The following column is written by Jason L. Ruchaber, CFA, ASA, partner with HealthCare Appraisers.
Here are five aspects of ambulatory surgery center operating agreements which can have significant negative implications on value.
1. Predetermined formulas — In an effort to facilitate ongoing buy-in/buy-out transactions, many operating agreements contain predetermined pricing formulas such as a 3.5x trailing 12 month earnings before interest, taxes, depreciation and amortization (EBITDA). Though predetermined formulas do facilitate such transactions, they can be problematic for certain transactions if the formula results in a price that is not consistent with fair market value (FMV). For example, if trailing earnings are not representative of future earnings (e.g., lost a significant referral source causing material adverse effects to case volume and ultimately, profitability), then any multiple based on trailing earnings will lead to a faulty (i.e., overstated) conclusion of value. In addition, this FMV inconsistency is especially true of formulas based on book value (i.e., balance sheet value) or low earnings multiple formulas when used to set the buy-in price for potential referral sources. When using a predetermined formula it is important not only to apply the formula consistently for all transactions (i.e., don't deviate from the formula for certain classes of buyers), but also to make certain the results of the formula make sense in light of specific facts and circumstances surrounding the center and center's expected performance.
2. Failure to update — When setting a pricing formula in an operating agreement it is important to periodically revisit the formula to ensure that it incorporates changes in market conditions and entity characteristics that may influence the appropriate pricing of shares. A formula determined based on the FMV of the entity five years ago may be significantly above or below the current fair market value of the shares. By periodically adjusting the pricing formula based on a current appraisal of the entity, inadvertent mispricing due to changes in market conditions can be largely avoided.
3. Ambiguous or misused terminology — The language of the operating agreement should be as clear and concise as possible. When using valuation terms such as "fair market value", "book value", "EBITDA", etc., it is important to be consistent with the generally accepted definitions of such terms. The International Glossary of Business Valuation Terms is a widely accepted source for these definitions. The agreement should also avoid the use of conflicting language added to otherwise properly defined terms. An example of this: ". . the fair market value excluding consideration of discounts for lack of control and/or marketability." Such a clause is misleading, as the FMV of the interest may necessitate the application of such discounts, and the exclusion of such discounts would therefore result in a standard of value other than FMV.
4. Control provisions — The rights and privileges afforded shareholders has a direct impact on the valuation of shares. Super majority provisions that require the vote of greater than 51 percent of the shares for certain decisions may result in a discount for lack of control being appropriate even for a majority interest. Conversely, multiple classes of stock affording one class of shares additional voting or other control privileges may result in a minority block of shares having effective control.
5. Restrictive transfer provisions – Restrictive transfer provisions such as a right of first refusal can have an impact on the value of shares. Overly restrictive transfer provisions can reduce the marketability of the shares and reduce value. Conversely, put rights granted to minority shareholders may significantly increase the marketability of the shares and increase value. Restrictive transfer provisions should be worded in such a way as to provide protection over the ownership composition of the entity but not unduly preclude future transactions.
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