By Daniel M. Bernick, J.D., MBA

Published February 2008

As a health care attorney and advisor, I have prepared and reviewed hundreds of buy-in arrangements for all different medical and dental specialties. There are infinite variations on a theme, but here are some basic guidelines. In the discussion below, it is assumed that a solo physician is bringing on his first partner.

The first question that "Dr. Senior" is likely to ask is this: what percentage of the stock should I sell? I.e., should "Dr. Junior" and I be equal, 50/50 partners, or should I keep 51 percent, 60 percent, or more?

Often the concern here is one of control. Dr. Senior does not want to be kicked out of his own practice, and therefore he hesitates to sell Dr. Junior a full equal 50 percent share. Another concern is that selling a full 50 percent share will obligate Dr. Senior to split profits equally with Dr. Junior. This is a concern because, at the start of the partnership, Dr. Senior is typically more productive than Dr. Junior, in terms of generating patient receipts.

In fact, the percentage of stock sold does not necessarily dictate voting control or profit shares. With respect to control, Dr. Senior could sell Dr. Junior 50 percent of the stock and yet properly protect himself from premature ouster with appropriate provisions in the partnership agreement. And the percentage of stock need not have anything to do with division of profits, which can all be bonused out to the doctor owners based on production or any other desired formula.

Let’s assume for the sake of argument that Dr. Senior agrees to sell Dr. Junior 50 percent of the stock. How should the buy-in be valued? How should the buy-in price be split between pre-tax and post-tax payments?

There are the three basic components to medical or dental practice value:

· Hard assets (equipment, leasehold improvements, inventory).

· Accounts receivable and goodwill.

· Intangibles or "goodwill."

Of these three values, hard assets is typically the smallest. For example, in most primary care and internal medicine subspecialty physician offices, there are few "big ticket" medical equipment items or expensive inventories. Mostly the hard assets are desks, chairs, exam tables, computer equipment and cabinetry. Because these values are modest, it is typical to price the stock based on these items, and keep the larger receivables and goodwill values to be handled in a multi-year pre-tax "income shift." This pleases the new partner, who wants to pay the majority of the buy-in with (cheaper) pre-tax dollars, versus (expensive) post-tax dollars. Senior doctors prefer to put all values (hard assets, receivables and goodwill) into the stock price, to obtain favorable capital gains treatment on all payments. However, the "market standard" in buy-ins is that the junior doctor is accommodated on tax treatment, in terms of being allowed to "income shift" all values other than the hard asset purchase.

A common valuation approach with respect to hard assets is a "modified book value" approach. Book value is a readily ascertainable figure, since it is shown on the Practice’s tax return or workpapers, but it is not an economically accurate figure; the depreciation allowances allowed by the tax rules are typically far more "front loaded" than the actual economic depreciation, resulting in a low or no value for items that may be used for years and years after they have been "written off." Thus, it is common to use "modified" book value instead. For example, straight line depreciation may be used instead of the rapid double declining balance method; an average useful life of 10 or 12 years may be used rather than five or seven years allowed by the IRS; and an assumed minimum value is assumed at 20 percent of original cost, even if the item is fully depreciated (zero book value).

On receivables and goodwill, there are two buy-in approaches. Both are pre-tax income shifts.

The older, traditional approach is the so-called "exact" approach. Receivables and goodwill are valued as discrete assets, and the final price to Dr. Junior is his percentage stock ownership, times the total value of these assets. If, for example, the total valuation of receivables and goodwill is $300,000, Dr. Junior might "pay" this to Dr. Senior in income shifts of $75,000 per year for four years, without interest.

The "exact" approach is certainly viable, and it is still used by many practices. However, in the past 10 to 15 years, many practices have begun employing an alternative "inexact" approach. The pre-tax income shift is not calculated as a specific dollar number. Rather, it is calculated as a percentage of Dr. Junior’s compensation share.

For example, assume that Dr. Senior and Dr. Junior have agreed on an equal split compensation formula. They have also agreed on "inexact" buy-in percentages as follows:

· Year 1: 40 percent discount.

· Year 2: 30 percent discount.

· Year 3: 20 percent discount.

· Year 4: 10 percent discount.

· Year 5: 0 percent discount (buy-in complete).

In year 1, assume that each of Dr. Senior and Dr. Junior are entitled to $300,000 before buy-in, based on their equal split formula. Dr. Junior’s share is then reduced by 40 percent, leaving him with $180,000. Dr. Senior gets $420,000 ($300,000 plus $120,000 from Dr. Junior). In Year 2, the total doctor compensation pool is the same, so the equal split is again $300,000 per doctor. Dr. Junior’s share is then reduced by 30 percent, leaving him with $210,000, and Dr. Senior gets $390,000. And so on.

The "inexact" approach makes some people uncomfortable. After all, it is "inexact," and many people prefer the certainty of a fixed buy-in number. On the other hand, the inexact method avoids potentially contentious disputes over the value of goodwill. While most new partners do not deny the worth of hard assets or receivables, they may refuse to assign any significant value to goodwill. Admittedly, it can be difficult to appraise goodwill value. Yet the exact method cannot be applied without such an appraisal.

By contrast, the inexact approach does not require that goodwill value be firmly fixed. Rather, the concept is that it provides a fair transition between the associate level salary and a full partner salary. Each year, the percentage "give up" to Dr. Senior shrinks as Dr. Junior’s value to the Practice – and his contribution to Practice development – grows, until at the end of the buy-in period Dr. Junior has "paid his dues" and can keep a full partner share of the doctor compensation pool.

The inexact approach may also better reflect the value of the Practice than the exact method. The exact method attempts to fix the value of goodwill at a moment in time. The buy-in amount will not decrease during the buy-in period, even if the doctor compensation pool shrinks significantly due to declining reimbursements or rising overhead. It also will not change if the Practice experiences a dramatic increase in profitability.

By contrast, the inexact method responds to changing finances. If the doctor compensation pool shrinks, so does the buy-in, since it is calculated as percentage of Dr. Junior’s compensation share. Dr. Junior’s compensation loss is thus buffered by a reduced pre-tax income shift to Dr. Senior. This is appropriate (arguably) because the Practice may not be "worth" as much as originally thought (finances are deteriorating.) The benefit of the inexact approach for Dr. Senior comes when Practice finances improve. Now Dr. Junior is enjoying a larger compensation package than expected. His percentage pre-tax income shift gives a portion of this enhanced income to Dr. Senior. This is appropriate (arguably) because the Practice may be "worth" more than originally thought (finances are improving.)

The 40-30-20-10 inexact progression above is only one example of this approach. The percentages can be adjusted up or down to suit the Practice’s finances. For instance, in recent years many specialties have experienced a run-up in the market salary rate for newly trained physicians. This creates buy-in challenges when the gap between associate earnings and partner earnings is modest. For example, assume that the senior doctors earn $300,000. Meanwhile, an associate in the Practice in his third year (just prior to buy-in) is earning $200,000. Therefore, a 40-30-20-10 approach will be unacceptable; the first year discount will reduce Dr. Junior’s partner salary of $300,000 down to $180,000, meaning a pay cut of $20,000. By contrast, a custom tailored progression of say 30-30-20-20 would give Dr. Junior a first year partner salary ($310,000) that is slightly more than his $300,000 associate salary while keeping the total discounts the same at 100 percent (40-30-20-10 versus 30-30-20-20).

It is important to establish a good buy-in format for the first partner. The first partner’s buy-in establishes the "template" for the second and subsequent partners. Assuming that the first buy-in worked well, the template can be re-employed with confidence. Even if there were concerns with the first buy-in, a "track record" now exists in terms of the buy-in approach, and it can be difficult psychologically or legally to move too far from the original template.

Daniel M. Bernick, Esq., M.B.A. is an Attorney and Principal of Health Care Law Associates, P.C. and The Health Care Group in Plymouth Meeting, Pa.