Lindabury, McCormick, Estabrook & Cooper, P.C. Firm News & Events
For an owner considering the scale of a healthcare business, one of the first questions is usually: What is my business worth?
It is an important question, but determining value involves much more than applying a multiple to last year’s earnings. Two healthcare businesses with similar revenue and profits can receive very different offers. The difference may reflect the quality and predictability of their earnings, growth prospects, customer or referral concentration, management depth, regulatory risk, or how dependent the business remains on its owner.
When a prospective buyer makes an offer, the discussion often begins with EBITDA and a valuation multiple. A business owner may be told that the company is worth seven or eight times EBITDA. That sounds straightforward. But before deciding whether an offer is attractive, the seller needs to understand two things: what EBITDA figure the buyer is using and what the proposed purchase price will ultimately mean in dollars received and obligations retained.
An attractive valuation can tell only part of the story. The purchase price may include cash at closing, rollover equity, an earnout or other contingent payments. It may be reduced by debt, working capital adjustments or other obligations. The seller’s compensation and role after closing may also change significantly. Evaluating an offer therefore requires looking beyond the stated valuation and understanding the economics of the transaction as a whole.
EBITDA Is the Starting Point, Not the Valuation
EBITDA, which is defined earnings before interest, taxes, depreciation and amortization is commonly used to measure a company’s operating performance and as a starting point for determining enterprise value. Enterprise value is a financial metric that measures the total economic value of a business, effectively representing the theoretical price it would cost to buy the company outright.
In its simplest form, if a healthcare business generates $1 million of EBITDA and a buyer applies a seven-times multiple, the indicated enterprise value is $7 million. Actual transactions, however, are rarely that simple.
Buyers generally focus on “normalized” or “adjusted” EBITDA. The objective is to determine the earnings the business can reasonably be expected to generate following the transaction.
That analysis often requires adjustments for unusual or nonrecurring expenses, owner-related expenses, related-party arrangements and other items that may not continue after closing. Some adjustments increase EBITDA. Others reduce it.
These adjustments matter because even a relatively modest change to EBITDA can have a significant effect on valuation. A $200,000 adjustment at a seven-times multiple changes the indicated enterprise value by $1.4 million.
A seller evaluating an offer should therefore understand not only the EBITDA figure used by the buyer, but also the adjustments and assumptions used to calculate it.
Not All EBITDA Is Valued the Same Way
Two healthcare businesses with identical EBITDA can command very different valuations.
Buyers consider the quality, predictability and sustainability of earnings. A business with recurring revenue, diversified referral sources, strong management, favorable payer relationships and consistent growth may be viewed differently from one that depends heavily on a small number of customers, referral sources or key individuals.
Other factors may include payer mix, reimbursement trends, regulatory exposure, provider concentration, employee retention, geographic reach, scalability and the extent to which the business can continue operating successfully without the current owner.
For physician and other professional practices, owner compensation can be particularly important. A physician-owner may receive an economic return both as a practicing professional and as the owner of the business. Those two components often need to be separated in determining normalized EBITDA. An adjustment to owner compensation can materially affect both EBITDA and, because a multiple is then applied to that EBITDA, the resulting valuation.
A buyer’s valuation therefore reflects more than historical earnings. It also reflects the buyer’s assessment of the earnings that can reasonably be expected to continue after the transaction and the risks associated with producing them.
The Multiple Does Not Tell the Whole Story
Once adjusted EBITDA has been determined, attention usually turns to the valuation multiple. Multiples can vary considerably among different sectors of healthcare and even among businesses operating within the same sector.
The identity of the buyer can also affect valuation. A strategic buyer may see operational efficiencies, geographic expansion or other synergies that influence what it is willing to pay. A private equity-backed platform may value an acquisition based in part on its potential contribution to a larger regional or specialty organization.
This is why anecdotal statements that another healthcare company “sold for eight times EBITDA” have limited usefulness without understanding the underlying transaction. The calculation of EBITDA, the quality of the business, the structure of the consideration and the seller’s post-closing obligations may all be materially different.
The multiple is important, but it needs to be considered in the context of the entire transaction.
Enterprise Value Is Not the Same as What the Seller Receives
A buyer may value a healthcare business at $10 million, but that does not necessarily mean the seller receives $10 million in cash at closing.
Enterprise value generally represents the value attributed to the operating business. The amount ultimately received by the seller can be affected by debt repayment, cash retained or distributed, working capital adjustments, transaction expenses and other balance-sheet items.
The purchase price may also consist of several different forms of consideration. A portion may be paid in cash at closing. Some may be held in escrow or otherwise subject to post-closing adjustments. Other amounts may depend upon future performance. In a private equity transaction, a portion of the seller’s proceeds may also be reinvested in the acquiring organization as rollover equity.
The distinction between the stated valuation and the seller’s actual proceeds is fundamental. When evaluating an offer, the seller should determine how much will be received at closing, how much is deferred or contingent, what portion remains at risk and what obligations must be satisfied before the balance is received.
Rollover Equity Is an Investment, Not Cash
Rollover equity has become a common component of private equity transactions involving healthcare businesses. Rather than receiving the entire purchase price in cash, the seller reinvests a portion of the proceeds in the acquiring company or its parent.
The potential benefit is participation in the future growth and eventual sale of the larger organization—the frequently discussed “second bite at the apple.”
That opportunity can be meaningful, but rollover equity should be evaluated as an investment rather than simply another form of purchase-price consideration.
A seller should understand the entity in which the investment is being made, how the equity is valued, the rights associated with it, its priority relative to other investors, the potential for dilution and the circumstances under which liquidity may eventually occur. The seller should also understand whether the rollover investment is being made on the same economic terms as the buyer or private equity sponsor.
A dollar of rollover equity should therefore not automatically be viewed as economically equivalent to a dollar of cash received at closing.
Earnouts Can Change the Actual Purchase Price
A buyer and seller who disagree over value sometimes bridge the difference through an earnout or other contingent payment.
Under these arrangements, a portion of the purchase price becomes payable only if the business achieves specified financial or operational results after closing.
The concept may appear straightforward, but the details are important. After closing, the seller may no longer control many of the decisions affecting the company’s performance. The buyer may change staffing, pricing, operations, accounting practices or the allocation of corporate expenses.
The parties should clearly understand how performance will be measured, which revenues and expenses will be included, what operational discretion the buyer will have and what happens if the business is integrated into a larger organization.
Contingent consideration may ultimately produce significant additional value, but it carries a different degree of certainty than cash paid at closing. That distinction should be taken into account when evaluating the overall offer.
Working Capital Can Affect the Amount Received at Closing
Working capital is another area that can materially affect a seller’s proceeds.
Many transactions require the business to deliver an agreed level of working capital at closing so that the buyer receives a company capable of continuing normal operations without an immediate additional capital contribution.
The calculation may involve accounts receivable, accounts payable, accrued expenses and other current assets and liabilities. If actual working capital at closing falls below the agreed target, the purchase price may be reduced. If it exceeds the target, the seller may be entitled to an upward adjustment, depending upon the terms of the transaction.
These provisions can involve substantial amounts. The methodology for calculating working capital, as well as the target itself, should therefore be addressed during the negotiation of the transaction rather than treated merely as an accounting exercise to be resolved shortly before closing.
The Seller’s Post-Closing Economics Matter
Many healthcare transactions do not end the seller’s involvement with the business. Physicians, executives and founders frequently remain with the organization for a period after closing.
Their post-closing compensation and responsibilities therefore form part of the overall economic analysis.
A seller may receive an attractive purchase price but accept materially lower compensation after closing. Another proposal might offer a somewhat lower purchase price but more favorable compensation, incentives, governance rights or future equity participation.
For physician and other professional practices, post-closing compensation can be particularly significant because the seller may continue generating a substantial portion of the business’s revenue.
The purchase agreement, employment or services arrangement, rollover investment and other transaction documents should therefore be evaluated together. Looking at the purchase price in isolation may provide an incomplete picture of the economics of the transaction.
Evaluating the Full Economics of the Transaction
Determining the value of a healthcare business may require input from investment bankers, valuation professionals, accountants and other financial advisors. But a seller considering a transaction should understand the financial concepts that drive the buyer’s valuation and determine what the seller will actually receive.
The valuation multiple is important, but it is only one component of the transaction.
A meaningful evaluation considers normalized EBITDA, the quality and sustainability of earnings, the valuation multiple, cash payable at closing, debt and working capital adjustments, escrows, earnouts, rollover equity and the seller’s post-closing economics. It should also consider matters that cannot be reduced to a spreadsheet, including governance, control, restrictive covenants, professional autonomy and the seller’s future role.
For many healthcare business owners, a sale represents the monetization of a business built over many years. It may also fundamentally change their professional and financial lives.
The better question, therefore, is not simply, “What multiple is the buyer offering?”
It is “What is the total economic value of the transaction, what risks am I retaining, and does the transaction accomplish my financial, business and personal objectives?”
Understanding those issues before signing a letter of intent can provide a much clearer picture of what the healthcare business—and the proposed transaction—is really worth.