The valuation of a medical practice, or any business for that matter, typically encompasses the determination of “reasonable” or “replacement’ compensation. In small businesses/practices, the compensation paid to owners is more a function of available cash flow as opposed to the services provided.
The theory of reasonable compensation is to restate the earnings of an entity to encompass the salary that would be expected to be paid to an individual qualified to perform the required duties. The reasonable compensation can be more or less than the salary actually taken by the individual(s) for whom the adjustment is being made. The term reasonable compensation is used in the Internal Revenue Code and is defined as the amount that would ordinarily be paid for “like services” by “like organizations”.
The more common factors given consideration in the development of reasonable compensation include:
It is important to remember that in a business valuation, reasonable compensation is a hypothetical adjustment. That being said, the considerations given in its determination are very similar to what one would do if an actual replacement were being considered or if a service arrangement was being developed.
There are a number of sources of data that may be used in the determination of reasonable compensation. These include benchmarking sources (typically as a percentage of gross revenue), internet resources and subscription databases. It is not uncommon for all three sources to be given some level of consideration in the valuation process. These sources contain different information, so it is imperative that the user understands the components of compensation contained in each.
An important consideration in the determination of reasonable compensation is the productivity of the physician being analyzed. This is because compensation will vary based on whether the individual being assessed either over or underperforms his or her counterparts. The more common databases include compensation statistics at the 25th, median, 75th and 90th percentiles. In addition, they commonly include the work relative value units (wRVU’s) and compensation per wRVU.
Productivity is important, but so are collections, making it necessary to view compensation in relation to collections as well as productivity. If the practice being valued has a significant Medicare component to it, (and as a result higher fee adjustments) the profitability of the practice is affected and therefore, so too, is the compensation that can reasonably be paid to the physician.
Another but less commonly used way to determine reasonable compensation is the RBRVS Method. Medicare uses resource-based relative value scales. These scales apply three types of RVU’s. They are work RVU’s (wRVU), practice expense RVU’s (peRVU) and malpractice RVU’s (mpRVU). To use this method, one applies the percentage of wRVUs to the total RVUs to determine the amount of the reimbursement applicable to compensating the physician. The application of this method requires the practice to maintain detailed records.
The determination of reasonable compensation requires the consideration of numerous factors. The better the underlying information, the more data points available for use in the process.