Short Answer: Fair market value is the price a medical practice would change hands for between a willing buyer and a willing seller, with neither side under pressure to act and both knowing the relevant facts. That is the number a valuation is supposed to find. The trouble is that it is easy to land somewhere else, and in my experience the miss is almost always on the high side. This post walks through what fair market value actually means, when federal rules narrow the definition, and the four places where a medical practice valuation most often goes wrong.
What Fair Market Value Means
The valuation profession defines fair market value as a cash-equivalent price agreed between a hypothetical, well-informed buyer and seller, dealing at arm's length in an open market, with no compulsion on either side. That definition comes from the International Glossary of Business Valuation Terms and is the one most appraisers work from. Two words in that definition do a lot of work. Hypothetical means we are not valuing the practice for one specific buyer with one specific plan. Compulsion means a physician who has to sell this year because of health, burnout, or a lease expiring is in a different position than the standard assumes, even though the valuation does not change to reflect it. It is also worth separating fair market value from price. Price is whatever two real parties agree to. Fair market value is an opinion of what a typical, informed buyer would pay. In a straightforward physician-to-physician sale the two usually line up. When the buyer is a hospital, health system, or another party that could send referrals to the practice, a second definition enters the picture.When the Stark Law Changes the Math
The federal physician self-referral law, usually called the Stark Law, applies when a physician has a financial relationship with an entity that bills Medicare for designated health services. Practice acquisitions by hospitals and health systems are the most common place this comes up in a medical practice appraisal. Under the current regulations at 42 CFR 411.351, fair market value means the value in an arm's-length transaction that is consistent with the general market value of the subject transaction. General market value, for an asset purchase, is the price the assets would bring through bona fide bargaining between well-informed parties who are not otherwise in a position to generate business for each other. The Centers for Medicare and Medicaid Services rewrote these definitions in a final rule effective January 2021. The rewrite separated fair market value from the volume or value of referrals and gave commercially reasonable its own definition, but the practical point for a seller did not change. That practical point is this: when Stark applies, the value of the practice cannot include any premium for the referrals the buyer expects to receive. Comparable sales that did reflect a referral relationship cannot be used as comps. And a deal can be at fair market value and still fail the separate test of being commercially reasonable, meaning the arrangement would make business sense even if no referrals ever happened. If a hospital or health system is on the other side of your table, have healthcare counsel review the structure early. The valuation and the legal review need to agree with each other before anyone signs.| Question | Fair Market Value | Investment Value |
|---|---|---|
| Who is the buyer? | A hypothetical, typical, well-informed buyer | One specific buyer with its own plans |
| What is being valued? | The practice as it operates today | The practice plus what that buyer can do with it |
| Are synergies included? | No. Added services, overhead cuts, and relocations are excluded | Yes. Those synergies are the point |
| Where does it belong? | In the appraisal and in any deal where the Stark Law applies | In a buyer's own analysis and, sometimes, in a negotiated price |
Four Places a Fair Market Value Appraisal Goes Wrong
Every one of these errors pushes the number up, and every one of them tends to surface during a buyer's due diligence, which is the worst possible time.1. Valuing the past instead of the future
A buyer is paying for the cash flow the practice will produce after closing, not the cash flow it produced last year. That is why the income approach is the method most often used to value a medical practice. The income approach estimates the future cash flow of the practice and converts it to a single present-day value. Historical results matter as evidence of what is likely to continue, but they are the starting point, not the answer. The questions to ask of any projection are simple. Does the patient volume make sense for the specialty and the market? Does the assumed reimbursement hold up against where payer rates are actually heading? If revenue is projected to grow sharply, does the staffing, space, and supply budget grow with it? A projection that raises revenue without raising expenses is overstating value.2. Revenue that is overstated or will not survive a sale
The goal of a medical practice valuation is to find the real income stream. Revenue that is inflated by coding errors, by utilization that a new owner would not continue, or by anything that would not pass a compliance review is not real income for valuation purposes. Neither is revenue tied to a referral relationship that will end when the current owner leaves. A careful appraiser normalizes revenue down to what a typical buyer could expect to collect, then checks that expenses are complete. Owner perks run through the practice, below-market rent from a related party, and unpaid family labor all have to be adjusted so the expense side is as honest as the revenue side.3. Mixing investment value into fair market value
Investment value is what a practice is worth to one particular buyer because of what that buyer can do with it. If a group tells me it can add ancillary services, cut overhead by moving the practice into its own building, or route its own patients to the new location, those are real benefits to that group. They are not part of fair market value, because the hypothetical buyer in the definition does not have them. Sellers sometimes hear a buyer describe these synergies and assume the price should reflect them. Occasionally a motivated buyer will share some of that upside in the negotiated price. That is a business decision, not a valuation conclusion, and a fair market value appraisal should never include it.4. Leaning on comparables that are not comparable
The market approach values a practice by looking at what similar practices actually sold for, usually expressed as a ratio of sale price to revenue or to earnings. It sounds like the most objective method, and for many kinds of businesses it is. Medical practices are harder. Two practices in the same specialty can differ in payer mix, provider count, real estate, hours, referral sources, and how much of the revenue depends on the selling physician personally. A transaction from a different state or a different year may reflect a completely different buyer landscape. Before any comparable sale is used, it has to be a true apples-to-apples match. If it is not, it should not be in the valuation. Buyers buy cash flow, and a comp that does not reflect this practice's cash flow tells you very little.Who Should Perform the Valuation
Valuation is a discipline learned over years of transactions, and healthcare adds a layer of regulation that a general business appraiser rarely deals with. Look for a valuator who holds a recognized valuation credential, works in healthcare specifically, and can explain every adjustment in plain terms. If the first draft of a valuation lands well above what practices in your specialty typically sell for, ask which of the four issues above might be driving it. At Tinsley Medical Practice Brokers, our valuations are led by Reed Tinsley, a physician CPA, medical practice valuation analyst, and the author of Valuation of a Medical Practice, published by John Wiley and Sons. With over 40 years of experience in medical practice transactions, we have seen most of the ways a number can go wrong, and we would rather catch them before a buyer does.What to Do Next
If you are considering a sale, a buy-in, or a hospital affiliation, start with an independent fair market value appraisal before any price is discussed. It gives you a defensible number, protects you if Stark applies, and tells you where the practice can be strengthened before it goes to market. To talk through your situation or learn more about how to sell a medical practice or how to buy a medical practice, reach out for a complimentary consultation at 512-659-0643 or info@tinsleymedicalpracticebrokers.com.Frequently Asked Questions
What is fair market value in a medical practice valuation?
Fair market value is the price a medical practice would sell for between a willing, informed buyer and a willing, informed seller, with neither side under pressure to complete the deal. It is an opinion of what a typical buyer would pay, not the price any one specific buyer offers, and it excludes benefits that only a particular buyer could realize.
How does the Stark Law affect the fair market value of a medical practice?
When a buyer such as a hospital or health system could receive referrals from the practice, federal Stark regulations require the price to reflect fair market value with no premium for expected referrals. Comparable sales that included a referral relationship cannot be used, and the arrangement must also be commercially reasonable on its own. Healthcare counsel should review any transaction where the Stark Law may apply.
What is the difference between fair market value and investment value?
Fair market value is what a hypothetical typical buyer would pay for the practice as it stands. Investment value is what the practice is worth to one specific buyer because of synergies that buyer can create, such as adding services or cutting overhead. Investment value can influence a negotiated price, but it should never be included in a fair market value appraisal.