By Catherine Lightfoot, CPA, CHBC, Director of Healthcare at EEPB
Over the last several months, I have seen concern over an increased capital gain rate cause some clients to accelerate their succession planning. At the time of this writing, it is not clear that Congress will actually make this tax adjustment during 2021. However, it is still good to have the mechanics of a succession plan mapped out in advance. As the saying goes, those who fail to plan, plan to fail. A successful succession plan should be well thought out, not rushed through.
Valuation First
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You need a rough idea of where to start, and that all begins with a valuation of the practice. Is your practice worth $800,000 or $8,000,000? If you thought it was worth $8,000,000 and the value is much less than that, then you have some work to do. It is important to know the baseline before taking further steps. A valuation not only reviews your assets, but it also takes into account your goodwill. Of course, debt will reduce any valuation. Therefore, if your practice is heavily leveraged, that will figure into your succession timeline. Since most valuations are based on some multiple of earnings, you might need time to clean up your earnings. Many practices are good at watching their revenue, but not so much the expenses. In a sound valuation, both are important. You will want financials to be optimal for at least three years to get top numbers from the valuation process.
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Identify Candidates
The valuation is used to determine how much of the practice can be sold over how long of a time. Evaluate and consider current providers to determine if they are a valid candidate. It is always easier to move an established associate into an owner position than to bring in a new candidate from the outside. Either works, it is just that the latter takes longer to identify and incorporate. External candidates can be one of two types, providers or financial players. The buy–in agreements are very different between these two groups.
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It is recommended to present a succession opportunity to the candidate verbally first, while carefully managing the process so that employees do not learn about it too early. Once an agreement is reached, it will be easier to onboard the rest of the team by delivering a positive message.
Due Diligence
Once a buyer has been identified and a valuation set, there will be a period for conducting due diligence. The buyer’s legal/accounting team has to review various types of records before the closure of the sale. It is common for a non-disclosure agreement (NDA) to be signed before such records are released. The selection of diligence items typically includes: payor agreements; healthcare facility agreements; equipment leases; management, employment, and non-owner’s consulting agreements; licenses; tax returns (3 years); financial books and records (3 years); lines of credit; loan and credit agreements; leases, employee benefit arrangements; related-party transactions; deferred compensation/termination pay agreements; security agreements, etc. There is usually a limit on the time available for due diligence.
Key Transaction Documents
Your legal team will be instrumental in collecting all of the necessary documents for the deal. These will include: Letter of Intent (LOI), Acquisition Agreement, Ownership Agreements, and Employment Agreements. The following are some key components that will be worked into the final agreement:
Asset vs Equity Transaction
An asset transaction is more tax favorable. An asset purchase, in most cases, leaves the liabilities with the original owner. The agreement should itemize the values for the asset categories purchased. Common categories are Furniture and Equipment, Supplies, and Goodwill. Cash and Accounts Receivables normally stay with the original owner, but the deal could be structured to include them. The seller recognizes capital gain on the goodwill side and any asset basis that has not been depreciated. Note that depreciation is recaptured at ordinary tax rates. The buyer has a step-up in asset value equal to the purchase price in the categories agreed upon. The assets can be depreciated, and the goodwill is amortized.
An equity transaction is selling stock. In this scenario, the seller recognizes capital gain, and the buyer purchases stock. The buyer has nothing to depreciate or amortize, so there is no recognition of any tax deferral during ownership. When the buyer subsequently sells the stock, the cost basis reduces the recognized gain at that time. The tax benefit is not lost. It is just held until the ownership changes.
Conclusion
The best succession plans have an undisputed value, readily available documents and records, and an identified valid candidate. Planning ahead with respect to key agreement terms, potential candidates, and values will streamline the process and make your succession planning a success.