Valuations Part Two: Fair Market Value and You
While part one of our series on valuations gave the textbook definition and explanation of what Fair Market Value (FMV) is, part two will focus deeper on what FMV does. Every aspect of business has its strengths and weaknesses, and this installment is meant to explore those facets of FMV so you can put this type of valuation to better use.
There are three main processes by which FMV can be reached for the purposes of a sale: market approach, income approach and cost approach.
The cost approach to valuing a business isn’t really a process that would be relevant to valuing an ASC, according to Deepa Menon, Managing Director at CBIZ Valuation Group, LLC.
“Cost approach makes a lot of sense in valuations that are more hard-asset intensive,” she explains. “If you’re looking at an operating company that has a significant amount of intangible value, either by way of the relationships in place, and so on and so forth, those types of things are better captured with the income and market approach, and the cost approach falls short of providing reliable estimates of value for an operating company.”
Rather, market and income approach are more widely used to come up with the FMV of an ambulatory center.
Jennifer Smith, who works in healthcare valuations at CBIZ, explains that the market approach can have several different components within it depending upon what type of transaction is in question.
“If we are valuing an entity, market approach would include looking at comparable entities,” she said. “If you’re looking at the value of the services agreement, we can also use market comparables, but it’s difficult often to find a critical number of truly comparable entities. When there are new trends in the marketplace where different types of agreements or arrangements are popping up it becomes more difficult to find comparables because there aren’t many out there yet. It’s kind of a moving target.”
The methods used to create comparable data within the marketplace are varied as well. Valuators make use of market surveys for looking at things like cost structure or market-based salary.
“We can look at an ASC’s financial statement and in figuring out what the FMV is, look at the expense profile and the cost profile and see how that compares to the industry as presented in surveys,” Smith said. “If there are any items on the entity we are valuing that seem unique we would need to normalize those and make an adjustment so that the ultimate valuation conclusion we come to has smoothed out those things that are aren’t reflected in market survey data.”
Menon notes that the income approach is utilized more with closely held healthcare entities. In this approach, FMV is reached by looking to the circumstances underlying the specific entity.
“We look at historically what has been going on with [the ASC],” Menon explains. “The market data provides some ranges to work with, but the income approach more directly addresses the specific circumstances. Plus, as you’re valuing it, you have the ability to test a lot of the assumptions, so there is the ability to have more control of the process and it relies on information directly gathered from the company.”
Jason Ruchaber of Root Valuation in the Greater Denver area explains that market data should always be considered and reviewed in the valuing process.
“This data includes comparable ASC transactions, capital structures, cost structure, rates of return, reimbursement, etc.,” he said. “Market transactions are not necessarily excluded on their face, but the OIG does caution against the use of ‘tainted data.’ In other words, care must be taken to get comfortable that the market data is not reflective of any improper payment.”
The Good, the Bad, the Complicated
As mentioned before, there are strengths and weaknesses to all aspects of business. Getting down to the strengths and weaknesses of FMV can be tricky.
Firstly, with the significance of having market data in the valuation process, no matter which approach is taken, how can you avoid the “tainted data” described by Ruchaber?
“Because transactional detail is often limited to basic financial information, geography, basic deal terms, etc., it is often difficult to know with any level of certainty that the market data points are not tainted,” he said.
The difficulties can prove more difficult when an unique ASC is being evaluated, one that possesses certain intangible qualities or services that cannot be compared to anything through market data because there is simply nothing like it out there, in many respects, to compare the entity to.
This can result in skewed data or an imperfect overall valuation.
There are a few different ways in which to attempt to counter this problem. Ruchaber chooses to not rely solely on market data.
“I often use market data as a corroborative approach to test the reasonableness of the DCF model as opposed to relying on market data exclusively,” he said. “I also try to eliminate any outlier transactions, which is appropriate in any event.”
Menon describes using more than one approach to arrive at the most accurate FMV. However, this process can be problematic as well.
“If you use an income approach with a market approach and come up with a divergent type of value, that is an indication that something needs to be adjusted with either one of the approaches or there has to be an understanding as to why those differences exist,” she said. “Another weakness would be, if for some reason there have been some specific things going on with the ASC and there are some changes that need to be made and they aren’t done correctly, you could end up with an inaccurate estimate of FMV under that approach.”
Now we come to the “big question,” so to speak.
“The law does not require the parties to a transaction to obtain a formal independent valuation to support the transaction,” said Blayne Rush, President of Ambulatory Alliances, LLC. “The law requires that the transaction conform to Fair Market Value. I do not believe the parties to a transaction that consummate a deal at FMV, truly understand the tenets of FMV and have a well documented process that comports with FMV are under any risk.”
66 Fed. Reg. 945 would seem to agree with Rush’s claim, as it states:
“We agree that there is no requirement that parties use an independent valuation consultant for any given arrangement when other appropriate valuation methods are available. However, while internally generated surveys can be appropriate as a method of establishing fair market value in some circumstances, due to their susceptibility to manipulation and absent independent verification, such surveys do not have strong evidentiary value and, therefore, may be subject to more intensive scrutiny than an independent survey.”
There are naturally certain challenges presented to an owner looking to sell at FMV without an independent valuation, though.
“You as a seller must design and execute (and document) a process that markets your business to any willing buyer, negotiate at an arm’s length and not pay anything for referrals,” Rush said. “The McLaren* decision supports this in that the actual negotiations were given more weight than the valuation analysis.”
Curtis Bernstein, managing director at Altegra Health, goes further to note that not all transactions must even be executed at FMV.
“When a transaction involves a referral source, the valuation expert might assume the transaction was consummated at FMV,” he said. “However, as proven by various court cases, not all transactions are consummated at FMV. For example, DaVita entered into a CIA agreement related to 11 joint ventures that supposedly violated the anti-kickback statute**.”
All this taken into account, Rush does see the reasoning behind having that third party, independent valuation done.
“I will concede that the most conservative route, assuming that a seller wants to maximize their transaction prices is to prepare your business for sale, proactively market your business to the entire market at the same point in time, negotiate the price and terms as high as the general market will pay then after the price and all the terms are negotiated and memorialized in writing is to then have a third party valuator issue a report more akin to a fairness opinion.”
However, with the absence of a referral source, the law does not require that the deal be executed at FMV.
“For example, in the recent purchase of Symbion by Surgery Partners, the price paid was likely investment value, which is the specific value to Surgery Partners,” Bernstein said. “This value would account for synergies related to the combination of the two entities.”
“To take the position that a FMV opinion of value should be conducted upfront or to establish the value when we are discussing selling a center or business would be short of the legal requirements and be contrary to smart business,” Rush said. “Just look at the appeals court case with Carlisle HMA***. That case supported that the actual negotiations with a written agreement covering all of the terms should be considered in determining FMV.”
Furthermore, there exist certain circumstances under which a center can sell above FMV, namely, if no relationship exists or has ever existed between the two parties wherein referrals of healthcare services were conducted.
“While the amounts paid or the economic value of the transaction must be consistent with FMV, if the parties are in position to refer healthcare services, we can influence Fair Market Value,” Rush said. “FMV can be influenced by establishing a strategic process that leaves no stone unturned and then going to the entire market at the same point in time and the negotiating the price and terms.”
Be on the lookout for part three, where we will introduce the topic of Strategic or Investment Value.
*United States ex rel. Goodstein v. McLaren Regional Medical Center, 202 F. Supp. 2d 671 (E.D. Mich. 2002).
***United States ex rel. Kosenske v. Carlisle HMA, Inc. et al., 554 F.3d 88, 98 (3d Cir. 2009), rev’g No. 1:05-CV-2184, 2007 WL 3490537 (M.D.Pa., Nov. 14, 2007).
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