CEO SUMMARY: Historically, there was virtually no market for buying and selling pathology practices. That is rapidly changing as the first pathology practice management (PPM) companies enter the marketplace. Their business plan requires them to acquire pathology practices if they are to grow and prosper. In the first installment of this special two-part series, we take a detailed look at the methods used to determine the value of a pathology practice. The second installment will provide pathologists with a checklist of do’s, don’t’s and pitfalls in negotiating a sale.
PROBABLY THE MOST VISIBLE CHANGE to occur within pathology in 1998 is the arrival of pathology-based physician practice management (PPM) companies. By year’s end, as many as nine such companies might be in the marketplace competing for business.
This will present many pathologists with a new business dilemma: should they sell some or all of their pathology practice to a physician practice management company? Whether the answer is yes or no, it will be essential for the pathologist to know how much money his practice is worth.
“It is important to understand that selling to a PPM is different than selling to another pathologist,”? said Christopher Jahnle, Managing Director of Haverford Healthcare Advisors, “A PPM is interested in acquiring a pathology practice because of its existing cash flow and its potential for sustained future growth.”?
Two pathology-based PPMs have experience in the marketplace. American Pathology Resources of Nashville has been active during the last three years. AmeriPath, Inc. of Riviera Beach, Florida began serious acquisition activity in early 1996. It went public in October 1997 and continues to acquire pathology practices at a steady rate.
At least six other pathology-based PPMs are known to be at some stage of development. Pathology Service Associates of Florence, South Carolina is a network-based business model which does not meet the strict definition of a PPM and is not involved in buying pathology practices.
“It is my opinion that an active market for pathology practices will emerge during the next 24 months,” stated Jahnle. “If AmeriPath is joined by even two or three well-financed pathology PPMs, then there will be spirited bidding for the choicest pathology practices. This has to occur, because none of these companies can survive without ‘rolling up,’ or acquiring pathology practices. It is the only way they can build the revenue base necessary to sustain their company.”
Jahnle’s assessment is correct. Competing pathology PPMs will want to acquire the most desirable pathology practices in the United States. The implication is that pathologists should understand how a pathology practice is valued.
Such knowledge creates two opportunities for the shrewd pathologist. First, an informed pathologist can more successfully negotiate the highest price. Second, by understanding the elements which add value, the pathologist can restructure existing business arrangements at the pathology practice to make it worth more money before starting any sale negotiations with a pathology-based PPM.
“Pathologists should expect to see two different business models from PPMs,” said Jahnle. “One is the employment model. The other is the equity model. By far, the most common model is the equity model. Probably 90% of publicly traded PPMs utilize the equity model.
“I would like to outline the differences between the valuation techniques used by both models,” he continued, “since pathologists will mostly likely negotiate with PPMs based on either an equity or employment model. Both are similar in many ways. The primary difference is how each model defines the cash flow stream that the pathology practice is giving up to the PPM.
“In the employment model, the PPM wants to acquire the entire practice and all its assets. It will normally pay some multiple of ‘normalized’ earnings before interest and taxes,” said Jahnle. “That is the source of the term EBIT.
“The process of ‘normalizing’ earnings simply means that the employment model calculates the practice value based on salaried pathologists,” said Jahnle. “Assume that typical pathology salaries in a market average $200,000 per year. Any earnings distributed to the pathologist partners above that number are defined as excess earnings. The PPM uses the excess earnings figure to calculate a purchase price. Typically an employment model PPM will pay a multiple of four to seven times normalized earnings to acquire a pathology practice.
“The equity model PPM calculates a purchase price using a different method,” continued Jahnle. “It determines a baseline figure for the total compensation paid to the pathologists during the year. It will take a percentage of this baseline income, varying from 15% to 40%, for its management fee. It will pay a multiple of four to seven times that amount for the income stream it wants to buy from the pathology practice.”
“I can identify seven factors which influence the multiple a PPM will pay,” explained Jahnle. “It is important to understand how each individual factor makes a pathology practice worth more to prospective buyers.”
In simple terms, Jahnle is describing a process whereby the PPM determines a cash flow stream that it considers as “profit.” The PPM will pay the pathologist partners between four and seven times that number to acquire that proportion of the cash flow stream.
But what determines whether a pathology practice gets four times its EBIT or seven times its EBIT? The difference in sales price at each multiple is considerable.
“I can identify seven factors which influence the multiple a PPM will pay,” explained Jahnle. “It is important to understand how each individual factor makes a pathology practice worth more to prospective buyers.
“The first factor is size. The size of the pathology practice directly impacts the magnitude of the multiple,” he said. “The larger the pathology practice, the higher the multiple.
“Second is profitability,” continued Jahnle. “The greater the excess profit over the normalized level of physician salaries, the higher its value will be. Furthermore, those factors that enable a practice to have higher profit generally result in higher multiple as well.”
“Several of the other factors are subjective,” commented Jahnle. “Number three is stability and reputation. Obviously a buyer will value a practice that has an established, loyal customer base over a practice which holds tenuous contracts.
“Number four is market opportunity for the buyer. If a pathology practice is located close to other pathology practices which the PPM could buy, then a higher multiple would be warranted. The possibility of gaining new pathology contracts that could increase the size of the business would be reason for the acquiring PPM to use a higher multiple.
“Number five is timing. This is always important,”? stressed Jahnle. “Pathology PPMs have not been around for very long. Most pathology PPMs have just been formed. At this point it is a seller’s market. As these new PPMs compete for business, the multiples paid will probably be higher today than three years from now.”
“Number six relates to the business form of the pathology practice; whether it is a partnership, S or C corporation, or LLC. Each business form can impact the multiple for a simple reason,” he said. “It affects the adverse tax consequences of purchasers if they must buy the stock of the practice as opposed to its assets.
PPMs: Equity Versus Employment
The practice sells to the PPM a partial equity interest in the business. In exchange for a long-term management agreement, the PPM receives a set percentage of the practice’s revenue less non-physician operating expenses. Under the management agreement, the PPM will provide the practice a variety of services such as administration, marketing, billing, etc.
In this model, the physicians sell total ownership of their practice for a sum of money. They become employees of the PPM. The employment model is not as common as the equity model because many states have legal prohibitions against the employment of a physician by a corporation. Employment contracts may have a term of 3-5 years.
“Number seven relates to the composition of your practice’s professional reimbursement. This also affects the valuation. To the extent that it is heavily weighted towards Part A fees, or, for example, in Texas where substantial portions of the professional component result from clinical laboratory testing in the hospital, those might be considered risky. In that event, downward adjustments would be made to the valuation multiple.”
Pathology Practice Values
On pages 13 and 14, Jahnle outlines how a typical pathology practice would be valued using both the employment model approach and the equity model approach. “In comparing the pricing formulas, it is easy to see how the PPMs determine what type of revenue stream is going to pathologist compensation,” noted Jahnle.
“Once this determination has been made, the PPM will follow a pretty simple formula to determine what the specific purchase price will be,”? he added. “The more difficult negotiations involve the nature of employment agreements, terms of the management agreement (in the equity model), and any issues unique to that particular pathology practice.”
Although a calculation of “normalized”? income and EBIT is fairly straightforward, Jahnle points out that the composition of the purchase price can vary. Terms of the purchase must be negotiated and those discussions can become fairly complicated.
“Typically there are three components to the purchase price paid the the sellers,” noted Jahnle. “The ranges given are based upon representative sales. It is important to recognize that each purchase transaction will be unique. Although every sale contains these three basic elements, the actual percentages will vary.
“First, there will be cash paid up front to the sellers,” said Jahnle. “Anywhere from 33% to 60% of the purchase price may be tendered as cash. This is negotiable and depends on the quality of the selling practice, desire of the buyer and competitive market conditions at the time of sale.
Stock Provides Incentive
“Second, stock in the PPM will be offered, ranging from 10% to 15% of the sales price. This is designed to give the selling physicians a financial incentive to support the business objectives of the PPM. If the PPM has the potential to go public, such stock might appreciate substantially in value.
“Contingent notes are the third component,” noted Jahnle. “These may or may not be guaranteed. They typically are subordinated to senior indebtedness of the PPM. Payout of the notes may be based on future cumulative EBIT levels earned by the practice.
“Between 25% to 40% of the sales price might be in the form of contingent notes,” he added. “Typically the notes are for three to five year terms and do not bear interest. If an earn-out matrix is present , the selling practice may get zero dollars if they hit 80% of their target, and up to 1.5 times the value if they exceed 100% of their target.”
Jahnle’s outline of the valuation process shows the rather objective process used to measure EBIT (earnings before taxes and interest ). The major portion of the purchase price is based on EBIT.
“This demonstrates the essence of the PPM transaction,” noted Jahnle. “Basically, physicians are giving up a percentage or portion of their income. This is true of both the equity model and the employment model.
“When pathologists sell their income, they are accepting a reduced annual compensation in exchange for cash and assets up front. That is the basis of PPM valuation methodologies.
“In these transactions,”? he continued, “there are a number of ancillary agreements and other factors which dramatically impact taxation and the governance structure of the pathologist’s relationship with the PPM after the transaction closes.
“Under the equity model, what links the pathology practice to the PPM is the management services agreement, said Jahnle. “It is common for this agreement to last 40 years. It is executed between the professional corporation and PPM. It specifies the type of management services which the PPM will provide the practice and how the PPM will be paid. There may be an equity sharing kicker for growth in the practices revenues and operating profits.
“It is difficult to unwind this agreement,” cautioned Jahnle. “Because of the importance of this management agreement, it usually takes longer to negotiate provisions of this agreement than the actual purchase price.
“Another ancillary agreement which is part of the sales transaction is the employment agreement,” he added. “Employment contracts are part of the equity model and the employment model. Simultaneous with the management agreement, the selling physicians will sign employment agreements with their professional corporation.
“This is because the equity model PPM wants to know that all physician partners are covered by employment and non-compete agreements,” explained Jahnle. “Obviously, with employment model PPMs, the employment agreement is of prime importance. Typically these employment agreements run two to five years with non-compete clauses.
“Despite the fact that PPMs are offering a lot of money up-front to purchase the practice, pathologists should carefully consider their long-term business and career needs,” advised Jahnle. “After all, the essential element in the PPM transaction is that the PPM is buying a portion of the pathologists’ income. So the question is: do you want it now, or do you want it over time?”