Working Capital Settlement Woes
Too often, a game of tug of war over working capital ensues in healthcare transactions.
Have you ever wondered:
- Why are working capital settlements so difficult to resolve?
- Why do so many of my clients end up in disputes over working capital?
- Why do buyers think that a working capital settlement is a second chance at due diligence?
- Do working capital settlements affect the value of the deal?
When buyers and sellers agree on a price in a transaction that includes the purchase of working capital, their agreement does not generally represent the end of price negotiations. In addition to finalizing the terms of payment, the parties involved must agree on the specific current assets to be transferred and the current liabilities to be assumed; either may be in flux up to the time of the transaction close. In the healthcare industry, discussions concerning working capital settlement are particularly relevant given the challenges associated with valuing accounts receivable and third-party payer settlement amounts.
Typically, an entity’s net working capital will provide the necessary funds for the ongoing operation of the business. Buyers and sellers may address working capital in one of three basic ways. In the first, the seller retains all working capital and related risks as to its value. In this case, the buyer must fund the purchase price and the cash necessary to establish new working capital, but assumes no risks associated with the value of the seller’s working capital. Second, the buyer can simply buy the entity outright including all working capital assets and liabilities, and assume all related risks. This approach is generally used only in special circumstances, and then only with very good due diligence and perhaps an appropriate discount applied to the purchase price. Third, the buyer and seller may agree to a post-closing settlement of the working capital, limiting the buyer’s risk relating to the value of working capital.
What is a “Working Capital Settlement?”
Typically, at the outset of a deal, a Letter of Intent will establish general expectations as to what will be included in and excluded from the transaction. Prior to closing the deal, the parties must agree on what specifically will be transferred or sold. Ultimately, a settlement will ensue concomitant with any changes in the level of net working capital actually transferred at the time of delivery. Disagreements often arise as to the settlement.
A working capital settlement consists of two key components:
- A working capital definition
- A working capital target
A working capital definition will define the group of current assets and current liabilities that will be exchanged. When defining working capital, it is critically important to keep in mind that a balance sheet account may not be comprised of a homogeneous set of items. For instance, accounts receivable may include expected payments from individual patients, from insurance companies, or from Medicare or Medicaid. Each may have its own payment period, and the proportions of payers will vary from company to company. The buyer should have reasonable expectations from each component of the account.
A working capital target establishes the level of the working capital that the buyer expects to be transferred. Typically, the level of working capital that provides the company with sufficient liquidity to meet current routine short-term operating demands without incurring additional debt is considered in the methodologies used in determining the company’s business enterprise value.
Working Capital Disputes
A working capital settlement provides buyers with an opportunity to adjust the deal consideration for inevitable changes in current assets and current liabilities in the balance sheet from the last date reviewed by the buyer to the transaction closing date. Some changes may be material. For instance, between the time when the buyer and seller agree on a level of value and the final purchase agreement, a company may receive a payment on a large receivable, creating a decrease in the level of accounts receivable and an increase in cash. If the purchase agreement excluded cash but included receivables in the transaction, the seller would keep the cash, while the terms of the purchase agreement would remain unchanged.
The level of dispute surrounding the working capital settlement may be relatively minor; but it can also be extreme. The following factors provide a basis for predicting the level of potential dispute arising from a working capital settlement:
- The relationship of the buyer and seller during the transaction.
- The extent to which the buyer and/or seller understand the working capital settlement process.
- Other unanticipated issues that arise out of the transition.
- Clear definition and mechanics of working capital in the purchase agreement.
- The experience of the third-party advisors (accountants) managing the process for each party, as well as the level of preparation for the working capital settlement during the period from due diligence through closing.
A few specific working capital issues arising from common working capital assets and liabilities include the following:
- Accounts receivable. Accounts receivable is usually the largest of the working capital assets and the most subjective in valuation.
- Buyers may want to have some period of collection activity to allow for greater accuracy. Alternatively, the parties may agree to a methodology for valuing accounts receivable. In this case, special attention should be given during due diligence.
- Receivables are also affected by closing date cutoff issues. For example, in hospitals, the proration of in-house patients must be considered. In other words, how the value of an inpatient stay that straddles the closing date will be allocated between the buyer and the seller.
- Credit balances in accounts receivable that are excessive in amount or age may present a compliance issue and/or an issue with state escheat laws. Although some degree of credit balances is part of the ongoing day-to-day business, any beyond a reasonable and typical amount should likely remain the responsibility of the seller. – Authors’ note: In one case in which we were involved, over half of ‘old’ credit balances were related to erroneously posted adjustments.
- The current portion of debt. Generally, working capital should be defined as being exclusive of current debt liabilities. When the price of the stock is addressed in the agreement rather than the company’s enterprise value (e.g. the value to both equity and debt holders), and the definition of working capital does not address the treatment of the current portion of debt, the refinancing by the seller before the settlement date of a current debt to long-term debt effectively increases the value of the working capital settlement (where the buyer would receive no adjustment for the now long-term debt).
- Capital leases. At times, a capital lease may be discovered after closing, although the issue of such leases had not been addressed in the working capital definition. The buyer may claim a reduction in working capital based on the current portion of the capital lease.
Working Capital and Valuation
In certain transactions, working capital may be excluded from the purchase. One example where this is common is in the acquisition of physician practices, which typically follow a modified-cash basis of accounting in which accounts receivable and payable are not recorded on the historical balance sheet. Depending on which of the three commonly accepted approaches to valuation (income, market and asset) is used to determine fair market value (FMV), some adjustment may be necessary to accommodate the exclusion of net working capital from the transaction.
Under the income approach, the value determined by use of the capitalization of earnings method generally includes all operating assets, whether tangible or intangible. If net working capital or specified working capital components are to be excluded from the transaction, an adjustment to the value determined under this method will likely be required in order to determine the FMV of the acquired assets. If accounts receivable are excluded from the sale, one way to determine the adjustment would be to use a “days revenues outstanding” approach derived from industry averages rather than using actual accounts receivable reported by the target of the transaction. A typical accounts payable adjustment can generally be estimated based on the monthly average of expenses paid through the accounts payable process, such as medical supply expenses. The discounted cash flow method under the income approach can be used to model the effects of excluded net working capital assets on the cash flows of the initial months after the acquisition. When this method is used, the value determined by summing the modeled discounted cash flows excludes the appropriate working capital assets and liabilities.
Likewise, under the market approach, some adjustment may be necessary to include or exclude net working capital. The methods under the market approach generally involve the application of “guideline” multiples, whether derived from publicly-held companies or transacted companies, to the target company’s fundamentals. Crucial to the appropriate application of these methods is an understanding of the source of the multiples. Guideline public company multiples generally include working capital assets. For guideline transactions, it is of the utmost importance to understand whether the reported “price” used to calculate the multiples includes working capital assets or not.
Conversely, under the asset approach to valuation, adjustments to exclude working capital may not be necessary since physician practices and other healthcare entities utilize a modified-cash basis of accounting in which excluded working capital assets are not presented on the historical balance sheet.
Limiting the Potential for Working Capital Disputes
There is certainly no guarantee that parties will ever agree, particularly if the implementation of the transaction goes poorly or one party sees the settlement as another opportunity to negotiate the purchase price. Collaborative efforts can reduce the risk, or at least minimize the level, of a post-closing dispute before the transaction closes:
- Consider the effects of including/excluding cash. Working capital settlements where cash is retained by the seller are more often disputed than those where cash is transferred to the buyer. Neither arrangement is necessarily preferred; but it is worth considering that the absence of cash is the absence of a potential offset to changes in other current assets and current liabilities. Cash typically moves conversely to changes in accounts receivable.
- Avoid surprises with thorough due diligence. Good due diligence should uncover many of the otherwise post-closing surprises in working capital. The target’s quality of earnings is enhanced by good payable accruals and accounts receivable valuation. Working capital settlements are not meant to be a second bite at due diligence, and good due diligence can prevent the unexpected discoveries that may lead to further inquisition.
- Choose methodology and processes wisely. Some working capital settlements seek to use existing processes, formulas and methodologies, particularly in the area of accounts receivable. This can work to expedite the settlement and avoid long debates over the ultimate value of accounts receivable. However, in agreeing to such a process, it is incumbent on the buyer to test and become comfortable during due diligence that the methodology produces a fair value on a consistent basis, accounting for variation in volumes and payer mix.
- Draft the purchase agreement carefully. Careful drafting of the settlement process and definitions can limit any latitude for dispute. Following are a few ideas to consider in the drafting of the purchase agreement:
- Be careful to address excluded assets and liabilities. Specifically, it is a good idea to exclude all debt, including capital leases. However, if assumed as part of the purchase price, exclude all current portions of debt and capital leases from working capital.
- Carefully consider the use of terms such as “consistently applied” and “applied consistently” relating to estimates or methodologies; there is some debate in instances where the methodology being applied consistently is consistently wrong.
- Including a provision that working capital amounts be determined under Generally Accepted Accounting Principles (GAAP) is typically a good idea; but be aware of the potential for GAAP deficiencies in the unaudited financial statement information provided during and post due diligence but before the deal closes.
- Be specific as to the manner of settlement, including the use of a third party. If there is an unrelated problem arising from the transaction, it should be addressed under specified terms of the agreement and not as an item to be added to or subtracted from working capital. Parties should agree to a reasonable period of review and consider naming an independent third-party accounting firm to review any disputed items in the purchase agreement.
- Model the settlement during due diligence. Accurate modeling of the settlement before closing can be particularly effective. The process of modeling the working capital settlement during due diligence provides the buyer with an in-depth understanding of the working capital that will be received in the transaction, as well as addresses areas of dispute prior to closing. Benefits from this process may include:
- An opportunity to flesh out each of the individual accounts comprising the included working capital assets and liabilities. This process provides knowledge of the composition of the smaller accounts that comprise working capital, particularly assets or liabilities involving physicians or other referral sources.
- Providing each party with the opportunity to look at the measurement of various accounts.
- The identification of any underlying accounting errors. If working capital is misstated due to underlying accounting errors, it is likely that reported earnings are also wrong. Identification of earnings adjustments may result in an overall adjustment to the purchase price.
- Identification of and formulation of a plan to address the values of transactions that straddle the closing date, e.g. utility bills, inpatients, etc.
- An understanding of any underlying contracts with nonstandard payment terms or springing liabilities, such as collection guarantees, rebates, leases with common area maintenance settlements and end-of-contract settlements.
- Consideration of any employment agreements with nonstandard payment terms or springing liabilities, such as retention bonuses or historical performance bonuses, that need to be handled by the seller but may be recorded within working capital on the historical balance sheet.
- Although typically retained by the seller, any third-party liabilities related to Medicare cost reports or audits require special attention by the buyer before closing to understand the magnitude of risk and impact on earnings and the purchase price.
We Can Help!
At Elliott Davis Decosimo, our dedicated healthcare advisory group has extensive experience in assisting buyers, sellers and their legal counsel with all aspects of a transaction.
In the words of Albert Einstein, “The only source of knowledge is experience.”
Our experience has shown that performing thorough due diligence on the individual components of working capital balances and the related accounting processes helps to ensure a smoother working capital settlement. An accurate valuation, including a cash flow model consistent with the transaction terms regarding inclusion and exclusion of specific working capital assets and liabilities, ensures a purchase price reflective of the buyer’s requirements and expectations and reduces the potential for post-closing disputes and adjustments. Of course, maintaining a good working relationship and communication between the parties throughout the process and ultimate settlement is key to achieving the shared goals of the parties: a satisfied seller, a successful buyer and an undisputed, closed deal.
Contact an experienced healthcare advisor in confidence at 800.782.8382 or visit elliottdavis.com/industries/healthcare.