What is your clinic worth?

What’s it worth? How many times have you heard that expression? Determining what something is worth seems to be a straightforward concept. However, valuing entities that operate in the healthcare industry is generally anything but straightforward. This article will explain some of the complexities and issues involved in determining the value of dialysis clinics. Specifically, we will discuss value drivers for dialysis clinics, regulatory considerations that come into play and recent initiatives at the national level that affect dialysis clinic values.

Reasons for Valuation

In our experience, there are two primary reasons for clinic valuations: 1) ownership buy-in/buy-out transactions, and 2) joint-venture transactions between the clinic and a hospital or other partner. Although unique considerations apply for each of these reasons, the underlying valuation approach is generally consistent.

When valuing a clinic for ownership buy in/buy-out purposes, it is critical to understand the control elements associated with the particular interest being transferred. For example, a 26-percent ownership interest generally isn’t controlling but may have certain “swing vote” characteristics for governance issues requiring supermajority (i.e. 75 percent) approval. Such swing vote power can increase the value more than proportionally over, say a 20-percent interest that does not have the same ability. Additionally, it is important to understand any restrictions on transferring the subject interest, which could limit the pool of potential future investors.

Non-competition agreements are often used to help protect the business from departing employees who try to take part of the business with them. In some cases, noncompetition agreements can have significant value. However, in order to have value, the agreement must be enforceable and the departing employee must actually be in a position to compete. For example, a non-competition agreement may not have much value in connection with partners who are retiring or relocating to other geographic regions since they are less likely to compete with the clinic in the future. Even if the non-competition agreement doesn’t have much value itself, the clinic as a whole may be just as valuable due to the reduced risk of competition. However, if there is an opportunity for the departing partner to compete and no such agreement exists, the potential impact should be considered when estimating the clinic’s future cash flows. A valuation for joint-venture purposes, particularly if a hospital is the potential partner, can be a much more complicated undertaking. It is critical to understand the nature of the joint venture to ensure that it does not contain unnecessary regulatory risks. In particular, it is important to ensure that the operating agreement does not award incentives for referrals to the clinic. Also, it is important to understand any medical directorships that are attached to the operating agreement. If a medical directorship exposes the clinic to undue regulatory risks, this factor must be considered when determining its value.

Standards of Value

Before delving further into our discussion about dialysis clinic valuation, it is important to understand the different standards of value and how they impact valuation analysis. The standards of value vary depending upon the purpose of the valuation engagement and include: 1) fair market value; 2) investment value; and 3) fair value. The definitions for each of these standards and how they impact the valuation analyses follows.

Fair market value (FMV) is defined as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” This is the standard of value most commonly used for transactions involving healthcare entities due to certain regulatory issues such as the Stark and anti-kickback statute. When considering FMV, one must ignore the specifics of the transaction, and determine value to “any willing buyer” and “any willing seller.” The issue of considering only hypothetical parties can be a difficult proposition and sometimes presents a challenge for the current owners to understand.

Investment value is defined as “the value to a particular investor based on individual investment requirements and expectations.” When determining value for purposes of facilitating a joint-venture transaction, it is critically important to use the appropriate standard of value (generally FMV). Otherwise the transaction could be consummated in a manner that creates regulatory risk to the parties that did not otherwise exist. These regulatory parameters will be discussed in greater detail later in the article.

Fair value is a concept that is generally defined by the courts or by state statute. Fair value does not come into play very often in valuing dialysis clinics unless the valuation involves a shareholder dispute or a divorce in some states. If valuing a clinic under the fair value standard, it is important to consult with legal counsel to ensure that all necessary state law issues have been taken into consideration.

Regulatory Considerations

We strongly recommend that an attorney with substantial experience in healthcare regulatory issues be involved with transactions involving any healthcare entity. The regulatory issues can be quite complex and the penalties for violating these requirements can be severe. The following briefly discusses the four main areas of regulatory compliance considerations. A detailed discussion of the myriad of regulatory complications that can arise with healthcare transactions is beyond the scope of this article but interested readers may want to do additional reading from the referenced materials.

Stark

In general, the Stark regulations govern referrals from a provider of Designated Health Services (DHS) to an entity in which the provider has a financial interest unless the arrangement falls into one of several safe harbor classifications. Dialysis services are not one of the 11 categories of DHS subject to the Stark requirements. Therefore, the Stark restrictions do not generally have much of an impact on dialysis clinic valuations.

Anti-Kickback Regulations

The anti-kickback statute (AKS) prohibits the receipt or payment of anything of value to induce referrals of healthcare services. There are 13 established safe harbors; however, even if the arrangement does not fit squarely into a safe harbor, that does not necessarily mean it will be, per se, illegal. Unless the dialysis clinic is in located in an underserved area, it will not fit into one of the existing safe harbor classifications. Therefore, any analysis of the proposed dialysis transaction requires careful scrutiny to ensure the value of the interest is not negatively impacted by exposure to civil monetary penalties.

Office of Inspector General

Among other things, the Office of Inspector General (OIG) governs transactions which have anti-trust implications in violation of the Sherman Act and the Clayton Act. OIG concerns do not come into play in typical shareholder buy/sell valuations but may have implications in potential acquisitions of entire clinics or in hospital joint ventures. As in all areas of regulatory compliance, it is critical that the clinic engage competent legal counsel with experience in these areas.

Private Inurnment/Excess Benefit

The fourth regulatory area to consider is private inurnment and excess benefit transactions as defined by the Internal Revenue Service (IRS). In general, the IRS is concerned about financial or other arrangements that result in a benefit to private individuals in excess of the benefit supported by arms-length market transactions. These concerns come into play most heavily when valuing joint-venture transactions involving a nonprofit health system. In particular, the IRS is concerned that nonprofit assets will be transferred in excess amounts to private individuals. If a transaction is determined to contain private inurnment or excess benefits, significant civil monetary penalties apply to both the organization making the payment as well as the individual receiving the benefit.

Valuation Approaches

There are three basic approaches used for determining the value of any asset. Depending upon the facts and circumstances of the particular clinic being valued, some of the approaches may be more applicable than others.

Asset Approach

The asset approach establishes a value for the clinic based upon its tangible and identified intangible assets. This approach is generally not used for operating companies, such as dialysis clinics, unless the business is not generating sufficient cash flows to make its operations more valuable than the underlying net assets less any outstanding debt obligations.

Market Approach

The market approach values a business based upon publicly-traded guideline companies or sale transactions of other similar privately held businesses. The challenges of applying this approach are two-fold. When using the publicly traded guideline method, it is critical to make the necessary adjustments to the public company information so that it is comparable to the private company being valued. These adjustments involve an analysis of the balance sheet differences such as levels of debt as well as differences in growth rates. This type of analysis can be quite time consuming and difficult to accomplish. When using merger and acquisition transaction data to develop valuation estimates for the subject company, it is important to gather and consider as much information about the sale transactions as possible. For example, sometimes the published transactions include assets (such as real estate) that may or may not be include in your transaction. Many times, the transaction data is limited making application of the approach difficult.

Income Approach

The income approach values a clinic based upon its ability to generate future cash flows and the anticipated risk associated with those cash flows. Depending upon the circumstances, the income approach can be a single period capitalization of earnings or a discounted cash flow analysis. Many times, an income approach will be stated as a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). Publicly-traded companies will generally state their acquisition prices as a multiple of EBITDA. The income approach is the most commonly used valuation approach for privately held businesses such as dialysis clinics.

Value Drivers

There are five primary drivers of value for any dialysis clinic. The following section of the article discusses each of these drivers and their potential impact on value.

Demographics of the Community

Senior adults, African American and Native American adults use dialysis services more heavily than others. Therefore, it is critical to understand the current demographics of the community where the clinic is located as well as the projections for future population growth in the area. Medicare patients often make up as much as 60 percent to 70 percent of the patient load for many dialysis clinics. Therefore, the composition of senior adults in the community as well as the projections for growth of this segment can have a tremendous impact on a clinic’s ability to grow. It is also important to consider the geographic placement of the clinic. A location too far from the dominant patient base is vulnerable to competition from another clinic that’s more conveniently located.

Relationship with Area Nephrologists

For any dialysis clinic to survive long term, it must secure and sustain relationships with area nephrologists. It is important to establish relationships with nephrology groups that have a good reputation in the community and that have a good mix of experienced physicians, preferably some of which are still early in their career. Many times, the dialysis clinic will formalize their relationship with a key nephrologist or group by negotiating a medical directorship contract. Medical directorships generally help build the physician’s loyalty to the clinic which reduces the risk of losing revenues to a competing center.

Competition

The existence and aggressiveness of competitors can have a significant impact on the value of a dialysis clinic just as with any other business. When considering investing in a dialysis clinic, it is important to understand the competitive landscape in the community and any expansion plans that dominant groups may be considering. A community with one or two dominant nephrology groups will be a more difficult competitive environment than a community primarily comprised of many independent practices. The value of a clinic can be substantially eroded away if the dominant group in a community is planning a competing center in close proximity. Typically, certificate-of-need (CON) regulations do not govern the establishment of new dialysis clinics as the capital investment is not as significant as with some other healthcare ventures. However, the existence and extent of CON regulations is state specific so it is important to understand any limitations specific to your community.

Merger and Acquisition Activity

The dialysis industry has undergone extensive consolidation over the past few years. There are currently a small handful of companies that dominate the industry on a national basis. When considering the value of a clinic for merger and acquisition purposes, it is critical to understand the status of current consolidation activity taking place, especially in your geographic area. These acquisition transactions could have a substantial impact of the multiples of revenue or EBITDA at which your clinic could be worth in the market place.

Recent Payor Initiatives

A clinic’s payor mix can have a substantial impact on its value. However, because dialysis clinics are typically dominated by governmental payors, specifically Medicare, it is very important to stay abreast of any upcoming changes in Medicare reimbursement rates. In March of each year, the Medicare Payment Advisory Committee (MedPac) issues their recommendations for changes in Medicare reimbursement rates for the upcoming year.

The most recent MedPac report (March 2006) did not include any recommendations that would have a significant impact on dialysis treatments specifically.

However, the MedPac reports generally include recommendations regarding outpatient reimbursements, so it is important to stay abreast of these developments and their potential impact on the clinic’s revenues.

The Congressional Budget Resolution Act for 2006 required implementation of the provisions in the Deficit Reduction Act of 2005 (DRA). Although the DRA will have a significant impact on many areas of Medicare reimbursement, particularly where outpatient services are concerned, there were no provisions specific to dialysis treatments. Even so, the DRA’s impact on other areas of reimbursement is a good example of why it’s important to stay current on legislative changes and their potential impact in your clinic’s revenues.

Conclusion

Determining the value of a dialysis clinic is a complex undertaking. Therefore, it’s important to ensure the valuation professional not only understands valuation techniques and methodologies, but also the regulatory issues of the healthcare industry. Additionally, a thorough analysis must be performed of the current and projected demographics of the community, the relationship with area nephrology groups and the state of merger and acquisition activity going on in the industry. RBT

Carol Carden is Director of ValuePoint Consulting Group, LLC, which is based in Knoxville, Tenn. W. James Lloyd is the managing director of ValuePoint.

References

1. Revenue Ruling 59.60, 1959-1, C.B. 237.
2. International Glossary of Business Valuation Terms
3. Federal Register/Vol. 69 No. 59/Friday March 26, 2004/Rules & Regulations, XI. Definitions (Section 1877(h) of the Act; Phase I-66 FR 922-49; Sec. 411.351)
4. Federal Anti-Kickback Law and Regulatory Safe Harbors, Fact Sheet, November 1999, Office of Inspector General, Office of Public Affairs
5. Intermediate Sanctions--Excess Benefit Transactions, Internal Revenue Service at www.irs.gov/charities/charitable/0,,id-123303,00.html and Inurnment--Section 501 ( c)(4), Internal Revenue Service at www.irs.gov/charities/nonprofits/article/0,,id=156404,00.html
6. 2006 United States Renal Data System Annual Data Report, Chapter 2 at www.usrds.org/atlas.htm
7. Congressional Budget Office Cost Estimate, January 27, 2006, S. 1932 Deficit Reduction Act of 2005 at www.cbo.gov/showdoc.cfm?index=7028&sequence=0