General
Associate/Transition Discussion Points
R. F.
Willeford, MBA, CPA/CFP
This is an overview of some of the primary elements you should consider
in an associateship or practice transition. It is meant to stimulate
conversation between the senior doctor and the associate/buyer—and generate
some questions for you to ask your advisors. Needless to say, there are many
fine points to work out; and there is no “one-size-fits-all” solution. Check
out the Practice
Purchase – Due Diligence List for a list of detailed items to look into
when evaluating a practice opportunity.
Contracts:
“Ambiguity is not benign!”
Ideally, contracts should be signed before the Purchaser/Associate sets
foot in the practice. At a minimum, at least some kind of “letter of
understanding” should be prepared to address the issues below to insure that
there are no surprises or “deal killers”. This protects both the Seller and
Purchaser/Associate from misunderstandings.
Many times the Seller never gets around to going to the trouble to work
out a contract. The longer the Purchaser stays without a contract, the less
leverage they have to force the Seller to sign a contract later. This is of
special concern if the Purchaser is counting on being able to buy into the
practice. The Purchaser needs to know at least the general terms up front.
Likewise, it is unwise for the Seller to allow the Purchaser to remain
beyond a “honeymoon” period without signing a non-compete agreement and an
agreement requiring them to buy the practice, if applicable.
The contracts should address every phase of the practice transition up
front – not just the associateship period. There are five potential
phases to address, depending on whether there will be just an associateship
forever, a 100% “buy out” or whether there will be a “buy in” followed
by a “partnership” period, and then an eventual “buy out”. (If the
associate is not expected to ever become an owner, then just an
“associateship” contract will be sufficient. This would focus primarily on
the compensation and non-compete elements in Phases I and II.)
I. “Honeymoon” Period.
This is a period to see if each of you want to commit to a relationship.
Depending on how long you have known each other, this could last up to 6-9
months.
A. During this period, either doctor can terminate the
relationship for any reason.
B. Any non-compete will not apply to the Purchaser if
they leave during this period. (A new doctor should not be able to harm the
practice within the first six months or so. If a new doctor returned to their
own home town or moved their family to a new town, they should be able to remain
without penalty if they wish.)
II.
Associateship Period.
A. Decide whether the Associate/Purchaser should
be compensated as an Employee or an Independent Contractor. This decision should
involve your CPA.
B.
The associate should be paid between 30-35% of collections, after the lab
fee is deducted; but with a minimum guarantee of $250 per day for the first 6-12
months. If the Seller is uncomfortable with such a guarantee, this may be a sign
that the practice can’t support an associate. This guarantee is NOT typically
just an “advance” against future earnings. During the guarantee period, the
Seller should have the prerogative to determine which cases the associate can
work on.
C.
Determine which expenses of the associate, if any, the practice will pay
for.
D.
Some consultants advocate using a compensation formula to put the
associate “at risk” for a share of the overhead vs. a straight commission.
Part of the argument is that this will “encourage” the associate to buy in
so they can share in part of the profits of the practice. If the contracts are
properly drafted in the first place, and if the practice is truly able to
support two doctors, then such an “at risk” approach is not necessary and
adds unneeded complexity.
III. Buy-In.
The Seller should decide if part of his objective is to insure that this
associate is his “heir apparent”. If so, it is not sufficient to give the
associate the “right” to buy in. Instead, the associate must have the obligation
to buy in at some point.
A.
There might be a set date or a time range for the associate to buy in.
The associate might have the option
to buy in any time after,
say, one year, but have the obligation
to buy in by, say, the third year. The Seller might consider a way for the
Purchaser to buy his way out of the non-compete if he ultimately decides not to
buy in, but wants to stay in the area. If the Seller was counting on retiring
quickly, this would not satisfy his objective though.
B. There is not a totally satisfactory answer to the
question as to when to value the practice. Suppose the practice was grossing
$600,000 per year before the associate came, and is grossing $700,000 a year
later. On the one hand, the $100,000 increase probably is not due to the
associate generating any real growth – he is just doing the work the Seller
could not get to. So the seller would argue that the associate should not get
any credit for that growth, and the practice should be valued based on the
higher $700,000 gross.
However, the Seller could not have grossed that much without the
associate – and that production may drop after the associate clears out the
Seller’s backlog. To avoid hard feelings with the associate, and recognizing
the fact that the Seller in fact profited from the extra production during the
year, I would err on the side of valuing the practice based on the gross when
the associate first starts. I would increase the gross for any fee increases and
increase the value to include any new major capital purchases prior to the
associate buying in.
To put it in another perspective, if the Seller truly wants to maximize
the value of the practice, they could hire a temporary “worker bee” to get
the practice gross up to $700,000. Then fire the worker bee and get the career
associate to buy in. The career associate would not question the value based on
the $700,000 gross. But at that stage, the gross was “real” and not just
“potential”. You can’t sell “potential”. Also, you probably would not
be willing to go to the trouble to hire the worker bee just to get the gross up.
If you are not willing to go to that trouble, that is another reason that you
should not expect to base the value on the higher gross.
Based upon the circumstances, one option might be to count one half of
the growth toward the valuation. Also, the Seller may feel that he needs to
encourage the Purchaser to buy in sooner than later. In that case the Seller
might consider holding the value based on the initial $600,000 gross for only
two years. After that the practice can be revalued.
C.
The “selling price” of the practice is not just based on the
“practice value”. There are three components that affect the ultimate price:
the practice value, the financing terms and the tax ramifications.
1. Valuation. The valuation method and/or value
should be established up front. This same method
will be used as a starting point for the second half of the practice someday.
This can be discussed in more detail as more is known about the practice.
2. Financing. If the Purchaser is expected to pay
all-cash, then the selling price should be reduced 5-10%. By receiving all
cash, the Seller’s risk is reduced and the Purchaser does not have any
leverage if a dispute arises. This is the same concept many practices use when
they give a patient a discount for paying up front on a big case.
Depending on how much the Seller will continue to work (especially in the case
of a total buy out), and if he provides Seller financing, there may need to be
limitations on how much the Purchaser has to pay on the note. For instance, if
the Seller cuts down from 4 days a week to three, he is not doing the Purchaser
any big favor: the Seller might produce about 90% as much as he did before,
since he can send all the non-productive procedures to the Purchaser. In such a
case, the practice might not be able to afford to pay the Seller a commission
AND pay the note payments AND let the Purchaser have enough left to make a
living!
There are various ways to put a “cap” on the amount of payments the
Purchaser needs to make initially. A simple method is to say that the Purchaser
doesn’t have to make ANY payments or accrue interest as long as the Seller
works over, say, 3 days a week. At 2-tag3 days a week, the Purchaser might pay
interest only. There should be enough cash flow after note payments such that
the Purchaser can earn about 30% of his own production (i.e., excluding
hygiene).
If the Seller provides owner financing, he should expect about a 20% down
payment. This is necessary to pay taxes on the sale, along with any fees and
expenses involved with the sale. The purchaser may need to go to a bank for that
down payment, so the Seller needs to be prepared to give that bank a first lien
on the Seller’s equipment.
3. Tax impact.
The purchase price should be allocated such that about 75-80% is allocated to
“goodwill” and other intangibles and the balance to equipment. (The larger
the practice, the less that is allocated to equipment.) Goodwill should be
taxable personally to the selling doctor at reduced long term capital gains
rates. This is not ideal to the purchaser, but it is not devastating either.
The Purchaser would prefer for the entire price to be allocated to
equipment and other “tangible” assets. He can depreciate such assets over 7
years. He does not like “intangible” assets, like goodwill and patient
records, because they are depreciated over 15 years.
The Seller prefers intangible assets, because they are taxed at favorable
capital gains rates vs. higher “ordinary” rates. This could cut his tax bill
by 35-50% vs. the sale of equipment. This difference in taxes is a
“permanent” difference to him, whereas the longer depreciation period the
Purchaser experiences just delays the deductions that he will still get
ultimately.
Be careful with sale techniques that involve paying the Seller “management
fees” or “deferred compensation” instead of capital gains. These
techniques create “ordinary” earned income which is taxed at the highest
rate. In exchange for giving the Purchaser the ability to immediately deduct the
payments as they are paid (vs. 15 year depreciation), the accountants may try to
increase the purchase price to make up some of the extra taxes paid by the
Seller. There is NO equitable way to do this. If the Seller truly receives all
the after tax money he would have gotten by using capital gains, that means the
Purchaser had to “overpay” by about 40% - and the IRS got half of that
increase!
D. If the Seller is a proprietorship, LLC or S Corporation, the Purchaser
will buy into the existing entity. However, if the Seller is a C Corporation,
the method to sell the practice involves the Purchaser forming their own LLC or
PC to buy ½ of the assets from the Seller’s PC. The Purchaser typically does
not “buy in” to the existing Seller’s PC. You then decide whether the two
PCs will share space like a solo-group arrangement or whether they want to
practice in a tighter arrangement. (The decision often hinges on whether each PC
wants to bill the patients separately, have their own staff, etc. This is often
messy and impractical. However, this may be worth the trouble if each doctor
wants a different retirement plan. This might cause a big public relations
problem with the staff that is left out of a plan.)
To appear more to the public like a single practice, the two PCs would
form an “operating partnership” to actually run the practice. The new
partnership will collect all fees, pay all bills, employ the staff, etc. The
public will see the partnership as the “practice”. The partnership then pays
each PC their commissions and share of profit. Each PC then pays some individual
bills (continuing education, etc.) and then pays the doctor a paycheck, like an
employee. Unfortunately, the whole group has to do the same retirement plan.
Since the staff is typically intertwined and shared, it is often not possible to
try to do otherwise anyway.
E. In the case of two owner-doctors, the Purchaser will generally be offered
the right to buy 50% of the practice. (Don’t bother to try to sell just
49%—the Purchaser’s advisors won’t permit it, and it is almost an insult
to the Purchaser. The Seller’s fear of losing control is natural, but there
are other ways to satisfy that concern.) However, the Purchaser may choose
to buy only a small portion of the practice now, typically equal to their share
of the total production. Even though they would be a minority owner, they can be
protected by the contract by requiring unanimous consent for major decisions.
F. If the building is owned by the Seller, a realistic lease and rent need
to be established up front. The Seller may have been charging himself an
arbitrary amount of rent, more for tax purposes than based on the fair rental
value. Both parties need to know if the Purchaser will have an option to buy the
building and under what terms.
IV. “Partnership” Period.
A. If the Purchaser “buys in” vs. a total “buy-out”, how will each
doctor get paid? There are many acceptable scenarios, some more complicated than
others. None are perfect and all involve compromises.
1. Some people prefer to try to split expenses precisely, but there is no
absolutely correct way to do this. It is relatively easy to identify and
allocate “variable” expenses like clinical supplies and lab fees. But what
do you do about “fixed” expenses like rent and “semi-fixed” expenses
like staff salaries? What about the telephone bill, accounting fees, etc.?
Should they be split equally or based on relative production? One could argue
that the lower producing doctor still had equal access to the facilities and
staff, regardless of whether they produced the same amount. This is used by many
offices, once they agree on the formula.
2. A simpler approach is to simply pay each doctor as though they were
associates. For example, pay on a sliding scale like this: for the producers
first $150,000 of collections pay them 30%. For the next $150,000 pay 35%. Over
$300,000 pay 40%. This sliding scale reflects the fact that the overhead
decreases as collections go up, since the fixed overhead does not increase. This
also rewards for extra production. The pay scale should be set up so that there
will be about 5-10% of collections left over to split as profit.
3. The question then arises about how to split the profit – in proportion
to production/collection or in proportion to ownership of the “partnership”?
Probably the profit should be split in proportion to ownership (50-50), since
the higher producing doctor already got paid a higher commission – and the
Purchaser did pay for half the ownership.
B. The contract has to state how large expense decisions will be handled.
For instance, you may require that both partners must agree before spending
over, say, $3,000 on a non-routine expenditure – like new equipment. If one
“partner” adamantly wants something special, like their own air abrasion
unit, their own PC can buy it for their own exclusive use.
V.
Buy-Out.
A. Is there a
minimum period of time and service that the Seller is required
to provide? Likewise, is there a maximum period that the Seller has the right
to stay?
B. As with the first half, the Purchaser should be
obligated
to buy out the second half – not just have an “option” or “right of
first refusal”. By the time the older doctor is ready to sell, the younger
doctor may be as busy as he wants to be, and he does not really “need” the
rest of the practice. However, it can be awkward for the senior doctor to try to
sell to a third party, and the value might be reduced accordingly. If explained
properly, this “obligation” is not a major burden to the younger doctor.
For instance, the younger doctor might only own the practice briefly,
because he should be ready to immediately sell to a third doctor. In fact, that
third doctor may have already been in the wings as an associate. The advantage
to the young doctor is that he gets to “control” the sale. This allows him
to determine who his new partner will be.
C. I use the term “older” and “younger” doctor, but what if the
younger doctor decides to sell first? That wasn’t the way it was “supposed
to be”! So you need language to give certain prerogatives to the “senior”
doctor, while still protecting the “junior” doctor. Language regarding
prerogatives based on seniority are especially important in a multi-doctor
practice.
D. You need to address how the buy
out differs, if at all, depending upon the circumstances of the senior
doctor’s departure. Does it work the same whether the departure is a result of
death, disability, dispute or traditional retirement?
E. There
should be conditions under which the practice can force the senior doctor to
“retire”. For instance, if the senior doctor fails to produce an amount
equal to 25% of the total practice production for a period of two years in a
row, that would be grounds to require him to retire.
F. There need to be terms dictating under what circumstances the senior
doctor can be “forced” into retirement. For instance, if the senior doctor
fails to produce, say, 25% of the total production of the practice for two
years, then he could be forced to retire.
