By: Jeff Cohen
Private money (e.g. private equity) is in full swing purchasing medical practices with large profit margins (e.g. dermatology). This is NOT the same thing as when physician practice management companies (PPMCs) bought practices the 90s. Back then, the stimulus for the seller was (a) uncertainty re practice profits in the future, and (b) the stock price. Selling practices got some or all of the purchase price in stock, with the hopes the purchasing company stock would far exceed the multiplier applied to practice “earnings” (the “multiple”). Buyers promised to stabilize and even enhance revenues with better management and better payer contracting. If the optimism of the acquiring company and selling doctors was on target, everyone won because the large stock price made money for both the buyer and seller. The private equity “play” today is a little different.
Today’s sellers are approaching the private equity opportunity the same way they did with PPMCs, except for the stock focus since most private equity purchases don’t involve selling doctors obtaining stock. Sellers hope their current practice earnings will equate to a large “purchase price.” And they hope the buyer have better front and back office management that will result in more stable and even enhanced earnings. And for this, the private equity buyer takes a “management fee,” which they typically promise (though not in writing) to offset with enhanced practice earnings.
Physicians have to know what they’re dealing with and then have at least a basic understanding of the issues that drive these deals. To begin with, “private equity” simply means private investors (typically a group that pools their capital) that buy a portion or all of an operating company. Their investments are usually much larger than venture capital firm deals. They are not publicly traded entities. What do they want? To invest money in mature businesses, grow a company’s profitability and then “flip” their ownership to another buyer, typically in three to five years. In contrast, venture capital firms usually invest in start-ups, buy 100% of the company and require control.
Selling doctors should be aware of one small “secret” about these transactions: they are mostly designed for doctors at or near the end of their career and less favorable (and more financially risky) for “younger” doctors. With experienced healthcare legal and accounting help, sellers will understand that the “purchase price” is recaptured by the buyer in just a few years. While sellers may hope there is a substantial up side with (a) enhanced practice earnings and (b) any management company stock obtained, they need to be realistic about the prospect of more money. Where is the buyer in their “flip” cycle? What’s the actual financial performance of the buyer look like with prior acquisitions? What is a realistic purchase price when the current buyer sells to a larger private equity firm?
The up-front issues sellers ought to focus on include:
- Structure. Most private equity firms use a “management model,” which means they own a company that provides management services to the medical practice. The medical practice remains owned by doctors, but the management agreement between the practice and management company ties the practice’s hands, from a management perspective. Typically practice founders will obtain an ownership interest in the management company. Non-founders may want to negotiate for ownership as well.
- Buyer experience. How much experience does the buyer have in the space occupied by the seller? Since the buyer promises to grow the seller’s profitability, sellers need to know the buyer has experience growing the very sort of business being sold by the seller, and also need to see specifically how the growth will occur (based on actual experience, not just expectations).
- Impact on the seller. Sellers need to understand how the transaction will affect the seller. Will it hurt the seller’s culture? Will it mean big changes at the C Level? What sort of changes in control will the buyer require? Selling practice typically give up 100% of the business control and negotiate to retain as much clinical control as possible. Sellers would do well to speak with other sellers to see what life is like after the acquisition.
- Buyer plans. Issues like timing of other rounds of investment are critical too, especially if there is any stock (stock, warrants, options) involved in the transaction. If the usual flipping period is 3-5 years and the buyer is in its first year of options, stock (typically in the management company) would likely have no value at all for several years (since the buyer is just buying and incurring debt for a while).
Prepping for the Sale
Sellers considering a sale need to get prepared to maximize value at least a year in advance. There may be loans on the books and other things that impair profitability. Perks is another add in when calculating the earnings to which a multiple will be applied by the buyer. Sellers need to clean up their books to increase profitability. Similarly, there may be a variety of legal “clean up” that needs to be done to remove fears of the buyer. Are corporate documents in place and signed? What about state filings? Are there UCC-1s that need to get resolved?
Assessing corporate compliance issues and finding the “holes” is a great thing to do when prepping for a sale. Since any compliance deficiency tends to slow (and even derail) these transactions, selling practices would do well to obtain a full spectrum regulatory compliance assessment before entering the transaction.
Getting It Done
The sale process usually begins with non-disclosure agreement signed between the parties. The NDA is designed to simply have the parties keep all information and documentation exchanged as confidential.
Next is the non-binding letter of intent. Sellers who think the terms of the LOI aren’t important (because it’s non-binding) will be stunned to learn that the entire transaction is actually driven off the LOI. Mistakes made at this stage will come back to bite the sellers. That doesn’t mean changes can’t happen to the deal once the LOI is signed. It just means it’s often difficult for material changes to be made after that point. In fact, both parties tend to consider material changes after LOI to be a “bad faith” sort of move. Sellers must have input from their accountants and lawyers before signing the LOI, since seemingly innocuous things (e.g. stock vs. asset transaction and purchase price allocations) can have a big impact on the value of the transaction. This is also where the bulk of price and stock negotiation happens.
Due diligence is the period of time after an LOI is signed (30-90 days), during which time the buyer will dig through all aspects of the business to identify any issues. They are seeking to avoid upsetting surprises. And of course, these surprises are often used as leverage to reduce a purchase price. Hence, the suggestion above about self-assessing practice compliance BEFORE you get to this point!
Sculpting the deal with private equity is critical early on. How much will the buyer be required to reserve under the banner of “operating capital” (which is typically left on table for the buyer)? If a buyer isn’t careful, the buyer may claim that all the receivables are operating capital. Are the accounts receivable allocated to the buyer or reserved to the seller? If the buyer wants them, you will have to discuss their net value. Is real estate part of the transaction? If it is not contained in the Letter of Intent, or if it is not specified in the legal documents, it is not part of the deal.
Papering it up. Buyers typically propose all the legal documents in a purchase transaction, because of the risks to the buyer. And of course it’s normal for all of the terms and condition to favor the party that drafted the agreements. For instance, the reps and warranties (promises made by the seller) will be extensive. But many of the things you will have to promise about your practice are not even knowable. For instance, governmental or licensing board investigations are confidential. You won’t even know about them. So how can you rep and warrant that there are none? Indemnification obligations can be “first dollar” and unlimited, which is a huge risk to the seller. Sculpting a proper indemnity threshold and cap is important. Sellers can expect at least three rounds of changes to the proposed agreements, plus perhaps many discussions on the client level (between purchaser and seller representatives) and legal counsel level. Sellers need to understand that the buyer is most impacted by ensuring the seller (not their lawyer) is reasonably happy. As such, these deals do not typically get done at the lawyer level. Knowing which issues the client will carry and which ones the lawyer will carry is critical.
Selling your practice (or any healthcare business) is an exciting time, but not one where you want surprises. Your advisors will help you on that journey and will reduce the risk to you while maximizing the value you receive from a private equity buyer.