Capitalizing earnings

While most of those situations are reasonably collaborative, we’ve been involved in a variety of legal actions in which appraisers have provided outlandish valuations. That’s largely because lawyers for non-doctor spouses and other plaintiffs sometimes rely on a valuation approach broadly known as capitalization of earnings. It is a common method for valuing commercial businesses and a staple in determining stock market values.

It can create havoc for a defending doctor. A solo physician works very hard to produce a $200,000 annual income. An aggressive lawyer obtains a business valuation expert to say that 6 times earnings is a fair value for the “business,” thus finding the practice worth to be $1,200,000. We in the healthcare profession, know that his practice just cannot sell for that sort of price. That’s because the “business” has to pay a fair wage to an excellent doctor to generate its revenue. Subtracting $200,000 (the median income in that doctor’s specialty) leaves zero earnings to capitalize.

The issue particularly arises in divorce cases involving a doctor with inordinately high earnings. We recall a case of a very successful specialty surgeon with a sterling reputation and a huge case load. He worked exceptionally long hours and his income was nearing seven figures. His divorcing wife’s lawyer asserted that the practice’s goodwill value was $5,000,000.

In truth, the practice had almost no goodwill value because no buyer could have stepped into that surgeon’s shoes. The goodwill was personal to the surgeon, due to his unique personal capacities and his personally devoting far more hours than even physicians would consider normal. Hence it was not due to the practice, and it was not a quantifiable, transferable asset. The goodwill issue was rejected as it deserved to be.

Group documents rule

While someone might claim that the group is worth millions of dollars, they run into what the partners themselves, acting at arms’ length with each other, have agreed to in their shareholders or partnership agreement. What better indicator of value is there, than what has been agreed at arms’ length among individuals having conflicting interests in the issue? Furthermore, how can the group be worth more if no member is free to sell his or her interest in it except back to the group at the contracted price? Unfortunately, some courts have not accepted this argument.

We routinely urge our group clients to be sure their buy-out agreements are in place and are realistic. Having seen too many agreements left intact for ten, twenty and even more years, we fear that some groups may be headed for trouble if and when someone leaves and the documents calling for an unrealistic buyout are in place.

Goodwill as one asset

Notice one essential difference between calculating a value on the capitalization of earnings method and the way actual medical and dental practice buy-ins and pay-outs are handled. When capitalizing earnings, the resulting figure represents all the practice’s assets, wrapping cash, equipment and furniture, accounts receivable and goodwill value into one number. Group documents, on the other hand, look at each asset category as a separate part of the overall value. Valuing cash, furniture, fixtures and accounts receivable (less outstanding debts) doesn’t usually result in huge variations, so the question typically comes down to realistically valuing that amorphous and often contentious item — goodwill.

Many practices do indeed have some goodwill value. The best indicator of intangible value is what a buyer and a seller, acting independently and at arms’ length, would pay and receive — essentially, what would happen in the marketplace. Based on their work experience, consultants and attorneys involved in medical and dental practice matters deal regularly with such pricing issues and can fairly well predict where the parties will come out.

Not great prices

Doctors hoping to reap great sums by selling out are likely to be disappointed. They are usually better off financially by working another year. The heady days when hospitals and “PPMCs” bought medical practices for big dollars are long gone.

Still, while a myriad of factors dictate a practice’s value, we and our peers tend to find values ranging from zero (in surprisingly many situations) up to 50% of the most recent year’s practice revenue — and sometimes considerably more in a few isolated situations. Such values aren’t to be sneezed at, but they’re far short of what so-called experts find by loosely applying capitalization of earnings methods.

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