Mid-Atlantic Health Law TOPICS

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Going Public - What's in it for You?

Physicians, in increasing numbers, are selling their practices to for-profit companies in return for stock in these companies. More specifically, doctors are entering into long-term management agreements with publicly traded management companies, which agreements transfer many of the indicia of ownership from the doctor to the management company.

The standard deal often asks the physician to take a 10%, 20% or 30% cut in pay to make sure that the management company makes a profit. In turn, it is believed that this assured profit will attract public investors.

For example, if a practice management company offers to manage a doctor's practice for 30 years in return for that practice's profits, assuming the doctor will accept a 20% pay cut, and the practice management company offers the doctor stock in the practice management company, how does the doctor determine if the stock is of equal or greater value to the income being foregone? In a parallel vein, should the doctor enter into such a transaction just for the stock, or for reasons other than the stock?

At first blush, these questions are dizzying. The vertigo should subside, however, if a physician can adopt an analytical framework to measure the opportunity to go public. The purpose of this article, is to offer that analytical framework.

A. Value of Lost Income

As indicated on Table #1, if one assumes that a particular physician presently earns $500,000, but is willing to take a 20% reduction in his or her compensation in return for the stock of a practice management company, then that physician is giving up $100,000 this year, and some other amount of compensation each year thereafter.

One could make different assumptions as to the correct computation of the present value of the stream of lost income. If the physician does not join a large practice management company, will the physician's income go down in any case? Alternatively, will the physician’s income go up, because the large practice management company will obtain favorable contracts?

Since the variables are numerous, for purposes of analysis, perhaps the best thing to do is use a simple computation, such as the present value of the lost income equals 5 times 1 year's lost income. In this example, 5 times $100,000 is $500,000. If one believes that a multiple of 5 is too high, then the first year’s lost income could be multiplied by 3, or 4, etc., to give a doctor a value of the lost income that can be compared against the value of the stock being offered.

Table #1: Loss of Income

Normal Income $500,000
Agreed Reduction (100,000)
New Income 400,000
Present Value of Lost Income
(5 x $100,000)

B. Value of Stock

On the other side of the coin, what is the value of the stock that the doctor will receive in return for creating this $100,000 of potential profit per year for the practice management company? The steps set out in Table #2, as explained in the remaining text of this article, attempt to answer that question.

Table #2: Stock Value

Income $100,000
Centralized Expenses (15,000)
Before Tax Income 85,000
Taxes (35%) (29,750)
After Tax Earnings 55,250
20 to 1 Price to Earnings Ratio x 20
Aggregate Stock Value Generated by $100,000 Reduction 1,105,000
20% For Venture Capitalist (221,000)
5% For Management (55,250)
Value of Doctor's Stock $828,750

1. Centralized Expenses. Part of the $100,000 will be used to fund new expenses, expenses that the physician himself or herself never incurred. The practice management company will have CEOs and CFOs, recruiters, marketers, managed care experts and information systems specialists, all of whose salaries will have to come from physician revenue.

Although some practice management companies may claim that they can reduce overhead, in fact, the best practice management companies should hope for is that they can keep overhead at the same level. In other words, to the extent that the practice management company can reduce any existing overhead expenses, such reductions are needed to fund all of the new expenses that the practice management company will be incurring.

For purposes of this analysis, one can assume that 15% of the $100,000 created by a physician’s agreement to reduce his or her $500,000 compensation by 20% will be eaten up by centralized expenses of the practice management company. Of course, this $15,000 deduction could be more or less.

2. Price to Earnings Ratio. Assuming that the 15% estimate for centralized expenses is correct, then the $100,000 generated by the physician’s agreement to cut his or her compensation by 20% yields $85,000 of before tax income for the practice management company. The practice management company will have to pay taxes on this $85,000, and assuming a combined state and federal tax rate of 35%, such $85,000 of before tax income results in $55,250 of after tax earnings for the practice management company.

If one assumes that the stock of the publicly traded practice management company trades at a 20 to 1 price to earnings ratio, then the $55,250 of after tax earnings, generated by a physician who earns $500,000 and agrees to a 20% salary cut, results in $1,105,000 of aggregate stock value.

3. Timing of Public Offering. Of course, if the practice management company is not already public, and never goes public, there will be no public market for the practice management company's stock. Moreover, if the practice management company is not public when the physician joins, but subsequently goes public, the favorable price to earnings ratio usually needs to hold for at least one year, since a physician who has obtained stock in the company may not be able to convert his or her stock to cash until a year has elapsed.

4. Promoters' Cut. Whether the price to earnings ratio is 40 to 1, 30 to 1, 20 to 1 or 10 to 1, the question remains as to who shares in the aggregate stock value. More than likely, the physician agreeing to the reduction in compensation will have to share the aggregate stock value, first with the venture capitalist, or other capital source, that is funding the enterprise, and second with the management of the enterprise.

Assuming a 20 to 1 price to earnings ratio, and assuming that 20% of the aggregate stock value generated by the Physician’s agreement to work for less will be demanded by the venture capitalist, then the $1,105,000 aggregate stock value would be reduced by $221,000. Of course, the venture capitalist may demand a much greater share than 20%, perhaps 50%. Accordingly, the particulars of each deal in this regard need to be determined.

Similarly, assuming that management is earning a 5% share of the aggregate stock value generated by the Physician’s agreement to work at a 20% discount, then the $1,105,000 aggregate stock value would be reduced by an additional $55,250. Of course, management might be demanding 25% of the aggregate stock value, and not 5%. Again, this aspect of each deal also needs to be determined.

However, if one assumes a 20 to 1 price to earnings ratio, 20% for the venture capitalist and 5% for management, then the physician who gives up $100,000 of his or her compensation, could, as indicated in Table #2, end up with $828,750 worth of stock in a publicly traded company. Further, this $828,750 compares quite favorably with the original estimate that the cost of giving up a $100,000 a year in compensation is worth $500,000.

Of course, if the price to earnings ratio is 15 to 1, instead of 20 to 1, the value of the doctor's stock drops to a still respectable $621,563. However, at a 10 to 1 ratio, the value of the doctor’s stock would be $414,375, which is less than the original $500,000 estimate of the value of the doctor’s lost income.

Further, if the venture capitalist's and management's cut in the aggregate is 75%, instead of the assumed 25%, then, even at a 20 to 1 price to earnings ratio, the value of the doctor’s stock drops to $276,250, well below the original $500,000 estimated value of the lost income.

5. Further Assumptions. The foregoing analysis also assumes that the number of shares a doctor receives in the practice management company bears a proportionate relationship to the income he or she is giving up. In other words, a doctor with a $500,000 present income would be getting twice as much stock as a doctor with a $250,000 present income. Whether that assumption matches the particulars of a specific deal, however, has to be determined.

Similarly, the $828,750 conclusion also assumes that physicians are receiving an ownership interest upon, and in return, for joining a practice management company, and not merely receiving a fixed dollar value of stock upon the management company going public. In some deals the physician is simply told that, if and when the company goes public, the doctor will receive a particular dollar amount of stock.

The good side of such an offer is that, if the company goes public and the price per share is lower than anticipated, the physician will receive more shares. The down side is that if the price to earnings ratio is good, the physician will not initially receive any of the resulting up side of the deal.

C. Conclusion

The moral of this tale is that there are an extraordinary number of variables to be considered in comparing the cost of giving up income in return for some speculative amount of stock. Things might work out well, and things might not.

Due to the speculative nature of the transaction, it may be advisable that a doctor enter into such a transaction for reasons other than the promise of stock. The stock should be the "gravy" on top of a deal that has merit on its own.

If the physician is receiving cash plus stock, then the physician should first be happy with the cash. Similarly, if the physician is joining the group, because he or she believes that the group will keep the physician’s office full, then the physician should join the group for that reason, and allow the stock once again to be viewed as "gravy." Of course, it might, in fact, be the publicly traded "gravy" that attracts other doctors to the group, which in turn, may help to keep the doctors' waiting rooms full of patients.


March 21, 1998




Rosen, Barry F.


Health Care