December 2002 Bulletin

Capitalizing and financing an ASC

By Michael J. McCaslin, CPA

This is the second of a three-part series on Ambulatory Surgery Centers (ASC). This article addresses the capitalization and financing of an ASC for orthopaedic surgeons. Part III will address the team of individuals needed to bring your ASC to fruition.

An ambulatory surgery center (ASC) may have a number of capital-intensive elements that will require a combination of cash contributions from the owners with the balance of funds coming from other forms of financing. The capital-intensive elements for a surgery center could include the following:

  1. Property and plant, that will house the ASC operation.
  2. Medical equipment, furniture and business office equipment that will be an integral part of the ASC operations.
  3. Working capital line of credit for the start-up operating expenses that will be incurred before cash is collected for the ASC operations.
  4. Property and plant that may house a medical office building constructed on the same campus where the ASC is built.
  5. Working capital line of credit for the ongoing operations of the entity.

Legal entity structure

In many ASC projects there are multiple legal entities involved. This segregates the distinct businesses that exist. The two primary businesses which are segregated are the ASC operations and the real estate which houses the ASC operations and, in some instances, a medical office building.

The first entity established is a Limited Liability Company (LLC) or Limited Liability Partnership (LLP), which will own all of the real estate necessary for the ASC operations, and, in some instances, the physician offices that are part of a medical office building complex. This entity is set up separate from the ASC because the investors in the real estate may not be the same as the investors in the ASC. The second entity established is an LLC (or LLP or a Subchapter S-Corporation), which will manage the operations of the ASC. Such operations will include the operating rooms and billing and collections related to the use of those operating rooms, staff, medical equipment, furniture and business equipment and medical supplies. We will address the capital financing requirements in accordance with this entity structure.

Start-up cash

The success of the entire project (including the various real estate elements) is tied completely to the success of the ASC. Therefore, our firm believes a significant financial commitment from each physician investor is essential to the success of the ASC. We believe the more cash the physician has invested in the ASC, the more seriously he or she will take the investment and the related obligations to make the center a success. This obligation typically includes a substantial change in behavior related to the historical time (day of the week and hours for each day) and location for performing outpatient surgery procedures. As a starting point, our firm prefers to have a minimum cash investment of $50,000 per physician. (Some projects target the physician cash contribution as a percentage of estimated annual collections, i.e. 10 percent of collections). While projects have been completed where the physician’s cash investment has been less than this, our firm’s experience over time has proven that this is the minimum level necessary for the physician to understand that this is more than a passive investment.

Please note: In this article the term "passive" is not being utilized in the same framework that the Internal Revenue Service utilizes this term for real estate investments. Please also note this is a minimum cash investment desired for the ASC operating entity. In most situations, there will be guarantees (limited) for the equipment loans, working capital line of credit, and leases (equipment and building lease).

Furniture, fixtures, medical and office equipment

The furniture, fixtures, medical equipment and office equipment will typically be owned by the ASC operating entity. There are a number of options available for financing these assets. The two most predominant options are bank financing and bank or equipment vendor leasing. The ultimate decision between bank financing vs. leasing comes down to the interest rate under each option.

Leasing is essentially another term for a loan. There are some differences from a tax perspective as it relates to the depreciation and interest expense when compared to the lease expense, but over the life of a loan or lease, these tax deductions end up being identical except for the difference between the interest rate on the loan vs. the interest rate built into the lease payment.

For both bank financing and lease financing, there are deals available that will finance 100 percent of your needs. The used equipment market is an alternative that needs to be explored because there are excellent values available, especially in relation to the cost of brand new equipment.

Start-up operations

The ASC will need a line of credit to finance the start-up operations. The maximum line of credit that will be needed should be determined during your financial feasibility modeling. It will take a minimum of 90 to 120 days before the cash starts being collected from the payers. This assumes you have obtained your state license and Medicare certification and have secured sufficient payer contracts.

While no cash–or very little cash–is being collected in the first 90 to 120 days, you still have to pay your staff, supply vendors and other organizations doing business with your facility. Even when the cash starts being collected, you will likely just start covering weekly and monthly operating expenses; it will take some longer period of time before you begin collecting cash in excess of your monthly obligations to enable you to begin repaying your line of credit. It could be between nine (9) and fifteen (15) months before the line of credit begins to be repaid.

In addition to the timing issues with respect to the receipt of cash and the need to pay operating expenses, the cash flow problem can be compounded by a slower ramp-up of surgical cases being performed at the ASC than projected or promised by the physicians. This typically occurs when the ASC owners believe all of the other physicians are going to be performing their cases at the ASC, so they do not need to be as concerned with utilizing the center themselves.

While our firm strongly recommends a conservative estimate for the ramp-up in case volumes, even this conservative estimate runs the risk of not being met. Because of these two items, you will clearly need a line of credit in place.

Real estate entities

The most capital intense component of an ASC project is the real estate. Similar to the ASC entity, there are a number of sources available for capitalizing and financing the real estate needed to house a surgery center and physicians’ medical office space (if applicable). The first consideration is whether the physicians want to own the real estate completely on their own, or invite a joint venture party to the table, or have no ownership and invite someone to own the real estate completely.

In each marketplace there are typically real estate developers who would have a high degree of interest in joint ownership or complete ownership of the medical office building, and there are a significant number of health care real estate investment trusts that may also have an interest. Your local hospital may also be a source for joint venture ownership or complete ownership of the real estate.

If the physicians choose to own the property on their own, this will usually require a 20 to 25 percent equity/cash contribution from the physicians with a bank (or other source) financing the balance. (Please note that as part of your feasibility study you should address the importance of location and its impact on the success of the ASC). Personal guarantees may be required and in the event you are able to negotiate away the personal guarantees, the tenants of the building (including your ASC operating entity and possibly your medical practice) may be required to execute lease guarantees whereby these entities guarantee their lease payment for the entire term of the lease.

With lease guarantees, the length of each lease could end up longer than otherwise without the lease guarantees (i.e., 15-year lease if lease guarantees are required versus a 5-year lease term with joint renewal options and without a lease guarantee). The lease guarantee is usually preferable to a personal guarantee. These guarantees are typically issued when developers and real estate investment trusts are involved in the construction and ownership of the facility without the physicians as owners.

Working capital requirement

Once the ASC is profitable and has repaid its initial start-up working capital line of credit, the needs of the organization from a financing perspective will shift to funding unexpected fluctuations in cash flow.

In most situations, a working capital line of credit is maintained that allows the ASC to draw funds on an "as needed" basis. Events that trigger a draw include the purchase of new equipment, prepaying vendor invoices to obtain purchase discounts, quarterly distributions to the owners and instances where expenses exceed collections in a given month (impact of vacation for the physicians, delay in payment from payers, etc.).

Personal guarantees

In an environment in which a personal guarantee is required, careful attention needs to be paid to the organization documents to ensure that each of the member/owners has appropriate indemnification provisions as to the obligations to each other. That way, if a guarantee is ever called, all of the parties are only liable for their proportionate share rather than liable for the other members’ share.

In most situations, guarantees can be limited to a multiple of one’s percentage of ownership. In other words, a physician who owns 5 percent of the ASC may be required to guarantee 10 percent of the debt. Ultimately, it will be up to the physicians to ensure these limited guarantees are crafted correctly in order to limit exposure for the owners.

Summary

An ASC and its related medical office building and real estate components can be an exciting and profitable venture for physicians and their joint venture partners. There will be a cash requirement on behalf of the physician owners, which is a necessity in order to ensure commitment to the project. When the physicians have a significant investment, they focus on the success of the project.

As it relates to financing, there are many opportunities available to ensure that your project can become a reality. The financial markets have gotten tighter in the last 12 months as the economy has slowed and loan defaults have increased across many business industries. This simply forces you to be better prepared when obtaining financing (feasibility study, financial forecast, physicians financial commitments, etc.). The ultimate deal you are able to negotiate will be driven by the cash contributed to the project, the viability of the project as defined in the financial projections, the lease guarantees and the personal guarantees provided.

Michael J. McCaslin, CPA, is director, Health Care Group Services at Somerset Financial Services Health Care Group in Indianapolis, Ind. He can be reached at (800) 469-7206 or MmcCaslin@somr.com.


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