An Rx for valuing physician practice goodwill in divorce

When Jack Johnson and Dr. Jill Johnson decided to dissolve their 15-year marriage, Jack hired Tom Smith, a valuation expert, to appraise the marital estate’s most valuable asset: his wife’s 50% interest in a local medical practice.

This fictitious example illustrates the process of valuing medical practices, including how to measure goodwill and how to split it into its component parts.

Extenuating circumstances - During the initial site visit, Tom explained to Jack some of the valuation challenges medical practices pose in the context of divorce. These include:

Fuzzy accounting - Physicians’ financial statements — when they exist — are often unreliable, especially if the practice is small. Few doctors use the accrual method of accounting. Instead, many practices rely solely on cash basis reporting, which excludes receivables, payables and accruals.

A more meaningful picture of a physician practice’s tangible net worth requires cash-to-accrual adjustments. For instance, Tom adjusted Dr. Jill’s balance sheet for patient receivables (including unbilled services rendered), unpaid bills and a significant Medicare underpayment (a hidden asset discovered during a Medicare audit). As a result of these adjustments, the practice’s tangible net worth jumped from $950,000 to $1.4 million.

Potential financial maneuvers - Without lenders or investors reviewing the practice’s financial statements, the potential for financial misstatement abounds — especially when an impending divorce provides an incentive for the physician to understate assets and income.

Before jumping into a costly formal fraud investigation, Tom decided to compare the practice’s financial reports with more reliable sources. For instance, he compared Dr. Jill’s financial statement to last year’s tax return, other financial reports prepared over the last five years and industry benchmarks.

Less typical valuation methods - Asset-based methods, which typically exclude intangible assets, tend to understate a physician practice’s value. So valuators typically turn to private transaction databases, discounted cash flow analysis and the excess earnings method.

Family courts tend to prefer the excess earnings method, especially when the subject company is a professional practice, even though the method has numerous shortcomings. Many courts are also willing to consider supplemental value metrics — such as loan applications or buy-sell agreements — when used in conjunction with more scientific valuation techniques.

During settlement talks, Tom showed how he used the excess earnings method and a discounted cash flow analysis to arrive at a value of $3 million for the entire medical practice. Conversely, Dr. Jill’s expert purported that the practice was worth only $1.9 million, using guideline transactions and the excess earnings method.

To reconcile these differences, Tom brought up the doctors’ buy-sell agreement, which called for an industry valuation formula of 80% of the previous year’s revenues. Under the terms of the buy-sell agreement, the practice was worth $2.6 million. For settlement purposes, the parties agreed to average the three value metrics.

Goodwill complexities - Perhaps the greatest valuation challenge for medical practices is goodwill. In a few states, goodwill is considered a marital asset, eliminating the need to separate the value of goodwill. But most states exclude some (or all) of a practice’s goodwill from the marital estate to avoid “double dipping.”

To value goodwill, the valuator subtracts the practice’s adjusted tangible net worth from the company’s overall value. In the case of Dr. Jill’s practice, the two experts subtracted $1.4 million of adjusted net worth from the agreed-on value of $2.5 million to arrive at a value of $1.1 million for goodwill. Tom noted that this estimate was reasonable compared with the range provided in the Goodwill Registry (30% to 35% of annual revenues).

In most states, the analysis doesn’t stop there. Instead, the parties must divide goodwill into two pieces: personal and entity. Personal goodwill is the portion attributable solely to the individual practitioner.

Entity goodwill is a business asset that remains even if the individual doctors leave the practice. In most jurisdictions, entity goodwill is included in the marital estate but personal goodwill is specifically excluded.

After lengthy discussions, the parties agreed that only 10% of the practice’s goodwill ($110,000) could be attributed to business-related factors, such as location, patient lists and skilled work force.

In light of the case’s jurisdiction, the parties agreed to exclude personal goodwill from the marital estate. They also agreed that the marital estate should include $755,000 (half of the $1.4 million in net tangible value plus half of the $110,000 in entity goodwill) for Dr. Jill’s 50% interest in the medical practice.

Special considerations

Many of these considerations also apply to other types of professional practices, such as accounting firms, law offices, or architectural and engineering firms. As this example shows, valuators need to take into account these firms’ characteristics to reach an appropriate estimate of value.

Sidebar: Dr. Jill’s Goodwill

Goodwill Registry. Plymouth Meeting, Pa.: The Health Care Group, annual.