Wondering what “adjustments” can and cannot reasonably be factored into your valuation?
In a previous post, we discussed the differences between price and value and highlighted the various standards of value, including both Fair Market Value and Investment Value. Yet, based upon some recent discussions with prospective clients, we felt the need to revisit these topics in additional detail.
Standards of Value
Two common standards of value which may be relevant in the valuation of a healthcare business, depending upon the specific buyer, include Fair Market Value and Investment Value.
Fair Market Value (“FMV”) is defined generally as “the value in arm’s-length transactions, consistent with the general market value of the subject transaction.” In the context of assets and a business, general market value means the price that an asset would bring on the date of acquisition of the asset as the result of bona fide bargaining between a well-informed buyer and seller that are not otherwise in a position to generate business for each other. This standard of value is typically used to comply with applicable healthcare regulations and is frequently relied upon by parties in transactions where there may be referral relationship(s) (e.g., a physician practice to be purchased by a hospital).
Investment Value (“IV”), on the other hand, is value to a particular investor based on individual investment requirements and expectations. The IV standard does not satisfy applicable healthcare regulation and, accordingly, would most typically be used by parties not in a position to refer to one another (e.g., a physician practice to be purchased by a private equity backed Management Services Organization).
But what do these really mean in practice? To answer this question, we first need to address the notion of “Adjustments”. Whether a particular adjustment is appropriate will depend, at least in part, upon the particular standard of value. Furthermore, there are (at least) two common types of adjustments, “normalizing adjustments” and “synergistic adjustments”. It’s important to understand the difference.
Common Types of Adjustments
“Normalizing adjustments” are adjustments to revenue and/or expense on historical income statements (most typically) frequently made by appraisers and investment bankers to restate results from operations to reflect expected financial performance on a go-forward basis. These adjustments can take many forms. Typical adjustments to revenue in cash basis financials might include adding revenue for services performed but not yet collected, or expected revenue from growth initiatives (e.g. new providers, services or even office locations) currently underway.
Expense adjustments can include similar cash basis financial adjustments (i.e., as described above in connection with revenue) or the elimination of non-recurring expenses (e.g., excessive legal spend due to an “outlier” litigation). Expense adjustments also include items of a discretionary or personal nature currently expensed to the business that would be eliminated post transaction. Examples include (excessive) compensation to a family member, personal travel, dining, or even rent payments to a related party real estate entity which may not be reflective of fair market value for similar space.
As the name would suggest, “synergistic adjustments”, on the other hand, reflect buyer-specific facts and circumstances, which cannot reasonably be realized by every buyer and, therefore, impart synergistic benefits on the target business which serve to increase its’ value.
Whether a particular adjustment is appropriate will depend, at least in part, upon the particular standard of value.
Aligning Adjustments with Standard of Value
Depending upon their nature, adjustments can be considered FMV standard type adjustments, adjustments to be made under an IV standard, or in certain cases, adjustments which would be reasonable to make in connection with both an FMV standard valuation and an IV standard valuation, as further described below. Most FMV adjustments also tend to apply to an IV standard; however, the reverse is not typically true.
In layman’s terms, if an adjustment can reasonably be “realized” or achieved by the general pool of prospective buyers, then it is reasonable to make these adjustments in connection with a valuation which relies upon the FMV standard. As set forth above, these could include adjustments to more accurately reflect results from operations (adjustments to revenue and/or expense) and the elimination of non-recurring and discretionary expenses.
Some adjustments, however, reflect buyer-specific facts and circumstances, such as a favorable payor contract that is otherwise unique to the buyer and unavailable to the seller and/or other prospective buyers, or a very unique group purchasing supply contract which would lower the cost of supplies post-transaction. Other similar adjustments which impart synergistic benefits and which serve to increase the value would be appropriate under the investment value standard but not the FMV standard.
Sometimes these adjustments can be made under both an FMV and IV standard of value. Examples include but are not limited to accounting based adjustments, non-recurring and discretionary expenses, and even a correction to an historical coding error which historically prevented otherwise realizable revenue from being collected.
When seeking reliable and comprehensive valuation services for healthcare transactions, we are here to help. Our expertise and commitment to providing tailored and insightful evaluations, makes Root Valuation the trusted solution for all of your valuation needs. Contact us at info@rootvaluation.com for more information.