Post Completion Purchase Price Payment Mechanisms in Medical Practice M&A

Post Completion Purchase Price Payment Mechanisms in Medical Practice M&A

Paying the purchase price when buying a business isn’t always as simple as might be expected. With valuations tied to revenue projections, EBITDA multipliers, and post-completion performance requirements, there are a wide array of payment mechanisms buyers and sellers utilise in M&A deals.

Like other service-based businesses, the value of a medical practice is often tied to intangible metrics which can make payment mechanisms a hotly negotiated topic. A common method to navigate this complexity is to include post-completion payment mechanisms in the sale documents, balancing the buyer’s risk with the seller’s entitlement to payment. This article examines some of the commonly implemented post-completion payment mechanisms buyers and sellers employ.

Why Payment Structuring Matters

The fair market value of a business is, simply, the price a willing but not too anxious buyer would pay a willing but not too anxious seller. Determining this price is not always simple in a service-based business as the value of a medical practice is heavily tied to the retention of individual practitioners, as well as being dependent on the earning potential of the business.

Where the seller wants to maximise the price paid for the practice, the buyer wants to protect against scenarios in which the medical practice faces a downturn in profit in the period after completion of the sale. A key way for buyers to mitigate this risk is by undertaking comprehensive due diligence on the target business, and ensuring the sale documentation includes comprehensive warranties protecting against key risks – see more on that in our recent article examining due diligence fundamentals in medical practice acquisitions. However, due diligence is only as good as the information available to a buyer, and warranties require enforcement which means time, effort, and legal costs.

A stronger way to protect against this risk is by tying the purchase price to post-completion metrics. In these instances, the buyer does not pay the full purchase price on completion and the parties agree on certain mechanisms to determine the post-completion payment of the purchase price. Typically, the arrangement will look something like this:

1. A purchase price will be determined at completion;
2. A portion of that purchase price will be paid on completion, typically called the completion payment;
3. The balance of the purchase price will be retained by the buyer;
4. A mechanism will be introduced that allows the parties to adjust the purchase price in the weeks, months or years following completion;
5. The retained amount will be adjusted up or down based on that mechanism and paid out to the seller.

Earn Outs

An earn-out is a type of post-completion payment mechanism which is tied to the financial performance of the business in the months or years after completion. Earn outs are typically calculated by reference to one or a combination of the following metrics:

1. Revenue;
2. EBITDA;
3. Gross billings;
4. Individual practitioner billings;
5. Number of new and / or recurring patients;
6. Overall profitability of the practice.

Earn outs are useful in service-based businesses like medical practices, as the value of such businesses are heavily tied to earning potential of key practitioners and the loyalty of their patients. If key practitioners or patients leave as a result of the change of ownership, this poses a serious financial risk to the buyer.

The earn out payment is typically structured in such a way that the post-completion payment can move up or down depending on the performance of the business during the specified period. So, if the business outperforms expectations in the earn out period, the seller could see an uplift and vice versa.

You can read more about earn outs here.

True Ups

Where an earn out focusses on a business financial performance with reference to revenue or EBITDA, a true up looks at the liquidity of the business at a specified date with reference to one or a combination of:

1. Net working capital;
2. Net debt;
3. The balance sheet.

This shifts the focus onto the actual financial position of the business at the true up date, as opposed to its ongoing financial performance over time. This is beneficial in medical practices where the financial position of the business can be impacted by variables which are unfixed at the completion date such as patient prepayments for services, accrued but unrealised employee entitlements, aged receivables, and other unrealised assets and liabilities.

True ups are generally structured as follows:

1. The parties agree on a target working capital;
2. The actual working capital is calculated after completion as at the agreed date; and
3. A true up payment is made by reference to the difference between the target working capital and the actual working capital.

Similar to earn outs, if the actual working capital exceeds the target, the seller stands to receive an uplift and vice versa.

Seller Risks in Earn Outs and True Ups

An immediate risk to the seller under these mechanisms is where the seller ceases to be involved in the business after the sale and loses visibility over the business’s financials. This can create disputes due to reduction of an the earn out payment or actual working capital, for example by not following how the seller accounted for expenses or liabilities prior to completion. As such, it is common and recommended practice to include the following protections for the seller in determining earn out and true up payments:

1. Agree on a specific accounting methodology which is described in the sale agreement. This removes any ambiguity as to how the payment is to be calculated, noting that an entity’s financial position can vary based on different accounting methodologies.
2. Provide the seller with reasonable visibility over the business financials for the period prior to the payment date so it can verify the figures are being reported;
3. Prescribe an efficient dispute resolution process to deal with situations where the seller disagrees with the buyer’s calculations. Without such a process, a dispute over the earn out could end up in court, meaning delays and costs for everyone involved.

Holdbacks and Retentions

Earn outs and true ups are specifically designed to deal with the business’s finances in periods after the sale completes. Often, a buyer is less concerned with the amount a business stands to make and is more concerned with what it stands to lose because of risks such as negligence claims, key practitioners leaving, compliance issues (such as Medicare compliance) or ATO audits.

To protect against this, a buyer will often seek for the payment of the purchase price to include a holdback amount to be payable in the future if none of these risks manifest. The benefit of this approach is that it is somewhat simpler than an earn out or true up, as it requires minimal accounting. To avoid ambiguity, the key risks that can impact payment of the holdback amount should be clearly articulated in the sale document, so that it is clear what liabilities can and cannot be deducted from the holdback amount. The seller will aim to narrow that scope as much as possible, and the buyer will want it to be broader. However, both parties should seek to avoid ambiguity, as uncertainty can lead to disputes.

Holdbacks and retentions are typically structured as follows:

1. A fixed purchase price will be agreed prior to completion;
2. The buyer pays most, but not all, of the fixed purchase price, and retains the balance as the holdback;
3. The sale agreement specifies a fixed date on which the holdback payment is to be released;
4. On the agreed date:
   1. if none of the agreed risks have manifested, the buyer releases 100% of the holdback amount to the seller.
   2. If any agreed risks have manifested, the buyer is entitled to deduct its losses from the holdback amount prior to releasing it. So, if the holdback amount is $200,000, and the buyer has incurred a financial loss of $80,000 which came from an agreed risk, the buyer would only release $120,000 to the seller.

Vendor Finance

There may also be circumstances in which a buyer wants a post-completion payment of the purchase price simply to help manage its cashflow. For example, if the buyer is intending to fund its acquisition of the medical practice with the profits of that practice.

In such scenarios, it is common for the parties to agree to a non-performance based deferred payment, whereby the buyer pays a fixed purchase price after completion, whether in instalments or in one lump sum. This is typically structured as ‘vendor finance’, meaning the seller is loaning the buyer an amount equal to the purchase price, and the buyer repays that loan after completion.

Like any loan, vendor finance can have interest, security, both, or neither. In an arm’s length transaction, it is common for the vendor finance to be secured, for example over the shares in the company that owns the business, or in the assets of the business itself. This way, if the buyer fails to make payment of the purchase price, the seller is not as exposed as an unsecured creditor.

Looking to Buy or Sell a Medical Practice?

Buyer or selling a medical practice is a complex and risky process. The value of service based businesses that do not have material tangible assets (such as property or stocked products) are inherently more difficult to value than product-based or tangible asset rich businesses, which creates risk for a good-faith buyer. Complex transactions often require a combination of the post-completion payment options outlined above, which can lead to agreements requiring lengthy and complicated provisions to ensure the post completion payment is calculated correctly, and that the parties’ interests are protected.

Nine Dots Legal’s commercial and corporate team specialises in mergers and acquisitions and has extensive expertise in crafting post-completion payment mechanisms when buying or selling businesses of all types. If you want to discuss further, our contact details are below.