by Jason Ruchaber, CFA, ASA
The International Glossary of Business Valuation Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” Similarly, the IRS defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”
Mathematically, goodwill is simply that portion of the overall business value in excess of the identified assets held within the business. Most often, goodwill value is created when the profits generated by the business exceed the rates of return that would normally be earned on the assets utilized by the business.
For physician practices, payment for “goodwill” was a bit of a regulatory boogeyman due to the infamous 1992 “Thornton letter”, where Assistant General Counsel to the Office of Inspector (OIG), D. McCarty Thornton, reasoned that “any amount paid in excess of the fair market value of the hard assets of a physician practice would be open to question”, and further citing goodwill as a specific item of concern as a potential payment for a referral stream.
As a matter of practical consideration, a profitable going concern business will almost always have some level of goodwill value, and the seller of that business – whether it be a healthcare business or otherwise – would not be willing to simply give up value associated with that income stream absent purchase consideration. Since the issuance of the Thornton letter, there has been significant clarification on the issue of how fair market value and the “value or volume of referrals” is defined for healthcare regulatory purposes. These clarifications have alleviated most of the concerns related to the payment of goodwill in physician practice transactions, however, there are still some important considerations that should be followed.
Because goodwill is simply the difference between the overall value and the sum of its identified assets, the determination of overall value must be specified in a manner that is consistent with the regulatory definition of fair market value and not in a manner that takes into account the value or volume of referrals. Though not an exhaustive list, things that should not be included in the valuation model include:
- Enhancements to value that result from buyer specific synergies such as favorable payor contracts, increased utilization, or reduced overhead costs.
- Consideration of any extraneous or downstream revenue sources related to the existing patient base, but not currently billed in the practice. This may include as surgical facility fees, diagnostic imaging, pathology, etc.
- Inclusion of personal goodwill that is retained by the selling physicians. Often this can be accounted for by properly modeling the post transaction compensation model, but there may be other carve-outs or exceptions that impact the economic value transferred beyond the comp model.
Physician practice valuation has numerous complexity and regulatory restrictions not found in other industries, but when properly fair market value is properly specified, goodwill value can (and should) be paid for in physician practice transactions.
At Root Valuation we help physician leaders successfully navigate business and employment transactions to that their value is fully realized. If your organization needs help navigating your goodwill within your physician practice contact us at email@example.com.