DUE DILIGENCE IN HEALTHCARE PRACTICE ACQUISITIONS (Part 2)

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This is Part 2 of a Series about "Due Diligence in Healthcare Practice Acquisitions".? In this Edition we take an in-depth look at hands-on, in-Practice investigations to verify the value of Intangible Assets, known as "Goodwill", in the acquisition.

Additional "Due Diligence" topics will be covered from time to time in future Editions.

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• ?MAXIMIZE YOUR BANG-FOR-BUCK? In good quality, mid-to-large-sized Practices, Goodwill accounts for 80%-90% of the value of the Practice, while tangible assets represent only 10%-20%.? Due Diligence should follow this hierarchy of value. Focus first on matters related to Goodwill.
• ?DON`T CUT CORNERS ?Doing Due Diligence on the intangible assets of a healthcare practice is difficult, painstaking and time-consuming.? As a result, most buyers avoid this, only to find after Closing that all was not as advertised by the Seller when they submitted their Offer.
• DON`T CONFUSE 'COUNTING' WITH 'AUDITING' PATIENT CHARTS? These are different, but complementary, procedures. Counting charts tells you how many revenue-generating patients there are. ?Auditing charts tells you how much revenue they generate.? Due Diligence requires both.

ACCOUNTING 101 (Don't Worry, There`s Only a Little Bit Of This!)

A Practice's patient base is the foundation of the Practice.? The Practice`s charts contain all of the Practice`s information about its patient base.? This patient information is an Intangible Asset:? i.e., the Practice owns it, it has value (because the Practice`s clinicians use it to provide treatment and thereby generate revenue), but it does not have a physical form.

The value attributable to the Intangible Asset that embodies the patient information is known as "Goodwill".? The value of the Goodwill is a function of the Practice's efficiency in generating revenue from the patient base.

You can't do Due Diligence directly on Goodwill, because it is an accounting concept that exists only in the Practice's financial statements.? But you can do Due Diligence on the 3 primary metrics that define the patient base and underlay the calculation of Goodwill:? (1) the number of active patients; (2) the number, types, frequency and value of treatments provided to the patients; and (3) the patients' geographic residential locations.

There are 2 methods for verifying patient information:? counting the charts and auditing the charts.? Many purchasers (and brokers) use "counting" and "auditing" interchangeably.? That`s incorrect; these are different, but complementary, approaches.? Counting the charts tells you how many revenue-generating patients there are; auditing the charts tells you what their characteristics are and how much revenue they generate.

So, first we count the charts, then we audit them.

COUNTING THE CHARTS

Counting charts is a cornerstone component of Due Diligence.? It enables you to verify the Practice's gross revenue (which should equal the product of the number of active charts times the average per-patient revenue as reported in the Appraisal) and Goodwill value.? It also creates a baseline for verifying other important patient-related metrics such as "per-patient revenue" which is a KPI for operational efficiency.

Active Patients

The first and most basic question to ask is:? How many active patients does the Practice have?? We are focused on "active" patients because only active patients attend at the Practice and have treatment procedures with sufficient frequency and regularity that they generate a revenue stream that is replicable and predictable going forward, thereby creating Goodwill value for the Practice.

The difficulty in doing Due Diligence to confirm the number of "active patients" is that there isn't a generally accepted definition of an active patient.? Traditionally, the standard definition of an active patient was one who had had at least 1 treatment procedure at the Practice within the prior 12 months.? However, the Brokers have tried to justify their steadily increasing listing prices over the past decade by stretching the definition of active patients so that they can claim a larger patient base for the Practice.

As a result, we now regularly see Appraisals that define the patient base to include "semi-active" patients who have attended at the Practice within the last 18 or sometimes even the last 24(!) months. ?Don't be fooled in this regard:? an exaggerated patient base is irrelevant and useless to you as both the Practice purchaser and the Practice owner.? The only patients that are valuable and should be counted are the "active" ones who regularly generate revenue and create Goodwill value in the Practice.

Our standard metric for an "active patient" is the traditional one:? a patient who has had at least 1 treatment procedure at the Practice within the past 12 months.? However, if the Appraisal uses another metric such as 18 or 24 months then that will be the benchmark for your chart count, because your objective is to verify the patient count as reported in the Appraisal.

Counting Paper Charts

In old-style, paper-based offices, chart counting is more time-consuming but also much more reliable.? In that situation, count the charts in the chart filing cabinets, plus any charts that may be in circulation in the dentist's office, the operatories or at the front desk.? Then compare your chart count total to the patient count in the Appraisal.

If your physical count is lower? than the number in the Appraisal by 3% or more, that's a potential problem.? It may indicate an innocent error in the information given by the vendor to the Appraiser. ?But, more likely, it's an attempt by the vendor to artificially inflate the patient base and the value of the Practice.? (Note: If the vendor will lie to you about the size of the patient base, they will lie to you about other things too!)

However, even a large chart count deficiency may not be good reason to kill a deal.? We once acted as a buyer's advisor in the acquisition of a mid-size practice where the Appraisal advertised that there were 1,650 active patients but our chart count only identified 1,250 active charts.? That was a very substantial 24% shortfall relative to the Appraisal.? It caused us to be extra careful in all our other investigations, but we found no other material discrepancies.? We concluded that the problem was a weak front desk administrator who hadn't culled the inactive charts.? The bottom line was that the Practice was capable of generating a desirable amount of revenue from this lower real number of patients, so we advised the purchaser to proceed with the acquisition and they have since been the happy owners for many years.

Counting Electronic Charts

In modern offices with electronic records, chart counting is much less time-consuming but the result is also less reliable.? You will be able to get a report from the practice management software that gives you the total number of patients who fall within your desired metric – 12/18/24 months or otherwise.? If you want to confirm that total number, you can also get a report that will give you all the patient names and you can count them manually.

However, bear in mind that it is relatively easy to 'fudge the numbers' by creating fake electronic patient files.? If you have doubts about the accuracy or authenticity of the computer-generated patient count, it's difficult and time consuming to find incorrect or fraudulent data.? You won't be able to easily test the accuracy of the computer's count by comparing it to the Appraisal because the Appraisal total is taken from the same computer report that you are using, so there won't be a discrepancy.? The only solution is to manually review a random sample of computer files that is large enough to be statistically significant for the entire Practice.

AUDITING THE CHARTS – Procedures & Revenue

Auditing charts goes well beyond merely counting them.? It involves an in-depth, manual review of a random sample of charts that is large enough to yield statistically significant conclusions about the Practice as a whole.

By auditing the charts, we are seeking to verify 2 very important Practice metrics:

1)??? The number, type, frequency and value of treatment procedures performed for patients. ?This enables us to verify the Practice revenue as reported in the Appraisal, a critical piece of information to substantiate Goodwill Value and Purchase Price.

2)??? The patients' geographic residential locations.? This defines the potential degree of patient loss and revenue risk due to the transition of ownership.

Audit Procedure

The audit procedure is straightforward.? Create a spreadsheet with columns to record:? (1) the number, type, frequency and value of treatment procedures performed for individual patients; and (2) each patient's geographic residential location by their postal code.? Take a random sample of charts that is large enough to be statistically significant for the whole Practice (there is a statistical formula to determine the random sample size).? Ensure random chart selection: ?for example, if there are 2,000 total charts and the random sample formula says you need a sample size of 100 charts, choose every 20th chart in sequence from start to finish.? Record each patient's data for each of the 3 last years, with each year having its own row in the spreadsheet.

Verifying Revenue

Your first calculation is to aggregate the value of the procedures performed for each patient in the sample on a year-by-year basis over the 3-year time frame.? Next, aggregate the value of the procedures for all the patients year-by-year, and then multiply each year's result by the number of active patients reported in the Appraisal for that year.? This will give you an estimate of gross revenue for each of the 3 years.? Compare your estimated revenue to the revenue reported in the Appraisal for the 3 years.? Your estimated revenue should be within 10% of the revenue reported in the Appraisal.? If it's not, that discrepancy indicates a revenue-capture problem in the Practice`s accounting that needs to be investigated further.

Revenue Risk Related to Ownership Transition

Lastly, determine the revenue risk related to the ownership transition by plotting all the postal code locations on a map (there is software for this).? In long-established practices, patients move away over time but continue to attend the Practice due to their personal connection with the dentist.? Their personal connection disappears with the ownership transition and the old-time patients who live furthest away will leave.? Calculate what percentage of the total patient base lives 1, 2, 3, 5 and 10+ miles from the Practice.? We can advise you on how to interpret the location risk from the results.

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