Don’t Put Off Planning How Your Group Would Allocate Proceeds From a Sale

One of the most difficult and divisive issues resulting from a practice merger or sale is valuation of ownership interests and fair allocation of purchase money among the physician owners. This arises in two contexts. First, what portion of the purchase price should be given to a departing physician, whether departing because of retirement or termination? Second, how should the physicians divide the income from the sale among themselves? Lawsuits arising from insufficient attention to (and preventive measures against) these dangers are frequent.

Putting it in the contract

Many medical practices include a shareholders’ or other co-ownership agreement. Often, this contract sets a precise formula for valuing the ownership interest of a departing co-owner. Sometimes the valuation is different for retiring physicians, relocating physicians and/or competing physicians. Quite often, the agreed valuation is based only on the practice’s tangible assets, and perhaps its accounts receivable. Intangible assets, including goodwill, are excluded from the valuation. At other times, a predetermined amount is applied to those intangible values.

Until recently, medical practice mergers rarely involved substantial payments of cash. Rather, there was a swap of stock (or other evidence of co-ownership), with perhaps some income shifting for a time, and possibly some small monetary payment as well. Often, an acquisition would be structured as a “merger,” with the retiring physician staying on awhile after the combining of practices. Thus, the acquisition price was partially or wholly subsumed into the retiring physician’s ongoing paycheck. Today, however, large payments are routinely made in the form of cash and future payment entitlements for medical practices. Thus, the question of how these payments should be applied to buy-out formulas is largely unprecedented. Certainly, few medical practices structured their buyout formulas with reference to this sort of event.

Would a sale change things?

Suppose, for instance, that a practice’s co-ownership agreement states that a departing physician will be entitled to $25,000 for his or her ownership interest. Should this be modified because the practice received a million-dollar purchase payment from a hospital? Suppose, on the other hand, that the co-ownership agreement provides for the ownership interests to be tied to the tangible assets of the practice. This certainly would include cash received by the practice. But would it also include the expectation of cash six months later? If the purchase price is tied to future payments, would the valuation include some accommodation of that future expectation? Suppose further that the purchase price is not precisely defined in the acquisition or merger documents, because it is tied to the presence or absence of certain contingencies. If a buyout formula would have counted future payments in the valuation formula, would the uncertainty of these payments render such inclusion too speculative to be appropriate?

Do not look to statutory or case law for clear, consistent help in resolving these issues. State laws generally protect minority shareholders in small businesses from unfair treatment by the majority. However, state laws also typically give very strong deference to a valuation agreement among owners for purposes of buyout. So, while a medical group could not easily force a physician near retirement to depart early to avoid sharing cash from a coming merger or sale, a group could detail in its structural documents exactly how ownership interests should be valued, as well as any differences in the formula between a sale to the remaining co-owners and a sale to a hospital or other third party.

A group’s failure to specify clearly how its ownership interests should be valued creates other dangers as well. The factors that apply to the valuation of practice intangibles have begun to change in recent years, as traditional concepts of patient and physician loyalty are eroded by such new factors as favorable managed care contracts, exclusive relationships and alliance leveraging. A buyout formula that includes practice intangibles will often result in a valuation far different than would have occurred a few years ago. Physicians who make retirement and/or buyout decisions on the basis of historic goodwill ranges may be in for a rude surprise.

The second context in which these issues arise is with the allocation of a merger or acquisition payment among a practice’s active physicians. Monies paid for many practice acquisitions and mergers these days are staggeringly large. Medical groups that, in a gentler age, would civilly allocate purchase monies among themselves find their congeniality strained when large amounts are at stake. Unfortunately, many medical groups’ co-ownership documents do not suggest how these proceeds should be distributed.

One assumption is that money will be split according to ownership percentages. Senior physicians and “rainmaker” physicians who bring significant amounts of business through their reputation, marketing ability and other attributes may complain that the practice’s enhanced value has been due disproportionately to their efforts. They might further point to a severance pay entitlement in their employment agreements, which bases their practice distribution on seniority or on individual earnings. Severance payments reflect individual contributions, they argue; why shouldn’t practice sale money be allocated similarly?

Generally, proceeds from a sale will be distributed according to ownership percentages, unless otherwise agreed by the co-owners. You can’t simply reallocate this entitlement without further justification, or the IRS may reclassify portions of the allocation as excess income and/or gifts. But you can build a severance pay entitlement into the buyout provisions, so that sales for more than a certain value result in disproportionate payments to certain physicians. Or certain physicians may be given the chance prior to a sale to purchase additional shares of stock from the corporation. Or they may receive a bonus (taxed as wages, not capital gains) to reflect their prior intangible contributions to the group.

Another idea would be for the shareholders’ agreement to provide for revaluation of junior owners’ buy-in costs if the practice is sold (wholly or partially) within some subsequent time frame.

There are no “right” or “wrong” answers to these questions. How a medical group decides these issues should reflect its philosophy, market position and group dynamic. But failure to address them in advance will lead to substantial problems.

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