Healthcare Goodwill In Medical Practices

Monday, March 1, 2004 - 01:00

The legal concept of goodwill as an intangible asset of a business is well established. Goodwill was defined in an old English case simply as "the probability that customers will return to the old stand."1 In time, the concept of goodwill has been considerably expanded. Medical practices generally have two types of goodwill:

Practice goodwill - an intangible asset of the entity, separate and apart from the value of the personal reputation and the distinct qualities of the physicians in the practice; and

Professional goodwill - goodwill that is attributable to the individual skills, reputation and personality of the physicians in the practice.

A professional practice will invariably have intangible value which, in other words, is the ability of the practice to earn an economic return over and above the return one could expect to earn from the tangible assets of the practice. The distinction between professional and practice goodwill becomes critical in cases where many states do not recognize professional goodwill as a transferable asset of the practice. The challenge for the valuator is to determine what part of the goodwill of a medical practice is attributable to the practice itself and what part is attributable to the owner professionals. Practice goodwill in a medical practice is the likelihood that patients will continue to return to the practice, in part because of:

• all the right business and operational systems in place, such as an in-place workforce of physicians and staff;

• effective billing, information, collecting and scheduling systems;

• restrictions, if any, on competitive practice by member physicians;

• an established patient base and current and transferable referral patterns from which to generate immediate and substantial cash flow, regardless of specific physician staffing; and

• the opportunity cost of setting up a competitive practice, in terms of "lost" income before all systems are in place and fully operational and an established patient following is developed.

The factors that contribute to professional goodwill generally include the age, health and past earnings of the owner professionals and knowledge, skill, training, reputation and professional success attained by the owner professionals.

An example of a professional practice with substantial practice goodwill is typically a clinic which attracts patients not because of any specific doctor but because of the high quality of service provided to the patients. In addition, it might have a laboratory attached to the practice which is well organized and provides quick and high quality service. The laboratory makes profits in excess of the normal return on its equipment. On the other hand, an example of an entity with professional goodwill but no practice goodwill would typically be a medical practice which attracts patients because they receive high-quality services personally from the doctors and that the personal reputation of the physician attracts the patients.2

In Geesbreght v. Geesbreght,3 a Texas appellate court held that a medical corporation possessed goodwill, apart from the physician as a professional practitioner. In the case, the physician owned a professional corporation which provided emergency room services for several hospitals on a contractual basis. The court held that the clinic attracted clients due to the clinic's reputation, separate and apart from the reputation of its owner physicians. The court reasoned that if a doctor owner were to sell an ownership interest, the professional corporation would still have retained the service contracts. Similarly, in Fexa v. Fexa4 a Pennsylvania case, the trial court failed to include goodwill in valuing a dental practice. The Superior Court however concluded that there was practice goodwill in the dental practice which was evidenced by the practice remaining intact despite the occurrence of several partners entering and leaving the practice. Likewise, when patients are shared by its owner professionals, it could be concluded that the professional practice possesses goodwill separate and apart from that attributable to the professionals. This view was indirectly affirmed in another Pennsylvania case, Demasi v. Demasi.5 In this case, a rheumatologist successfully appealed the trial court's decision to include goodwill in the valuation of his practice. The fact pattern of the case indicated that the practice consisted of the rheumatologist and another doctor who was an internist. Both doctors were equal owners of the practice. The rheumatologist treated the patients of the internist rarely and derived 70 percent of his patients externally. He was the only rheumatologist in the area of York, Pennsylvania and neither doctor had any contractual arrangements to provide services for any hospital or medical group other than an informal arrangement with a few nursing homes which did not produce a significant amount of patients. Based upon all these facts, the superior court concluded that if the rheumatologist left the practice, his patients would invariably follow him and hence his rheumatology practice did not have any practice goodwill.

Cases In New York State

Although in Mendelsohn v. Equitable Life Assurance Society the court held that "a professional partnership, whose reputation depends on the skill of the members, has no good-will to be distributed as a firm asset on its dissolution," courts have recognized that a professional practice could have practice goodwill separate and apart from that of the owner professionals. In Nehorayoff v. Nehorayoff,6 the subject matter of dispute was a fifty percent ownership of a medical practice specializing in abortions and related laboratory work. The court held that although the physician worked in the capacity of a doctor at the clinic, "there was evidence that the patient does not develop a personal relationship with the physician in such a clinic. Patients seek out the clinic because of advertising, reputation or referral. There is no reason to expect that a change in physicians in the practice would lead to a significant decline in business as it would in a private practice."7 In addition, other New York State cases have also addressed the issue of practice goodwill. In Spaulding v. Benenati,8 the court recognized that goodwill could be an attribute to a dentist's practice and a broker's practice. Similarly in Weiner v. Weiner,9 the court held that the name of the business, if different from the name of the partners, could be an element of such goodwill. Legal precedent in New York clearly established that professional entities of doctors, dentists, brokers, accountants, and in some cases attorneys, can possess goodwill that is distinct from the individual practitioners.

Valuators should consider the following factors in determining whether the goodwill attributable to a medical practice is practice goodwill:

• Frequency of patient contact with the physicians;

• Number of employees in the practice;

• Whether the practice is machine intensive or instrument rich;

• Number of patients treated per hour;

• Contractual arrangements with hospitals or medical groups;

• Sharing of patients among the physicians who own the practice; and

• The impact of the admission/termination of physicians on the business of the practice.

In certain cases, both practice and professional goodwill may exist in a medical practice. In such cases, the valuator would have to take into account the unique facts and circumstances surrounding the subject practice and use considerable judgment in determining what portion of the goodwill of the subject practice is purely attributable to the entity.

Valuation Methodology

Income Approach. Based upon consideration of the above factors, the income stream attributable to the practice goodwill can be determined. Usually, the best way to derive this income stream is to rely on the historic earnings of the practice. Valuators commonly use the following methods to determine the practice goodwill:

• Capitalization of Earnings Method. The simple or weighted average earnings of the earnings attributable to practice goodwill are capitalized using a fixed capitalization rate which results in the total value of the practice or in other words, the sum of its tangible and intangible assets. The value of the tangible assets is subtracted from the total value of the practice to arrive at the value of the practice goodwill.

• Capitalization of Excess Earnings. Once the normalized income stream of the practice is determined, the average compensation drawn by physicians with similar experience to that of the owner physicians is subtracted to arrive at the excess earnings of the practice. The excess earning is then capitalized using a capitalization rate to arrive at the value of the practice goodwill.

Market Approach. The practice goodwill under this approach is inferred based on sale transactions of similar medical practices based on the characteristics of the subject practice. However, this requires a very careful comparison of the characteristics of the sold practices to that of the subject practice including its geographical location, patient mix, specialty and major source of revenues.

Buy/Sell Agreements. Buy/sell agreements which provide for a specific sum of money when a doctor is admitted or bought out of the practice may provide an indication of practice goodwill, if such an agreement is negotiated at arms length. This amount may have to be inferred in an indirect manner. Although a partnership or corporate agreement may not provide for a buy-in amount, if an incoming physician is required to work for compensation levels below the average compensation levels for similar physicians in the market place, such compensation sacrificed by the incoming physician to buy into the practice may provide an indication of the goodwill of the practice. Similarly, deferred compensation arrangements when a physician leaves or retires from a practice can be a very useful indicator of goodwill.

Conclusion

In determining practice goodwill, valuators have to gain a thorough understanding of the facts and circumstances surrounding the case. Valuing a medical-related practice is not merely an exercise of quantitative analysis. It requires a thorough consideration of all qualitative factors which can prove to be critical in arriving at the value conclusions.1 Cruttwell v. Lye, 34 Eng. Rep. 129,134 (1810).
2 Parkman Allen M. "A Systematic Approach to Valuing the Goodwill of professional Practices" in "Valuing Professional Practices & Licenses," s 3rd Ed.
3 486 S.W. 2d 761 (Tex. 1972).
4 396 Pa.Super. 481, 578 A.2d 1314 (1990).
5 366 Pa.Super. 19, 530 A.2d 871 (1987).
6 108 Misc. 2d 311, 437 N.Y.S. 2d 584 (Sup. Ct. 1981).
7 108 Misc. 2d 311at 321, 437 N.Y.S. 2d 584 at 591.
8 442 N.E.2d 1244, 57 N.Y.2d 418 (1982).
9 390 N.Y.S. 2d 359, 88 Misc. 2d 920 (1976).

John Lemanski is a Manager in the Litigation, Valuation and Bankruptcy Services Department of Margolin, Winer & Evens LLP and Vijay Krishnamurthy is a Consultant in the same department. They can be reached at jlemanski@mwellp.com and vkrishnamurthy@mwellp.com, respectively.