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Legal Update
The Advantages of Group Practice Investment
Jerry Sokol, Joshua Kaye
Publish Date: December 14, 2007

While surgical centers have traditionally been owned by physicians in their individual capacities, an increasing number of centers are now owned by physicians through group practices. The group practice investment model may be just the right fix for two problems that afflict many centers:

  • the resentment that some physician-owners feel when an individual physician's productivity differs greatly from an ASC's profit distributions; and
  • when a center's fair market value is too high to attract young, talented physicians and sell them a meaningful interest.

Profit allocation flexibility
From a regulatory perspective, ASC profits are required to be distributed to physician-owners in accordance with their individual pro-rata ownership interest in the facility. As a result, when productivity and ASC profit distributions begin to differ greatly, many centers often consider whether they can reallocate the ownership of the ASC in a manner that is more reflective of each owner's relative use of the ASC. The reshuffling of ownership interests, however, would raise material regulatory risk under the federal Anti-kickback Statute.

If, however, a group practice entirely or partially owns an ASC, there could be substantial flexibility in how the ASC's profits are allocated among those physicians associated solely with the group practice. In a group practice, it's generally accepted that ancillary revenues from items such as clinical laboratory services, medical imaging and physical therapy are often pooled and may, under Stark and other applicable healthcare laws, be allocated among the group practice's physicians according to the relative professional fees generated by each physician — an "eat what you kill" compensation formula — as long as the allocations aren't directly related to the volume or value of each physician's referrals.

Although the Stark law doesn't apply to ASCs, the same compensation formula could also apply to the revenue generated by a group physician for his use of the group practice's ASC. Of course, this approach should only be considered if such an allocation is preferable to an allocation based on relative ownership. Also, the group practice investment model involves the group practice becoming an owner of the ASC. So since one of the practice's assets will now be its equity interest in the ASC, consider careful asset protection planning before you implement such a business model.

The group practice investment model is clearly applicable to a group practice's investment in a startup ASC. Additionally, if physicians who are part of the same group currently own individual interests in an existing ASC, those physicians could likely convert into a group practice investment model by contributing their ownership interests in the ASC to the group practice in a tax-free transaction.

For example, let's say that four physicians affiliated with a single gastroenterology practice each own 5 percent of an existing ASC. The four physicians could agree to contribute those ownership interests to a group practice. This group would then own 20 percent of the ASC (5 percent times four physicians). The result? When the ASC pays a dividend, it will distribute 20 percent of the ASC's profits to the group practice rather than 5 percent to each of the four physicians. The group practice could then allocate the ASC profits among the four physicians pursuant to their employment agreements in a manner that more closely reflects their relative use of the ASC.

Fair market value departures
Generally, the purchase price for an equity interest in an existing surgical center must be equal to fair market value. Otherwise there is concern under the Anti-kickback Statute that the ASC might be inducing a physician to become an investor in exchange for referrals. The purchase price for an equity interest is often calculated through this four-step formula:

  • take the ASC's earnings before interest, taxes, depreciation and amortization (EBITDA) for the 12-month period preceding the buy-in date;
  • multiply by a fair market value multiple;
  • subtract the ASC's long-term debt; and
  • multiply by the percentage being acquired.

For an existing ASC with a ramped-up EBITDA, the result is an expensive proposition.

For example, let's assume an ASC desires to sell a 5 percent interest to a physician who currently uses the ASC, but who's not an owner. If the ASC has $750,000 in EBITDA with no long-term debt and the fair market value multiple for a minority interest in an ASC is around 3, then the purchase price for the potential physician-owner would be $112,500 ($750,000 times 3, times 5 percent).

In such a situation, it's quite common for a potential investor to resist parting with that amount of cash, particularly since the ASC can't float the physician a loan or let him pay over time. It's conceivable that the physician might ask the ASC to offer its equity interests at a discounted price.

From a business perspective, the physician's request is a valid one. After all, he's increased his own purchase price by performing procedures at the center and contributing to its revenue. With limited exceptions, however, offering to sell the interests for less than fair market value to a physician who uses or will begin using the ASC would induce a significant level of regulatory risk.

But if a group practice owns all of the interests in an ASC, the practice's members may be able to depart from the fair market value requirement without engendering healthcare law regulatory risks. The ASCs that pursue this option tend to be more prevalent in such specialties as ophthalmology and gastroenterology, but they do also include midsized and large single- or multi-specialty group practices.

Group practice pointers
ASC management companies and health systems prefer for physicians to invest directly in an ASC, rather than through an entity, so that they can arrange contractual rights directly with the physicians. Generally, you can address their concerns through properly drafted documents.

For asset protection and other operational reasons, ASCs are often owned by their physicians individually or through a separate entity, such as a limited liability company. This business strategy could still be used in group practice arrangements as long as the physician ownership of the group practice mirrors the ownership of the ASC. In considering this approach, it's also important that each physician use the ASC as an active extension of his own practice, with little or no involvement from primary care physicians.

The key to an ASC's continued success is often driven by its ability to attract new physicians while keeping existing physician-owners satisfied that profit distributions and professional productivity are evenly balanced. Regulatory restrictions often hinder a meaningful resolution of these two issues, but the group practice investment model will likely continue to provide one possible solution.