Practice valuations are almost never commissioned in calm weather. The forcing events are known in the trade as the four Ds—disability, death, divorce, and divestiture—and every one of them arrives with emotion attached. That timing is the whole problem. A formula written while a retirement announcement sits on the table is not a formula. It is a position, and everyone in the room knows which side it favors.
Hence the craft’s first principle, and the rule PMI hands every partnership: set the valuation formula before the stressful event. The reasoning has a distinguished pedigree. The philosopher John Rawls asked what rules people would choose for a society if they had to choose from behind a veil of ignorance, an imagined position in which nobody yet knows what place they will hold (A Theory of Justice, 1971). Rules chosen in that state are fair by construction, because a person who might occupy any seat designs a table that is safe to sit at anywhere. A partnership cannot make its members forget who they are, but it can recreate the veil by timing. A formula adopted while every partner might be the next buyer or the next seller protects both sides, because nobody yet knows which side will be theirs.
One term of art belongs on the table before any arithmetic. The standard of value asks: value to whom, under what assumptions. The default in transactions and tax matters is fair market value, which Internal Revenue Service Revenue Ruling 59-60 defines as “the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” The standard is jurisdiction- and purpose-dependent, and nowhere more consequentially than in divorce, where courts apply fair market value in some states, fair value in others, and value-to-the-owner hybrids in a few. One practice can therefore carry several different correct values depending on the forum. That divergence belongs to the owner’s counsel, not to a partnership retreat.
Three approaches exist—income, market, and asset—and for a pediatric practice the income approach governs. The market approach fails for lack of comparables: no two practices are similar enough in Medicaid mix, payer contracts, panel shape, or vaccine program to establish a price by observation. The asset approach prices the furniture. What a buyer of equity is actually buying is earnings, and the method built for practices of this size isolates them: total owner earnings, less the compensation the market would pay a physician to do that clinical work, leaves the ownership premium—the part attributable to owning rather than to practicing. That premium, times a multiple that for internal transitions conventionally runs 0.75 to 1.5, is the earnings value. Net tangible assets are added on top: cash, less liabilities, plus vaccine inventory, plus equipment at conservative salvage, plus collectible receivables.
Outside buyers speak a different language, and owners should be able to speak it too. Private equity and consolidators price earnings before interest, taxes, depreciation, and amortization, times a multiple. Two traps travel with that formula. The first is adjusted EBITDA: a consolidator commonly layers a post-close management fee onto the acquired practice, so the multiple quoted is computed on earnings after a charge the seller has never borne. Compute the figure and the true multiple both ways. The second trap is the units. A hospital’s asset-price offer, a private-equity firm’s scraped-EBITDA multiple, and an internal partner’s ownership-premium formula are three fractions computed on three different denominators. A multiple of what matters more than the multiple.
Now the discipline that separates a defensible valuation from a flattering one. Normalization of the earnings side runs on the most recent trailing 12 months, not a multi-year average. The averaging habit—two or three years of shareholder compensation smoothed into one figure—feels conservative and predicts worse. It dilutes the estimate with a roster, a payer mix, and a cost structure that no longer exist, and the buyer inherits none of them. Every valuation is a photograph of the trailing 12 months, and the earnings base should be the same photograph. Prior years are a reasonableness check, never the base. When the trailing window carries a one-time distortion, strip the distortion as a normalization adjustment rather than reaching for an average.
From that base, the adjustment list is standard and should be written into the agreement so nobody argues about it later. Restate owner compensation at fair-market employed rates, which is the largest single adjustment in almost every pediatric valuation. Strip one-time monies such as incentive-program payments and grants. Restore below-market salaries taken to fund a project. Unwind compensation-formula artifacts. Normalize related-party rent where an owner owns the building. Convert cash-basis statements to accrual. And charge replacement compensation where a high-producing physician is on the way out, because a founder producing an outsized share of revenue at a below-market salary flatters earnings exactly until the model replaces her at market rates.
Goodwill causes more argument than any other word in the subject, and the argument dissolves once its two species are separated. Enterprise goodwill belongs to the entity: the systems, the brand, the workforce, the contracts, and the panel relationships that survive any individual’s departure. Personal goodwill belongs to the physician: the reputation and relationships that follow her out the door. The diagnostic question is operational rather than philosophical—how much of the practice’s value would be lost if the physicians competed, or were able to compete? That is why covenant scope is a valuation input at all, and why the same practice prices differently in a state that enforces physician non-competes than in one that voids them. Formal allocation is stepwise: value the entity with covenants in place, allocate to working capital, fixed assets, and identifiable intangibles, and treat goodwill as the residual. Goodwill is never added on top of an income-based value, because the earnings already embody the reputation. The tax consequences of the split are real—personal goodwill and covenant payments are taxed differently—and they belong to counsel and the practice’s accountant, together, before a transaction closes.
The maintenance system is what keeps all of it usable. Rerun the formula every year with fresh numbers and have every partner sign the result, so the value is ratified rather than asserted. Tie transactions during the year to the value determined from the prior December 31 financials, which removes any advantage in timing an announcement. Borrow the shareholder-agreement convention that if the partners cannot agree on a new value, the prior value stays in force—a quiet but powerful incentive to keep the exercise current. Require an independent third-party appraisal on a stated cycle, and on any buyout above a threshold or in any dispute. Review the formula itself at every admission, because a clause drafted for a $600,000 practice will be governing a $3 million one within a career. Match the purchase to the purpose as well: a full workup runs roughly $2,700 to $10,000, while the annual update needs a spreadsheet rather than an appraisal. Have it prepared by a qualified outside party rather than by the practice administrator. The companion textbook, Pediatric Practice Management: The Fundamentals, works the ownership-premium method end to end.
Red flags. No valuation formula in the agreement at all. Goodwill treated one way by the buyer and another by the seller inside the same transaction. No independent appraisal requirement above a stated threshold. And a methodology that prices admissions one way and exits another, which is not a valuation policy but a transfer scheme waiting to be discovered.
A valuation formula adopted while it still describes nobody is worth more than the best attorney arguing about it afterward.
The income approach governs, because the market approach fails for lack of comparables and the asset approach prices the furniture. Total owner earnings, less the compensation the market would pay a physician for that clinical work, leaves the ownership premium; that premium times a multiple conventionally running 0.75 to 1.5 gives earnings value, with net tangible assets added.
Enterprise goodwill belongs to the entity: the systems, brand, workforce, contracts, and panel relationships that survive any individual's departure. Personal goodwill belongs to the physician, being the reputation and relationships that follow her out the door. The diagnostic question is how much value would be lost if the physicians competed, which is why covenant scope is a valuation input.
Annually. The formula is rerun with fresh numbers and signed by every partner, so the value is ratified rather than asserted, and transactions during the year tie to the value determined from the prior December 31 financials. A full workup runs roughly $2,700 to $10,000, while the annual update needs a spreadsheet rather than an appraisal.
The Partnership Agreement Analyzer scores an existing agreement against the framework this series is built on — or schedule a discovery call to work through it with PMI. The full framework, with the arithmetic, lives in the textbook Pediatric Practice Management: The Fundamentals.