Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)
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Executive Summary
The day when a physician could leave residency or a fellowship, hang up a shingle, and begin practicing are, for the most part, long gone. Managed care, increased competition, and rising costs have made start-up medical practices a rarity. In general, physicians who are not interested in associating with an existing medical practice (that is, buying in as a partner of a multiphysician group, usually after spending several years as an associate) will find an easier point of entry through the acquisition of an existing practice. This option, nevertheless, comes with its hurdles and pitfalls.
Mistake 1 Not Reaching Out to Advisers at the Outset
Too often, physicians attempt to negotiate the terms of an acquisition without the benefit of counsel at least from an attorney and/or an accountant. Critical deal points and legal issues may be ignored, inadvertently given away, or made more difficult to negotiate in connection with the preparation of final documents.
Action Step Physicians should bring in competent advisers at the outset so that the transaction can be properly framed, which can in turn yield savings both in the short run and long after the transaction has closed.
Mistake 2 Not Spending Time at the Practice
The acquisition of a medical practice is likely to be one of the largest investments that a physician will make. Even so, the decision to acquire a practice is often based simply on the verbal and written representations of the seller, as opposed to an on-site evaluation of the day-to-day operations of the practice.
Action Step In general, physicians who spend as much time as possible in a practice before making a commitment will have fewer disappointments than those who spend little or no time evaluating the practice.
Mistake 3 Not Entering Into a Formal Letter of Intent
Not entering into a formal letter of intent is a mistake that ordinarily follows from Mistake 1. Too often, clients approach their counsel and state: “This is what I agreed to, draw up a contract.” Under the best of circumstances, the negotiation of the terms and conditions of a formal acquisition document can take many days and sometimes weeks. This time lag can be extraordinarily dangerous for a buyer, who may discover that the seller is out “shopping” the buyer’s offer to other interested parties.
Action Step Physicians should be sure to enter a carefully drafted formal letter of intent when negotiating an acquisition. A carefully drafted letter of intent will take the business “off the market” for an agreed upon period of time. A letter of intent will also outline the key terms and conditions of the acquisition that will serve as a road map for the preparation of formal agreements.
Mistake 4 Not Properly Evaluating the Purchase Price
“That sounds like a fair price, right?” Determining the purchase price for the acquisition of a medical practice should not be based on hunches, intuition, or what a colleague paid for another practice two years ago. Determining the purchase price for a medical practice should be based on hard data, which should be obtained as early in the process as possible. At a minimum, the purchaser of a medical practice should obtain three years of tax returns and financial statements, billing and collection records with receivables aging reports, and copies of third-party payer contracts with applicable reimbursement rates.
Action Step Enlisting the services of an accountant well versed in evaluating medical practices early in the process is critical. A qualified accountant will not only be able to determine a value based on the practice’s historical data, but also help forecast the practice’s performance in the hands of the new owner.
Mistake 5 Not Conducting the Appropriate Level of Due Diligence
Many purchasers view the term “due diligence” as a mere scavenger hunt for liabilities. The due diligence process goes well beyond this view and should include a careful analysis of all agreements to which the seller is a party and which the buyer wishes to assume.
Action Step Physicians should conduct a thorough level of due diligence that includes seeking answers to the following questions: How much time is left on the practice’s lease? Is the lease assignable or assumable? Are there other contracts in place for associate physicians and other personnel? Are these contracts assignable or assumable? Are key terms of these contracts (most important, restrictive covenants) assignable or assumable?
Mistake 6 Not Being in a Position to Bill Services to Third-Party Payers
In a time when control of the patient is less a function of the relationship with the doctor and more a function of which insurance plan the patient has, it is critical for any purchaser of a medical practice to determine how he or she will retain the patient. Considering that most third-party payer contracts are not assignable, the physician acquiring a practice that depends on these types of contracts will have to plan in advance to be able to retain the revenue of the practice.
Action Step The advanced planning involved in being able to retain the revenue of the practice may mean attempting to effectuate an assignment of the contracts, securing provider contracts well in advance of closing, or considering a stock acquisition. A stock option would potentially carry along with it all of the practice’s contracts and allow for a change of control provision, which may treat a stock sale in the same manner as an outright transfer of the contract. It also imperative that the physician buyer make sure to be properly enrolled with Medicare, Medicaid, and other applicable governmental programs as early in the process as possible.
Mistake 7 Not Protecting Against the Seller’s Liabilities
Very often the buyer of a medical practice will find himself or herself fending off a claim brought by one of the seller’s creditors. The determination of the price to be paid for the acquisition of a medical practice is typically based on either the assumption of none of the practice’s liabilities or only certain agreed upon liabilities. Consequently, any other liabilities, whether known or unknown, should expressly be made the responsibility of the seller.
Action Step The physician buyer should insist on an asset acquisition. If the stock in the medical practice is acquired, all of its liabilities, known and unknown, follow the buyer. In an asset acquisition, it will be much more difficult for a third-party creditor to pursue the buyer for the seller’s liabilities. The physician should be sure to
include a clear indemnification and hold harmless statement for any liabilities that the buyer will not assume, making sure the indemnification extends to attorney’s fees. In many cases, it can cost as much in attorney’s fees to defend a claim as the amount of the claim itself. The physician buyer should also
make sure there is a person or entity to which the buyer can seek recourse if a liability arises. Ordinarily, shortly after the last dollars have changed hands, the seller, if a separate legal entity, will be liquidated. Accordingly, it is advisable to obtain a guarantee from the seller’s owners.
In addition, the physician buyer should consider installment payments so that there is a source of funds from which to effectuate a setoff.
Mistake 8 Not Considering the Tax Ramifications of the Transaction
Improperly structuring an acquisition can often lead to disastrous results from a federal income tax standpoint. For example, aside from the liability issues, acquiring the stock of an existing medical practice has a significant drawback from a federal income tax standpoint. In a stock acquisition, no portion of the purchase price may be deducted or amortized. In an asset acquisition, depending on the tax allocation of the purchase price, much of what is paid can be depreciated or amortized over a given period of years. While the allocation of the purchase price weighted more heavily toward hard assets is beneficial to the buyer (these types of assets can be depreciated more quickly), such an allocation is less favorable to the seller because these types of assets have likely been fully depreciated and such allocation will result in “recapture” (which may treat a portion of the gain as ordinary income). On the other hand, an allocation of the purchase price toward “goodwill” is more favorable to the seller (recapture not being an issue) but less favorable to the buyer, who must amortize this portion of the purchase price over 15 years.
Action Step Physician buyers must carefully consider all of the long-term tax consequences when structuring an acquisition.
Mistake 9 Not Having the Seller Around to Transition the Practice
Consider this scenario: A patient of a medical practice that has changed hands did not receive the announcement notifying her of the sale of the practice. She shows up for an appointment that she booked six months earlier only to find that Dr. Smith has retired and the practice is now being run by Dr. Jones.
Action Step Although many states require physicians who are selling their practices to notify patients of the sale, there is no substitute for an in-person, face-to-face introduction of the patient to the incoming physician by the outgoing physician. Depending on the type and size of the practice, the transition period can be as short as 30 days or as long as one year. Therefore, the buyer may want to arrange to have the selling physician stay involved to help smooth the transition.
Mistake 10 Not Getting a Restrictive Covenant
Not getting a restrictive covenant can lead to the following situation: A physician has just acquired a medical practice, a portion of the purchase price includes a “goodwill” factor. The seller is liquidated, the physician who ran the practice takes the sales proceeds and opens up an office down the block.
Action Step Physician buyers should be sure that the purchase agreement or a separate document includes a carefully drafted restrictive covenant that prohibits the seller (and its owners, agents, and employees) from competing with the buyer for a specified period of time and within a given geographic area. State laws vary regarding the enforceability of restrictive covenants.
Conclusion
The purchase of a medical practice can be an extraordinarily complex transaction. With the proper counsel, guidance, and consideration of various issues, the purchaser of a medical practice is far less likely to have an undesired outcome.
Written by:
Mark A. Coel, Esq.
Peer reviewed by:
Rodney H. Dusinberre, Esq.
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