The Asset Approach to Healthcare Business Valuation
By Thomas Reinke, Advisory Services, Taylor Rosanova, Senior Manager, Advisory Services & David Glusman, Partner, Advisory Services
One trend that is continuing in the healthcare industry despite the COVID-19 pandemic is the transformation of the healthcare provider sector from a collection of highly fragmented organizations into consolidated and vertically integrated systems. Last year saw continued sales, acquisitions, mergers and new partnerships among all types of healthcare organizations.
The key to a successful sale, acquisition or other financial transaction is an accurate valuation of the entity or entities involved. An accurate valuation ensures that the parties involved have the necessary information to establish their negotiating positions.
Three Valuation Methodologies
A business valuation determines the overall value of a company. There are three generally accepted methods for valuing a company: the market approach, the income approach and the asset approach. All three methods may be used in the healthcare industry, with considerable variation across different sectors and types of transaction contemplated. Each of the three methods has characteristics particularly suited to specific types of healthcare businesses and transactions.
For example, a small medical device company with an innovative diagnostic product that is being acquired by a larger device manufacturer is likely to be valued with either the market approach or the income approach. That would allow the company to be valued in comparison to other innovative companies able to produce game-changing products, or in line with statistical information on comparable companies.
Federal Laws Govern Valuation
The largest sector of the healthcare industry is the provider sector, which includes hospitals, outpatient clinics, large physician practices, diagnostic facilities, home health agencies and nursing homes. Business transactions among provider organizations are commonly valued using the asset approach. The asset approach has emerged as the valuation method that complies with federal laws when there is an ongoing referral relationship between the parties. The specific applicable laws are the Anti-Kickback Statute (AKS) the Physician Self-referral Law (the Stark Law) and the False Claims Act. The AKS, for example, makes it a criminal offense to knowingly and willfully offer, pay, solicit, or receive anything of value to induce or reward referrals that generate business or healthcare services paid by federal health insurance programs. A key concept in these laws is that the financial terms of a business arrangement or transaction must be fair market value and commercially reasonable.
The asset approach has emerged as the valuation method that complies with federal laws when there is an ongoing referral relationship between the parties.
The asset approach is based on the principle of cost or substitution and focuses on the individual types of assets and liabilities of an entity. The theory underlying this approach is that a prudent investor would not pay more for a group of assets than the cost to replace them. Under the asset approach, a value indication is reached by adjusting the recorded book value of a company’s assets and liabilities to its fair market values. The value of the liabilities is subtracted from the value of the assets to derive the adjusted net asset value of the entity.
In most industries, when valuing operating companies, the asset approach is rarely utilized in a going concern as it fails to capture the goodwill value of the company. However, within the healthcare space, when federal laws dictate that goodwill or other tangible and intangible assets cannot be compensated, the asset approach becomes the de facto primary valuation technique. Assets and liabilities that have deviated from fair market value need to be adjusted as part of this approach.
The most common compensable assets that require adjustment to fair market value are the fixed assets and the assembled workforce. Fixed assets have a book value equal to their original purchase cost less any depreciation. Given slower turnover of fixed assets relative to other assets such as inventory, substantial adjustments from the book value may be required.
For example, an orthopedics practice may have an MRI machine with the follow characteristics:
- An eight year book life.
- $800,000 purchase price.
- Acquired 10 years ago.
- Determined to have a fair market value today of $200,000.
The book value would be $0 as the asset has been fully depreciated, but the fair market value is still $200,000. As such, the property, plant and equipment would need to be increased (or written up) by $200,000 as part of the valuation. This process is then completed for all of the company’s tangible assets, and the fair market value of the fixed assets replaces the book value of the fixed assets as part of the asset approach.
The assembled workforce is an intangible asset that is part of goodwill but typically is compensable in healthcare valuations that require the use of the asset approach, as the employees in place do not relate to referrals. Most commonly, the assembled workforce is valued using the cost savings method. The cost savings method values an asset based on calculating the costs avoided by the acquiring company when obtaining a pre-existing, fully functional asset, rather than incurring the costs to recreate the asset. Simply put: the amount it would cost to recruit, hire and train replacements for the subject company’s current workforce and bring them up to a reasonable level of productivity. This asset will not be on the company’s balance sheet, and therefore, for valuation purposes, an asset will need to be created equal to the value of the assembled workforce.
Occasionally, other assets and/or liabilities such as inventory, related-party items, other compensable intangible assets and unrecorded assets/liabilities will require adjustment as part of the healthcare valuation.
A common misunderstanding of the asset approach is that it is equivalent to the adjusted book value of the company. However, the goal of the asset approach is to determine the fair market value of the business based upon adjusted net asset value (compensable fair market value) without taking into account the value of referrals of designated healthcare services. This requires a detailed and insightful analysis of assets and liabilities.