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Capitalizing the Physician Organization
Capitalizing the Physician Organization

Richard Krohn
In previous installments in this series, the focus of discussion has centered on the strategic and regulatory aspects of network creation. It is at this early stage of organizational development that the planning team must also establish the financial underpinnings of the new entity. For purposes of context and continuity, the physician network is being referenced as a representative physician organization - although the following capital issues are relevant to physician organizations of every description.

Following completion of the strategy and legal formation phases of network creation, which largely define the framework and initial budgetary requirements of the organization, the network's founders must turn their attention to the funding of network startup and early operations. The development process can be an extensive one, and it should be anticipated that a substantial capital infusion will be necessary to support this phase of organizational development, in the absence of an early and significant revenue stream. The capital requirements of the network will vary according to network size, geographic scope, operational characteristics, and revenue growth, and can range from several hundred thousand dollars to several millions of dollars. At least nominally, the network will need to fund, prior to operations, development of network infrastructure including information and management systems, staffing, space and equipment leasing, marketing, and product development.

Internal Sources of Capital

From the organizational control and growth perspectives, it may be preferable to restrict capital funding of network development and startup to internal sources. As a startup with few assets, the network may be confined to four primary sources of internal capital:

member equity;
membership or capitalization fees;
line of credit or loan; and
usage fees.

Member Equity

Particularly in for profit network ventures such as equity models and allied practice management companies, physicians may be attracted to the investment potential of a rapid growth venture. Founding physicians may be offered an incentive to invest early (in the hope of capturing maximum share growth) in the form of a share discount limited to a specific number of shares, often referred to as "founders capital". Equity distribution can be structured in such a way that physician majority ownership is secure during successive rounds of capitalization. For instance, multiple classes of stock can be authorized and issued, with unique rights attached to each class.

Membership Fees

There are two typical types of membership fee: an initial entry fee; and annual dues. The sufficiency of this approach is a function of several criteria. First, can the capital goals of the network be reasonably met within the financial limitations of fees derived from a finite pool of members? Second, are there substitute organizations in the market that place competitive limits on the maximum fee that can be charged? Third, can the network demonstrate value in return for the membership fee (particularly if it has no track record)? Fourth, will founding members be offered a discount? Finally, will primary care and specialty physicians be charged the same or separate fees (in order to attract primaries or manage the physician mix of the network)?

Line of Credit or Loan

The network may be able to secure a private loan from its' members or from an alliance partner. Loans of this type are subject to close legal scrutiny, particularly if they occur between for profit and non profit entities. For joint ventures such as a PHO, the hospital may extend a line of credit to fund startup and initial operations.

Usage Fees

Once a revenue stream has been established, the network may capitalize further growth by assessing a fee (basically a tax) on existing contracts. Usually within the 1-5% of gross revenue range, the usage fee is equitable to members in that those physicians who derive the greatest benefit from their network relationship contribute the most to the continued solvency of the organization. (1)

External Sources of Capital

There are two main sources of external capital - debt and equity. To gain access to these markets the network must be able to demonstrate a compelling economic opportunity for the potential investor - according to the same eligibility criteria that determines investment in any new business venture. The Network Business Plan is the tool that validates the concept and outlines a blueprint for network success. The Business Plan reveals the network's market strategy, its' value proposition, its' products and services, it's infrastructure requirements, and its' growth projections. The Business Plan tells the networks' story and allows potential investors (as well as potential members) to make informed choices about the economic value of the enterprise.

Commercial Debt

As a startup, the network may choose to fund itself through the acquisition of a commercial business loan. For physician organizations, this is basically a commercial finance transaction, and will require some type of collateralization from the network. If not economically integrated, the network has little leverage to close the loan with internal resources, and so often physicians are compelled to personally collateralize the loan, by pledging personal assets. The advantage of commercial debt lies in the retention of organizational control and equity value, but the network must assume the additional debt service associated with the loan, at a time when it is attempting to achieve sustained profitability.

Equity Investment

With limited internal resources, networks often establish an equity alliance among providers, or create a strategic alliance with an equity partner, such as a health system, or acquire investor capital. The advantage of this approach is that it is a relatively inexpensive way to infuse the organization with substantial financial resources. However, this capital most often comes at a price - control. In exchange for capital, the equity partner(s) are usually granted representation in the governing body of the network, and retain voting rights that impact the strategic and operational development of the organization. The equity partner also participates in the appreciation in the network's worth, which of course dilutes the equity stake of the founding (physician) members. Finally, it must be remembered that the capital partner has its own agenda - which may or may not be consistent with the values and mission of the network. The capital partnership decision is a formidable one, and should be conducted with an appreciation of its near and long term consequences.

Use of Funds

The expected use of initial network funds is a fundamental part of the capitalization equation. At the very least, the network should anticipate some up-front expense related to strategy development and network startup. In more advanced networks, capital may be required to acquire practices. Generally, the early operations of the network must also be funded from seed capital. Typically, the greatest share of such funding is earmarked for network management salaries and information systems development. The network must staff some embryonic management team in order to gain contracts and establish basic infrastructure. Information systems are the platform for a whole range of range of network activities - from contract management, to clinical integration, to practice management services. Nominally, the network should plan on staffing an Executive Directorship and Medical Directorship. In some cases these functions may be purchased on a part time or gratis basis - but as the network matures they must evolve into full time dedicated staff. Additionally, mid level staff such as a contract specialist, information systems manager, claims processor, and clerical assistance may also be appropriate. The optimal composition of the network staff, particularly in the early days of network operations, is one, which makes the best use of lean resources. The management team is of critical importance in selling the network to potential alliance partners and investors. The network's success is in no small way judged by potential investors to be a function of the competencies and experience of the top management.

Additional capital should be appropriated to fund network operations during the startup phase. Expenses will include rent and utilities, telephones, marketing, professional services, and typical general and administrative expenses.

Determining Capital Requirements

As part of the Business Planning process, the revenue and expense assumptions are catalogued and loaded into a multi year financial projection which details the network's break-even point (the point at which the network achieves profitability on a cash basis) and the capital required to reach break even. The capital request is sum of money required to achieve (or exceed) break even, at which point the network becomes self-supporting. This equation becomes the basis of discussion for capital funding of the enterprise.

What are the relative costs of building alternative physician organizations? Clearly, the size, composition, and growth plan of the network will impact the initial cash requirements.

Obviously, at these prices the founding physicians will want to carefully consider the implications of each strategic option. What are the culture and values of the physician network, and can these be honored in an alliance with outside investors? How does the capital strategy support network goals such as market dominance or service integration? What is the tolerance of the physician members to investor risk? What are the costs of surrendering control and asset appreciation early in the life of the organization? These issues must be reconciled before a capital funding solution is chosen.

Accessing Capital for Sustained Growth

As the network matures and develops a record of competent management and revenue generation, it will be faced with recurring needs to fund additional growth. Often, the network may reach a plateau in which it cannot grow sales further through internal resources, and must look to the capital markets to access additional capital. These capital sources range from a private placement by a single or group of investors to venture capital and a public offering, in which the network "goes public" by offering shares to the general public. Minority investment has been successfully employed as a strategy to boost physician value in the organization, create a solid equity base in the organization, and create high visibility for the organization. For organizations with revenues in the range of $10-100 million, there is access to the market of mezzanine capital from venture capitalists and private placements. Well-established organizations with revenues above $50 million may complete a public offering of stock. However, in response to the collapse of the PPMC market in 1997-1998, activity in this area has been much subdued. There are costs to consider in pursuing these types of external capital. Obviously, investors have a single agenda - to make a profit, which may be incompatible with the core values of the network. Dilution of ownership of the organization may compromise the vision and mission of the network, in that non physicians gain a voice in strategic and operational decision making. In considering public financing, as well as any external investment, the physician leadership must carefully weigh the potential benefits against the potential threats to the mission of the network.

The fundamental math that must work in the capital equation is this: the network must remain faithful to its' mission, provide value to its' membership and customers, and remain economically viable while providing an acceptable return on investment to its' investors, whether they are founding physicians or outside capital partners.

Richard Krohn is a member and contributor of HealthBond. View his expert page on HealthBond.

Richard Krohn is President of HealthSense. Krohn is a widely-published managed care expert as well as a dynamic speaker providing in-depth, practical and timely information on topics such as managed care contracting, strategic positioning for provider organizations, building new provider alliances, reengineering practice operations, developing market driven products, and creating equitable physician compensation plans.

1. Straley, Peter, Funding and Budgeting Issues, Developing a Successful Physician?Hospital Organization, American Hospital Association Publishing, 1995, pp. 86-88.

October 5, 2000

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