Two previous articles appearing in Becker’s Hospital Review laid out the primary reasons driving private practice medical groups to consider mergers and acquisitions in the current market, as well as the key questions involved in determining the best path forward.
This article presumes that a medical group has decided, after a process of intense self-assessment, that a merger or acquisition is in its best interest.
Preparing a business for sale requires significant preparation, as well as consideration of the long-term goals for the business. This article provides an overview of the preparation process for a merger or investment transaction, and how an investment bank supports the process.
The four key steps are: preparing the offering materials, marketing, bid evaluation, and due diligence and documentation.
Step 1: Preparing Materials
There are three critical components used to market a company for a merger or investment transaction: an executive summary, a confidential information memorandum, and a financial model.
The executive summary is a two- to three-page overview of your company(ies) which provides key functional and financial highlights, as well as statistics about the practice and its potential for growth. The executive summary is often referred to as a "teaser," designed to draw the attention of potential partners or purchasers/investors.
The confidential information memorandum (“CIM”) is a document of between 30 and 80 pages that is often referred to as "the Book." CIMs are strategic presentations that are more or less standardized, though they may be customized to highlight synergies and strategic rationale with individual buyers or investors.
The third and most substantial component of the offering materials is the financial model. This is what really drives the valuation of an entity on the market. The financial model covers at least the last three years of historical performance and looks forward at least two or three years. Setting forth both historical and projected financials in the same methodology allows for articulation of how the transaction will impact the business and is therefore critical to valuation.
Another important factor in developing the financial model, especially for businesses in the medical area, is effectively creating the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). There are many drivers that contribute to EBITDA including, addback of non-recurring expenses, market based compensation adjustments, accrual adjustments, etc. Building EBITDA is a very complex process and there is significant value that an experienced investment banker can bring.
Typically, the most significant contributor to EBITDA is the adjustment in partner compensation. The first step is determining the appropriate market salary for a comparable group of physicians. For example, if someone is making $800,000 a year in total, and believes that $500,000 is the market salary for that position, then $300,000 is treated as the profit or EBITDA adjustment per physician. Under this approach, the model presents what the business looks like both in historical and projected periods assuming that all partners are employees at the market salary level.
It is very important to rebuild the revenue of the practice into an accrual basis. For example, revenues should be booked based on when the patient was seen, as opposed to when the cash was collected. For a growing practice, revenue presented on an accrual basis should always be higher than cash-basis revenue (as long as payor rates remain stable). Rebuilding historical revenue into an accrual basis also provides an opportunity to make a better-informed projection of future periods. The next step is layering in the impact of any new sites/contracts and modeling the impact of expected reimbursement changes (positive or negative).
Further, it is very important to build up each individual expense line on the income statement on an accrual basis. For example, medical malpractice premiums might be paid once per year in advance, but need to be amortized over the following year to properly reflect the economics of the practice. There may be one-time investments like IT infrastructure purchases or hardware that should be adjusted out of EBITDA. There may also be items like taxes, interest expense, depreciation, or partner buyouts that are not included in the definition of EBITDA.
Another essential item that must be developed in parallel with the offering materials is the outreach or buyer/investor list. The investment bank and the client must place significant consideration into this list, developing mutual approval of who should be included and approached. Should it include 10 names or 50? It is important to have clear consensus on the best possible suitors to approach and the strategic rationale of each party. Finally, the specific terms of what would be considered the structure needs to be spelled out. Which entities are involved? How much of the business do the partners want to sell vs. retain? Should a friendly PC and MSO structure be set up to comply with corporate practice of medicine requirements? Are there any partners that have not owned their stock for at least a full year? What strategies can be utilized to create the most efficient tax structure? Of course, the goal is always to be as tax efficient as possible, pressing toward capital gains rather than ordinary income tax rates.
Step 2: Marketing
Once these materials are compiled and the outreach list is finalized, the investment bank is ready to bring the company “to market”. At this point, it is the investment bank that primarily manages the outreach process, and is responsible for making “the pitch”, answering questions, supplying materials, scheduling meetings, and preparing for next steps in the process.
If the first stage has been completed thoroughly, the bankers should be able to answer all initial questions in step 2 without any assistance from the company.
Typically, at this point, the banker would set a target date for receiving all Indication of Interest (IOIs) submissions, and issue a letter to all relevant parties making them aware of the expected timeline. The letter would also contain details on the proposed structure of the transaction, indicating expected dates for management meetings, additional information that shall be provided and specific requests to be addressed in the proposal. At the end of this stage, after all IOIs are collected, the banker typically sets up a call with each bidder to walk through the proposal and clarify any open questions.
Step 3: Bid Evaluation
The transaction evaluation process involves looking at all received proposals side-by-side. The investment bank relays information about each bidder to the client and provides advice as to how to think about and compare them.
It is important to recognize that proposals can differ tremendously. It is never just a matter of comparing apples to apples. One party may offer a 100 percent buyout while another may present a 70 percent offer. Each may involve different treatments of liabilities, working capital, or go-forward salaries. Investment bankers will present a framework that enables the company to compare the proposals in an effective manner, and suggest strategies for an effective counterproposal.
Typically the banker will help the company navigate the process of narrowing down the list of candidates and agree on a strategy for moving forward. Sometimes the next step be an informal conversation with bidders to determine how much room there may be for negotiating. In other cases, this entails sending formal written markups of the IOIs.
Ultimately, these negotiations will lead to determining which subset of bidders to invite for management presentations. This involves a meeting, often on-site, where potential buyers will formally present their negotiated proposal and client management will further represent why the company or project is worthy of investment.
While facilitating these steps during this stage, the investment bank will also finalize an online repository of due diligence documents, referred to as the "data room." This involves compiling and organizing thousands of files—every piece of information that is relevant to the company— making sure they are all catalogued and consolidated into an organized online database. This is a key function of the investment bank, which must make sure that every single element is proofed and checked to ensure data integrity.
Based on these interactions, the next step involves negotiating the IOIs into Letters of Intent (LOIs) with the remaining interested parties. Drawing from the original IOI, the LOI include much more detail about the prospective deal. Every key business point in the transaction should be addressed in the LOI: not just the high-level purchase price, including the treatment of all cash and debt, employment contracts, non-competes, indemnification provisions. All the business terms and some legal items relevant to the transaction must be covered in the LOI to prevent any future surprises.
Once the LOIs are fully negotiated with each bidder, the banker will make another presentation to the owners to walk through the final terms of each proposal. The owners must then determine which subset of parties they want to pursue further.
In very competitive processes, the owners may choose to invite multiple investors forward in a non-exclusive process and not make a final decision until just before closing.
If the choice is clear, the owners may decide to narrow the field and enter into what is called an "exclusivity period” with the preferred partner. The client will sign a letter of intent which binds it to a period of exclusivity—perhaps 60 to 90 days—during which the seller will agree not to negotiate with other buyers. This provides a window for both teams to work through all details and confirm that the deal is formed precisely as initially negotiated, or adjusted as mutually determined. In essence, this step entails the conversion of the Letter of Intent into a set of legally binding documents, which are commonly referred to as the “Purchase Agreement.”
Step 4: Purchase Agreement, Final Shareholder Agreement, and Closing
The first draft of the Purchase Contract might be issued by either the buyer or seller, though it is more often the former. Once presented, the investment bank will carefully consult with the client's attorneys to ensure that the contract accurately reflects the agreed-upon business and legal elements. This phase also requires intensive confirmatory due diligence by all parties. The buyer, for instance, might hire an accounting firm to undertake a "quality of earnings" to confirm the seller's financials. Typically, all legal items, technology, contracts, HR matters, and other considerations come under close scrutiny during this phase as well.
All of this leads to a finalized set of purchase documents including a Purchase Contract, an Employment Agreement template, a Management Services Agreement if there is a MSO structure, and an Operating Agreement if there is a rollover equity component or other equity structure involved in the deal. With these documents fully negotiated, the attorneys and the investment bank agent will present the final terms at a shareholder meeting and, usually, open the deal for a shareholder vote. If the result is affirmative, the deal may be finalized immediately. In some instances, regulatory and third-party approvals are required, so the legal documents are signed and then the transaction is closed when those consents are obtained.
A Typical Process Timeline from Start to Closing
The timeline for a merger or investment transaction can vary depending on a number of factors. Naturally, this depends on market demand, internal preparedness of the organization, the structure of the transaction, the number and complexity of the entities involved, and so forth. That said, a typical process would realistically run approximately five to seven months. This includes preparation through marketing and closing. If an entity already has a prospective investor, buyer or partner in place, this could be reduced to as short as three months.
A specific estimate for the duration of material preparation would be 60 to 90 days, depending on the availability of the data and the number of parties involved. The transaction marketing process can vary, but one to two months will provide a fairly clear indication of market interest. Evaluating received bids should be completed within 30 days. Finally, one should assume a three-month period from Letter of Intent to a successful closing, provided there are no external consents or unforeseen complications.
The key component to an efficient investment/M&A process is the preparation of the offering materials and documents beforehand so that no surprises arise later on and require renegotiation. Making sure that the Revenue and EBITDA is forecasted accurately is essential. It can be done via the hiring of third-party accounting teams, but is usually best achieved through in-house analytical work by the investment bank, whenever possible.