The value of 'goodwill' in practice sales

By Lisa Cobb, Esq

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Published January 1997

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Goodwill isn’t all good. When the time comes to sell your practice, intangible assets, more popularly known as goodwill, can cause real headaches in the form of financial and legal obstacles if improperly valued. And, as one New Jersey physician found out, the problems can arise long after the purchase agreement has been signed.

Tangible versus Intangible Assets

     The tangible assets of a physician practice are those assets that can been seen, touched and easily counted. They include, among other things, equipment, inventory, cash, the medical library, land and buildings. Several widely-accepted methods exist to determine the value of these assets.

     Intangible assets, on the other hand, are significantly more difficult to value than their tangible counterparts. Intangible assets can include the use of the practice name, its business reputation, a trained workforce, noncompetition agreements and patient loyalty. Obviously, it is more difficult to determine the value of patient loyalty than the value of office space. The difficulty in ascertaining the value of goodwill is compounded by the fact that these intangible assets are often the largest assets of a physician practice.

     While important to the sale of all physician practices, the valuation of goodwill becomes crucial in two circumstances: the sale of a practice by a hospital-based physician and the sale of a physician practice to a hospital.

Hospital-Based Physicians Beware

     The sale of a physician practice is not a new concept. Surprisingly, though, few reported cases deal with this issue or the valuation concerns associated with the sale. Given the sparsity of case law, each court decision takes on a significance that it might not otherwise have. While it is important to keep in mind that Pennsylvania courts do not have to follow the rulings made by other jurisdictions, when there is a shortage of cases interpreting the law on a particular topic, it is common for a court to look to the decisions of courts in other jurisdictions for guidance.

     With that as background, we turn to a recent case decided by a federal court judge in New Jersey which addressed the topic of practice valuation. In July, 1996, Judge William G. Bassler issued a stern warning to those hospital-based physicians who might be considering selling their practices. The case was Herbert v. Newton Memorial Hospital.

     Dr. Herbert, an anesthesiologist, decided to move to California to spend time with his wife who was having a difficult pregnancy. He entered into a purchase agreement with Dr. Milne on July 1 and told his colleagues on July 7 (by introducing them to Dr. Milne, the person who was “going to take over” for him). Problems arose because the contract was made contingent upon an event which did not occur: Dr. Milne was not granted staff privileges at Newton Memorial.

     Dr. Herbert sued the hospital and the three remaining anesthesiologists claiming that, by denying staff privileges to his replacement, the hospital and the anesthesiologists had improperly interfered with his contract with Dr. Milne. Dr. Milne’s application for staff privileges at Newton Memorial Hospital was not considered by the Anesthesiology Credentials Committee (which apparently was comprised of the three other anesthesiologists with privileges at Newton). It is possible that these other anesthesiologists, irate that Dr. Herbert had sold his practice for money and without advance notice to them, did not consider Dr. Milne’s application for staff privileges for reasons other than quality of patient care issues.

     Judge Bassler, however, found for the hospital. The court determined that there were sufficient reasons to justify not hiring an anesthesiologist to replace Dr. Herbert, including the fact that Dr. Herbert had not resigned but had taken only a leave of absence. In addition, pending state legislation could have required the hiring of a specially-trained (pediatric) anesthesiologist, which Dr. Milne was not. No other applications for anesthesiologists were considered by the hospital during this time.

     Underlying the reasoning of this opinion, however, is the real burr under the court’s saddle: Dr. Herbert’s practice was not worth the money he was paid for it, and in the court’s opinion, the additional money must have been for the value of the staff privileges. Judge Bassler shared the anesthesiologists’ irritation with Dr. Herbert, finding that, “Dr. Herbert’s lawsuit implicitly seeks to impose a duty on the hospital to accord his chosen successor favorable consideration by virtue of his ability to purchase a departing physician’s practice. Such a duty would not inure to the public benefit.” The judge felt that Dr. Herbert’s sale of his practice, contingent upon the acquiring physician obtaining staff privileges at Newton Memorial, could be viewed as “an attempt to transfer non-transferrable hospital privileges” or “selling what he did not own.”

     The court noted that the contract between Dr. Herbert and Dr. Milne allocated a substantial portion of the purchase price of the practice to the purchase of goodwill. However, the facts demonstrated that Dr. Herbert obtained few patients on his own, that the majority of his patients were randomly given to him by virtue of his position on the staff of Newton Memorial, that he personally owned none of the equipment he used in his practice (it belonged to the hospital), and that he treated all of his patients at the hospital and none in his office. The court found the value of the goodwill and other intangible assets to be minimal. Therefore, the court reasoned, the asset that Dr. Herbert must have been selling was his staff privileges.

     In Dr. Herbert’s case, valuation issues arose in the context of a sale of a physician practice to another physician. In some instances, though, a physician practice is being valued for sale to a hospital. Particularly when the agreement calls for the selling physician to become an employee of the purchasing hospital, valuation concerns can determine whether the sale passes government muster or is opposed as violating the federal fraud and abuse laws.

Goodwill and the Federal Fraud and Abuse Guidelines

     When a hospital is purchasing a physician practice in which part of the agreement is the employment of the physician(s) by the hospital, some hospitals have indicated that they will not pay for goodwill because that action could be viewed by the government as a violation of the federal fraud and abuse guidelines. Specifically, the hospitals fear that the government may view payment for intangible assets (such as patient records and patient loyalty) as a disguised payment for referrals.

     Even if the purchase agreement makes no mention of goodwill or payment for intangibles, the government can construe inflated values associated with tangible or intangible assets as possible payment for future referrals. For example, if assets are transferred at below market value but the physician’s salary is greater as an employee of the hospital than it was while in practice, the salary increase could be viewed as a contingent payment for future referrals. In order to avoid these pitfalls, a physician negotiating to sell her practice to a hospital should carefully consider all aspects of the transaction and take certain precautions as discussed in the paragraphs below.

Some Practical Advice

     Several important lessons can be learned from the situations described above. First and most important, be careful how your practice is valued. If the values for certain assets seem too high or too low, question them. It is better to ask questions early in the process than suffer the consequences of silence later in the transaction.

     Find a competent expert to determine the value of your practice. Preferably, use a broker who previously has valued practices in your geographic region and who is familiar with your practice type.

     Don’t assume that your prospective business partners have analyzed and eliminated the risks discussed in this article. For your own financial benefit, not to mention peace of mind, take matters into your own hands and obtain a competent valuation of your practice. Don’t rely on the purchaser’s valuation of your practice.

     Make sure that you accurately describe the assets to be transferred to the person doing the valuation. Be as specific as possible so that there will be no dispute as to what is (and what is not) being transferred. In addition, you should fully disclose to the person valuing your practice details concerning from where you receive your referrals, how much of your practice is hospital-based and therefore possibly dependent upon your successor receiving staff privileges, etc.

     To the extent possible, detail what constitutes the goodwill that you will be transferring and the amount of the purchase price associated with it so that you will not find yourself in a situation similar to Dr. Herbert’s dilemma. When the purchase price is distributed more specifically among the assets to be transferred, it becomes easier to determine if some of the values are disproportionately high or low.

     The value of Dr. Herbert’s practice was determined by a medical practice broker based upon information provided by Dr. Herbert. It appears that the broker overstated the value of the practice by including the value of assets to which Dr. Herbert had no claim, such as the right to be on the hospital’s call list. An experienced broker should have questioned Dr. Herbert about these assets. Dr. Herbert, as well, should have questioned the broker about the inclusion of these assets in the value of his practice.

     The preceding paragraphs apply equally to the potential purchaser. Make sure that the purchase agreement for your practice accurately reflects what is being transferred. Again, be as specific as possible so that there will be no dispute as to what is (and what is not) being transferred and provide what detail you can so that any discrepancies in perceived value can be discussed and resolved.

     Careful drafting of the purchase agreement is a must. Above all, avoid making the sale of your practice contingent upon such things as your successor receiving privileges at the hospital or hospitals in which you work. In fact, it might be a good idea to explicitly state the opposite, that the sale is independent of the purchaser’s ability to obtain privileges. That way, you will avoid the appearance that you have sold that which you do not own, namely, your staff privileges. A good rule of thumb would be to assume that the prospective purchaser will not receive staff privileges at the hospital. Then ask yourself if he or she would be willing to pay the same price for your practice. If the answer is No, a reassessment of the transaction is warranted.

Lisa M. Cobb, Esq., is an associate in the Litigation Department and the Health Law Department of Schnader Harrison Segal and Lewis. Her practice is concentrated in the areas of antitrust and health care law.