Executive Update
September 2005   

Acquiring Practices:  Buying Strangers, Friends and Enemies
Part Two – Structuring the Purchase
Sandra E. D. McGraw, Michael Parshall and Mark Kelly

This is a short excerpt of the material that will be presented by all three authors during the AAOE Program of the 2005 Annual Meeting in their Instruction Course Marketing By Practice Acquisition (course #475). Register and purchase course tickets now for best selection. Advance registration closes Sept. 28.

In the August Executive Update, we looked at some reasons why you should consider purchasing another practice. In essence, a practice acquisition can provide an economic cushion to protect your practice against an unpredictable cash flow as a result of declining reimbursement levels and increased competition. While the already busy doctor may reject a practice purchase as adding work that cannot presently be handled, established practitioners should consider practice purchases as an excellent means to build and maintain their patient bases. 
 
Developing realistic expectations and understanding the seller needs is the most important aspect of this active process. Purchasing a practice at the best possible price and ensuring the actual transfer of goodwill and patient conversion requires careful business planning and perceptive business advice. The legal and financial obligations are significant, the process can be stressful, and there is always some risk involved. In this article, we introduce some of the considerations of the transaction. It is written from the perspective of the buyer, but is equally applicable to the seller. 

Sale Price and Goodwill
All potential buyers of eye care practices face two major problems: 
(1) establishing that a fair price is paid, and (2) assuring that the practice goodwill will actually be transferred to the buyer. 

Arriving at the fair sales price is a perplexing problem, because practices do not always sell for a “standard” percentage of gross or net income. Each sale depends on many considerations, including practice size and subspecialty, intensity of competition, the personalities of the doctors involved, and so on. Formulas and standard approaches provide only benchmarks for estimating the reasonableness of an offer. Ideally, in the absence of the Medicare program or state fee-splitting laws, the purchase price could be based on the revenues retained by the purchasers post-sale. In that way, you would know that you are not paying too much. However, the myriad of state law regulations generally prohibit payments of revenue based on patient revenues post-sale, and payments for referrals are strictly proscribed except in limited circumstances under the Medicare Fraud and Abuse Regulation.

Some common valuation principles have evolved. Generally, the buyer purchases the assets based on a formula valuation, and pays some price for goodwill. Accounts receivable are most always excluded, though the buyer may act as a collection agent for the seller. Typically the price for “hard assets” — furniture and equipment — is based on either an independent appraisal or the original cost of the assets to be sold less depreciation. 

Goodwill has no exact value and can vary from zero to more than one year’s gross income. While there are clear and commonly accepted ranges of value, where in that range any particular practice falls depends on many factors. Practices that depend heavily on only a few referring physicians or formal networks for their ongoing patients typically have lower values than practices which derive most of their business from a broad base of patient, physician and other provider referrals, or even patient self-referrals. In large part, this is because those practices that have a fewer number of referral sources are more likely to establish rapport with the managing owner physician, whereas the broader the base of referrals, the more institutionalized the practice generally becomes in the community.

Ophthalmology practices, generally speaking, tend to command some of the highest goodwill prices in the medical field. On average, ophthalmology goodwill values have remained between 30 percent to 35 percent of the most recent year’s gross income, assuming the gross income has not been too volatile over the past several years. Optometric practice goodwill values often sell slightly below 30 percent of their gross income (due, likely, in part to their high overhead). While purchasing an ophthalmology practice is preferable to purchasing an optometric practice due to the greater range of services provided, the pool of optometric practices is bigger. For this reason, they could be your best option in some communities. Some optometric practices will assume that an ophthalmology practice would be willing to pay more than a buyer from another optometric practice. Remember, Medicare guidelines prohibit paying more than fair market value.

Legal Requirements of a Practice Purchase
The structure of the practice purchase must be carefully planned to avoid legal pitfalls. For example the Medicare Fraud and Abuse Regulations stipulate that the seller must not retain or obtain a professional position to make referrals one year following the date of transfer. By purchasing a practice that participates in Medicare, the sale price could be interpreted as a payment to the seller for the referral of government program patients. Bona fide employment is another requirement under the Medicare Fraud and Abuse Safe Harbor. However, the regulation includes a safe harbor provision to protect a practice against claims of fraud and abuse as long as certain conditions are met. While a purchaser practice is well advised to comply with the technical requirements of each safe harbor independent of the other, taken together, they may permit post-sale employment of the seller-ophthalmologist or seller-optometrist. If you plan on employing the seller after the sale, then you need to structure a bona fide employment arrangement, as that is another requirement under the Medicare Fraud and Abuse Safe Harbor. 

Both the buyer and the seller should engage a tax advisor experienced in practice sales. The allocation of the purchase price along with the practice assets can have significant tax consequences, and there are many nuances to those allocations of the purchase price. For example, while it may be advantageous for the buyer to assign a fair amount of value to hard assets such as the equipment, which can then be depreciated based on the price paid, this may cause depreciation recapture for seller if you assign a value to assets that have been depreciated to $0. 

Patient Retention
The heart of the deal is the patients and the hope that they will continue treatment with the buyer’s practice. This is the reason behind a goodwill value. A practice’s goodwill value depends substantially on a variety of these “convertibility factors.” These determine how many patients are likely to stay with the practice, and thus establish the practice’s actual worth to the buyer. 

The best way to help assure patients stay with the practice post-sale is for the buyer and seller to provide care to patients jointly for at least six months prior to the seller’s complete withdrawal from practice. During this interim period, the doctors can present themselves as associated so that the buyer’s continuation of the practice seems a natural event. To assure maximum effect, this period should be long enough for all regular patients to be exposed to the new doctor or group. Thus, selling physician often stays on as an “employee” of the buyer’s practice after the purchase. Make sure to discuss with your attorney before making such arrangements to assure compliance with the safe harbor provision under the Medicare Fraud and Abuse Regulations. When properly executed, this is one of the most effective ways for the selling physician to endorse and introduce the buyer-physician practice to his potential patients.

Another decision that will need to be made is whether you should retain the physician post-sale. There are some instances where the seller has been working in the practice for several years, and has earned a reputation as a competent and caring physician. In this situation, it may be better to continue the physician’s affiliation with the practice. On the other hand, in many situations it is probably best to sever the ties soon after the ownership change. Maybe the physician has been steadily phasing down anyway, so the patients are increasingly accustomed to seeing other providers. Another consideration is patient volume; there may not be sufficient patient volume to keep both the buyer and the seller busy. Furthermore, long-time practice employees will probably never fully transfer their loyalty to the buyer as owner until the seller is gone. 

A letter should be sent to all patients from the selling doctor explaining the seller’s decision to leave the practice, the ownership change and the firm endorsement of the purchaser’s practice -- explaining why the seller chose this successor when presumably there were other interested buyers. Retaining the right to continue to use the selling doctor’s practice name (whether a real name, a fictitious practice designation or both) is valuable for both practice marketing and for telephone listing purposes.

Another strong convertibility factor is the continued employment of key office staff, especially receptionists and technicians who know the patients well. Since these individuals presumably also know the patients, their continued presence goes a long way towards establishing that the change, though significant, was beneficial, and everyone was “taken care of.” If the selling doctor employs a spouse or another family member, it should be clearly understood what their roles will be under the new ownership. In many cases, it may be best to sever the relationship with the office at the time of the sale.

Consult Your Advisors Early -- As in Before You Start
Too often the attorney or consultant is contacted after the basic deal terms have been discussed, making it impossible for the advisor to help you in any significant areas. More dollars can be squandered in a split-second negotiation over price than can ever be recovered when negotiating the fine print of the legal documentation. Excluding your attorney, accountant or consultant from discussions with the purchaser during your third or fourth meeting with the seller before understanding the transaction options and trade-offs is one mistake, but failure to seek early advice can be a true mess. 

Gaining an upfront, clear understanding of what benefits you have tax-wise and how that may disadvantage the seller (and vice versa) and how to negotiate those trade offs on the fly will provide you with a critical advantage to structure the deal properly. Since the one initiating the conversation generally leads the deal (whether buyer or seller), you are the one who has the chance to put the terms on the table. Any change from there is just that — a change — and it can be seen as a concession, a victory or a negotiated term. Once you understand the critical points of the transaction and what trade-offs are (or are not) acceptable, you come off as a reasonable negotiator, able to hold to the deal struck, rather than a wishy-washy buyer who needs to return to the seller repeatedly to renegotiate, or ultimately regrets the deal made. Certainly getting advice late in the transaction is better than getting no advice at all. It is also true that many “misunderstandings” can be worked out during the closing. However, you might be disappointed with the results. As negotiations progress, both the buyer and the seller begin to feel more heavily invested in terms of the amount of time and money (e.g., attorney and consultant and accounting fees) that they have already expended. In turn, this often makes the buyer increasingly reluctant to back out if seller “hardballs” them on a key issue at the last minute. While the seller may start to develop seller’s remorse, it is the buyer who feels so deeply invested that putting up another $5,000 or $10,000 does not seem like such a big deal, given the investment in what the overall deal will cost in purchase price, legal and accounting fees, administrative time, investment in bringing that office “on-line” and the like. This is especially true if the buyer does not have clear “walk-away” points. The three things to keep in mind before you even consider purchasing a practice seriously are these:

When you thoroughly understand the implications of the transaction for both you and the sellers, understand both your price ceiling and the other practice (operational) obligations, then you will know when to cease negotiations if it is not working so you do not suffer from “deal creep,” or waste time trying to negotiate with “the nibbler.” You would recognize these problems immediately. They are both marked by the words “…one more thing….” When this happens, the only countermeasure is to know your own bottom line, when to say “no” and walk away. 

Specify All Major Deal Terms Upfront
Before discussions get started in earnest, both parties should each sign a “simple” letter of confidentiality. Both parties, but especially the seller, can take comfort that you are not just going to spread around information to the close-knit medical community. Most buyers make the mistake of beginning negotiations with a seller with a discussion and agreement on general “purchase price,” or at least the offer range. Often this is discussed before such other items as structure (asset sale versus stock sale), tax allocation, payment terms, collateral and post-sale employment of the seller. Yet these “other” issues dramatically affect the pricing decision. For example, paying $500,000 for a stock sale where you assume all of the seller’s historical liabilities is much different from paying $500,000 in an asset sale, where you acquire no liability, and may be able to fully depreciate all of those acquired assets, thus acquiring tax write-offs. Similarly, paying $100,000 for equipment and $400,000 for goodwill is very different from paying $400,000 for equipment and $100,000 for goodwill when considering taxes (again, the tax write-offs). Therefore, an offer for the practice should be in an outline, letter of intent or other written document specifying all major deal terms, which includes the structure of the transaction.

What Are You Buying?
Before you make an offer to the seller (or accept one of his), make sure that you know specifically what the price includes and excludes.  

• Practice accounts receivable: on average 15 percent to 20 percent of collectible revenue, therefore no small item to overlook. 
• Ancillary businesses such as an optical shop or cosmetic skin care business. 
  Does it matter that the optical shop is separately incorporated, outside of the medical  practice corporation? What about the refractive laser owned outside of the medical practice corporation? Since these ancillaries may be in separate entities or at least considered separate lines of service within the same practice, saying you agreed to purchase the “ophthalmology practice” may not have conveyed the intent to buy every single asset related to the ophthalmology practice. 

Other Tips

• Purchase the seller’s practice through your existing practice — preferably through an entity that limits your liability exposure to the amount you have invested in the entity, whether a C-Corporation, S-Corporation or limited liability company. 
• Ask the seller to finance part of the sale — expect some form of a demand for a security interest in the medical practice being acquired.
• Negotiate basic lease terms with the landlord well before you reach final agreement with the seller.
• Do not agree to take over the seller’s provider assignment accounts as Medicare and commercial payors. Otherwise you could be held (the owner of the assignment account) responsible for any prior overbilling by the seller, even if this occurred well before the first day you set foot in the practice. 
• Talk to your attorney about holding some of the purchase price payments back in an escrow fund.

Closing Remarks
There are many details to consider when purchasing a practice. This article briefly discussed some of them.  Ideally, you foresee most of them before you open negotiations with a specific seller so you are able to make intelligent trade offs as you discuss the deal. In most cases, the most informed party, fully aware of his own motivations, including what he will gain or lose from the transaction along with his bottom line and a full understanding of the other party’s position, is the one who will cut the best deal for himself. This topic will be examined more thoroughly in course #475 Marketing by Practice Acquisition during the Annual Meeting.

About the authors: 
Sandra McGraw is a both a consultant and a lawyer, with more than 20 years experience advising physicians in their business and legal matters for The Health Care Group. Michael Parshall is vice president of The Health Care Group. He is an authority on practice valuation, mergers and acquisitions, practice and ancillary services development, operations and strategic planning. Mark Kelly, the chief executive officer of Eye Care Specialists, has more than 23 years of experience and has negotiated more than 15 practice acquisitions. As a result of the described strategies, practice revenues and locations have quadrupled over the last six years. Currently the practice employs 12 ophthalmologists, 10 optometrists and more than 200 total employees.

Bulletin Board

Advance registration for Annual Meeting closes Sept. 28 Register and purchase course tickets at www.aao.org between now and Sept. 28 and you can pick up your badge and materials in the Advance Registration area onsite in Hall A. After Sept. 28, you can register onsite in Chicago.

In addition to the ticketed program, the AAOE program includes a host of unticketed sessions — part of the extensive AAOE Free Program. Be sure to arrive for these sessions early, as space is limited. The Free Program kicks off with the AAOE General Session: Integrating Innovation into Your Practice (Sunday, Oct. 16, 10:15 a.m. – noon).

Come See the Future: Seamless Integration of Digital Imaging Devices and Electronic Health Records Don’t miss the Integrating the Healthcare Environment Multi-Vendor Interoperability Showcase, booth #2381, during the Annual Meeting. This hands-on exhibit will show how you can access patient data anytime and anywhere, improve workflow, increase efficiency of care and provide better documentation.

Mark your calendar for the AAOE Member Reception — an exclusive event for AAOE members only (plus a guest). The reception is on Sunday, Oct. 16, from 6:00 – 8:00 p.m. in the Crystal Room of the Fairmont Chicago.

Be sure to stop by the AAOE/Practice Management booth in the Academy Resource Center (booth #2144) to take a look at AAOE products — including a demo of the brand new 2006 Ophthalmic Coding Coach CD-ROM. You can also schedule an appointment for a free one-on-one consultation with a practice management expert, and post your specific coding questions to our coding experts.

Registration open for the Professional Choices Job Fair If your practice is in need of an ophthalmologist, register today as a Hiring Practice at the Professional Choices Job Fair. The Job Fair will take place at the Annual Meeting on Sunday, Oct. 16, from 2:15 p.m. to 5:00 p.m. The Hiring Practice fee ($360) includes admittance to the Professional Choices Job Fair Opening Session: Hiring an Ophthalmologist for Your Practice—What Do You Need to Know? The Job Fair is free for job seekers. Learn more at www.aao.org/jobfair.

2006 ICD-9 for Ophthalmology now available! Place your order today for AAOE’s 2006 ICD-9 for Ophthalmology (#012224) to ensure that your coding is accurate and in line with updates that will be implemented Oct. 1. The book comes with a bonus searchable CD-ROM and is available exclusively from AAOE. To order, call 866.561.8558 or visit www.aao.org/store. To see the complete list of coding products available from AAOE, go to www.aao.org/store and enter keyword “coding.”

Identify Gaps in your Coding Knowledge before Someone Else Does. Take the Ophthalmic Coding Specialist™ Exam, jointly offered by AAOE and JCAHPO. Those who pass will be awarded the Ophthalmic Coding Specialist (OCS) certificate of completion. Everyone who takes the test will receive a report identifying areas where your coding skills need further improvement and feedback to help improve your coding abilities. The exam is a take-home and open-book test. Visit www.aao.org/store for a list of ophthalmology-specific coding resources that will aid your preparation, including the 2006 Ophthalmic Coding Series, the recommended study guide for this exam. You can learn more and print out a registration form at http://www.aao.org/aaoesite/coding.

Introducing a New Diabetic Retinopathy Patient Education DVD Understanding Diabetic Retinopathy (#050104), a new Academy-developed patient education DVD, combines interviews with patients, physician explanation and high-quality animation to explain both proliferative and nonproliferative diabetic retinopathy and available treatments. Also includes an OMIC-approved Aid to Informed Consent and a Spanish translation. You can view clips and place your order at www.aao.org/store.

E-Expert, Etalk and E-Retina are three free listservs for members to participate in a dialog on a variety of practice management topics. E-Expert features a bi-monthly scheduled topic moderated by a seasoned professional. Current topic: Performance Appraisals Sept. 16 – 30.  Learn more or subscribe to AAOE Listservs today.

September Issue of EyeNet Magazine is Now Live Savvy Coder continues to address the issue of coding for services in the ASC (Part 3). Practice Perfect addresses how Electronic Health Records of tomorrow may affect you today.

For more information about AAOE products and services, visit www.aao.org/aaoe.