney, the UHMG physicians decided to donate their practice intangibles to SMF and deduct the value of those charitable donations on their tax returns. This approach had been used successfully by other medical groups and was recognized in IRS training manuals for field agents.
Doing the deal
The physicians formed a professional medical corporation that did business as Sutter West Medical Group (SWMG) and then entered into a professional services agreement with SMF.
The professional services agreement, which required SWMG to provide professional services exclusively to SMF’s patients, was conditioned on at least 25 UHMG physicians becoming shareholder-employees of SWMG and selling their practices to SMF under prescribed asset purchase agreements. Although the professional services agreement contained a noncompete provision, it exempted physicians who left SWMG’s employment.
The professional services agreement based SWMG’s compensation on a percentage of net revenues from patients. The percentage varied depending on the type of revenues. It also provided for each full-time physician to receive a $35,000 signing bonus. SWMG was also given a role in the management of SMF.
Ultimately, 29 UHMG physicians signed on, selling their practices to SMF and entering into physician employment agreements with SWMG. The agreements required the physicians to practice full time and exclusively for SWMG (except for a reasonable amount of volunteer work). The agreements also permitted departing physicians to solicit patients that were on their patient lists as of the agreement’s effective date and obtain the medical records of patients who chose to go with them.
Each physician entered into an asset purchase agreement transferring all tangible and intangible assets related to his or her practice to SMF.
The parties engaged a valuation firm to determine the “business enterprise value” of the to-be-formed medical group and obtained a separate appraisal of the physicians’ tangible assets. To determine the value of goodwill and other intangibles, the business valuation firm took the business enterprise value (which was based on a discounted cash flow analysis) and subtracted the value of the fixed assets as well as the aggregate accounts receivable, which were retained by the SWMG physicians.
The residual, which was presumed to be the value of the intangible donation to SMF, was allocated among the SWMG physicians according to a formula devised by one of the physicians, not by the valuation firm.
Going to trial
In preparation for litigation in Tax Court, the SWMG physicians retained a new appraiser to value their intangible assets. The appraiser postulated that this value was equal to SWMG’s business enterprise value less its “implied working capital” and its fixed assets.
The appraiser determined the enterprise value through a combination of income, asset and market methods. Significantly, in applying the income method, he based future distributable earnings on the median compensation of physicians in the region rather than on the actual, above-market compensation the SWMG physicians had negotiated. The appraiser concluded that this compensation “had no market value beyond the value of their professional services.”
Implied working capital also was based on industry standards, and fixed assets were valued at their previous appraised value. He allocated intangible value among the physicians according to the formula described above.
The Tax Court noted that the appraiser made no distinction between personal (or professional) goodwill, which is associated with the individual practitioner (and isn’t transferable), and enterprise goodwill, which is associated with the practice itself.
More important, however, the court found the physicians failed to show that they had donated their intangible assets to SMF. The physicians argued that they had received no consideration for intangibles because payment for goodwill would have been illegal. But this argument ignored the substantial consideration they received in the form of future employment with SMF. The asset purchase and physician employment agreements were contingent on each other, such that the entire arrangement was part of an integrated transaction in which the physicians sold their practices in exchange for future employment “on carefully delineated terms.”
The court observed that SMF clearly wanted the physicians’ patient lists and other intangibles and that the physicians “negotiated aggressively for the best terms they could get,” which included employment with above-market compensation, signing bonuses, a management role, the absence of noncompete agreements and greater professional autonomy than other potential acquirers had offered. They had even turned down a previous deal with a for-profit organization that would have purchased their intangible assets because they feared a loss of autonomy.
In other words, the court said, the SMF deal allowed them to “maintain or improve their accustomed level of earnings from the practice of medicine,” which was inconsistent with the “donative intent” required for a charitable deduction. The physicians also failed to establish that their transfer of intangibles was a partially deductible “dual character” donation, because they were unable to demonstrate that the value of the intangibles exceeded the value of the benefits they received.
Using a holistic approach
Derby demonstrates that valuation in the context of a health care transaction requires a valuator to look at the entire relationship between the parties. This includes expected post-transaction compensation (including signing bonuses), the impact of noncompete agreements (or the lack thereof), intangible benefits (such as professional autonomy or participation in management) and other relevant terms of the deal.