Valuation Issues for ASCs 5th Annual Orthopedic, Spine, Neurosurgery and Pain Management Driven ASC Conference June 16, 2007 Presented by: Todd J. Mello, Principal, HealthCare Appraisers, Inc. Todd J. Sorensen, Partner, VMG HEALTH

ASC Valuations Presentation Outline Valuation Framework Factors Affecting Value Valuation Approaches Selection and Application of Appropriate Approaches and Methodologies Valuing Minority Interests Issues Related to Recurring Transactions Other Valuation Issues

Valuation Framework What is the ownership interest being valued? What is the purpose of the valuation? Pending transaction (e.g., a physician buy in/out or a transaction with a hospital or an ASC company) Compliance with federal ASC safe harbors and IRS private inurement issues Shareholder disputes/litigation What is the standard of value? Fair Market Value (“FMV”) Fair Value Investment Value What is the premise of value? Going concern Liquidation Scope Limitations

Valuation Framework

Definition of FMV Internal Revenue Service Revenue Ruling 59-60 “the amount at which property would change hands between a willing seller and a willing buyer when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and when both have reasonable knowledge of the relevant facts.” Stark II “the price an asset would bring as a result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business or compensate the other party”

Valuation Guidance from the IRS Revenue Ruling 59-60 also states that all relevant factors should be considered, including the following: the nature of the business and history of the enterprise from its inception; the overall economic outlook, and the condition and outlook of the specific industry in particular; the book value of the stockholders' equity and the financial condition of the business; the earning capacity of the company; the dividend-paying capacity of the enterprise; sales of the stock and the size of the block to be valued; and the market price of publicly traded stock of corporations in similar industries or lines of business.

Valuation Issues Specific to ASCs Physician ownership makeup or lack thereof is critical Physician risk is the most important risk factor in ASC valuation Value related to distributions (i.e., dividends) as compared to capital appreciation – much higher liquidity built into investment Divestiture typically required upon retirement, relocation, and inactivity – buyout typically formulaic or fair market value Importance of restrictive covenants Numerous regulatory hurdles – anti kickback statutes and potentially private inurement regulations Publicly traded corporations are not generally relevant comparisons Sales of similarly sized blocks of stock often not comparable In valuing entity, important to understand uniqueness of industry

Primary Factors Affecting Value Case volume, mix, and reimbursement Impact of potential change in Medicare Reimbursement Orthopedics +77% Pain Management -20% General Surgery +58% GI -23% Growth in volume and reimbursement Diversification (e.g., # of surgeons, number & type of specialties, payers) Size of physician ownership, appropriate non-competes and ability to attract new investors Nature of payer contracts; is there a substantial portion of “out of network?” Ability to generate sustainable cash flow from operations and on-going distributions Financial leverage, working capital, and on-going capital expenditures Quality and age of facility and equipment Opportunities for expansion (rooms, surgeons) Competent management Barriers to entry (e.g. CON)

Valuation Methodologies Primary Valuation Approaches Asset Based Approach Market Approach Income Approach

Valuation Methodology Selecting the Valuation Approach and Methodology Asset Based Approach PURPOSE: Measures the value of an ASC by identifying and individually valuing the ASC’s tangible and intangible assets and liabilities. Based upon the Principle of Substitution; i.e., the premise that a prudent individual will pay no more for a property than he/she would pay to acquire a substitute property with the same utility. Asset-based approaches are useful when: The ASC has no expected earnings or other attributes of value whereby an “orderly liquidation value” yields the highest valuation; or To establish a “floor” of value when using other valuation methods

Valuation Methodology Selecting the Valuation Approach and Methodology Market Approach PURPOSE: Measures the value of an ASC by evaluating comparable companies and/or transactions in the marketplace. Also based on Principle of Substitution. Market Approach includes: Guideline Publicly Traded Company Method – not applicable here Comparative Transaction Method – depends Market Approach may be more relevant if: Valuing a controlling (as opposed to a minority) interest Truly comparable entities are available

Valuation Methodology Selecting the Valuation Approach and Methodology Income Approach PURPOSE: Measures the value of an ASC by determining the present value of its expected future cash flow stream. Income Approach includes: Capitalization of Earnings Method Discounted Cash Flow Method Income Approaches may be more relevant when: The ASC is generating significant, normalized cash flow from operations to fund ongoing distributions When valuing minority interest in cash flowing centers When the ASC has significant intangible value and when reasonable market comparables are not available

Valuation Methodology Decision Tree ASC Attributes

Valuing Minority Interests Simply stated: Interests providing absolute control (i.e., greater than a 50% interest whereby key aspects of control are not diminished by governing documents or otherwise) are worth more than interests which do not have the same control rights Control granted by the governing documents (examples on next slide) Concept of “effective” control – physicians control with their feet Valuation Guidance: absence of control adjustments in financial projection (preferable approach) or application of minority interest discount (reliance on published studies or other; more difficult to quantify and support) Control premiums are often paid over and above fundamental value Management Agreements Control premiums typically do not exist in ASC equity interests that exhibit high levels of physician risk

Valuing Minority Interests Matters Subject to Control Capital Calls Admission of new investors Borrowings greater than a certain amount Acquisition of equipment greater than a certain amount Selling, assigning or otherwise disposing or encumbering assets Entering into material contracts Selling, liquidating, or merging the entity Changing the core governing documents Typical ASC ownership agreements are very friendly to the minority shareholder Note: Physicians display a certain level of control regardless of ownership interest level

Issues Related to Recurring Transactions Buy ins are subject to greater regulatory scrutiny – anti kickback statutes Use of an independent FMV appraisal achieves the greatest regulatory comfort Consider asking a valuation firm to develop a mechanism to “roll forward” the valuation analysis Typical Multiples of 3.5 to 4.0x Trailing EBITDA Language addressing situations where historical earnings are not likely representative of future performance (Recent loss or addition of physicians, reimbursement changes, CAPEX needs, etc.) Consider engaging the valuation firm to prepare or review the “roll forward” for each transaction

Other Valuation Issues Discounts for lack of liquidity/marketability Developed but not yet operational (value “in place” is greater than equity in underlying fixed/tangible assets?) ASCs at an “inflection” point and importance of projections

Todd J. Mello, MBA, AVA, Principal HealthCare Appraisers, Inc Todd J. Mello, MBA, AVA, Principal HealthCare Appraisers, Inc. 858 Happy Canyon Road, Suite 24C Castle Rock, Colorado 80108 (303) 688-0700 tmello@hcfmv.com Todd J. Sorensen, Partner VMG HEALTH One American Center 3100 West End Avenue, Suite 940 Nashville, Tennessee 37203 (615) 777-7300 todds@vmghealth.com