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HEALTH CARE
TRANSACTIONS
RESOURCE GUIDE
SPONSORS
Decosimo
HORNE LLP
Huron Business Advisory
Lancaster Pollard
Pershing Yoakley & Associates
Stroudwater Associates
Towers Watson
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2 AHLA Health Care Transactions Resource Guide

Minimizing Working Capital Disputes
in Health Care Deals
Ken Conner, CPA, Principal, Decosimo
kenconner@decosimo.com
Cole Powell, CPA, CGMA, FHFMA, Principal, Decosimo
colepowell@decosimo.com
Shannon Farr, CPA, ABV, CFF, Director of Valuation Services, Decosimo
shannonfarr@decosimo.com
Working Capital Settlement Woes
Too often, a game of tug of war over working capital ensues in
health care 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 health care 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. Even in stock transactions, there are provisions
for minimum working capital and special handling of various
assets and liabilities. 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 ensure 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. Payment periods, the
expected amounts and the efficiency of the revenue cycle will
vary from company to company. The buyer should have reasonable
expectations from each component of the account. There
should be an expectation that the accounts accurately reflect
value and obligations.
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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 large payments
on patient receivables, 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
disagreement 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 quality of due diligence.
❯❯ 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, it is important to address 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 credit balance
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. However, the addition of a capital lease would
generally be offset by a corresponding increase in
earnings before interest, taxes, depreciation and amortization
(EBITDA) as a result of removing operating
lease payments from expenses.
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. Physician practices 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.
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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 publiclyheld
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 health care 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 and accounts payable.
❯❯ 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.
–If parties agree to a valuation intended to allow
for an actual number, make sure there is sufficient
time to determine value, typically 90 to 120 days.
❯❯ 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 debt is
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 will be
debate in instances where the methodology being
applied “consistently” is consistently wrong.
–Including a provision that working capital
amounts should 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.
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–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. The
single most effective way to minimize disputes
is to model the working capital settlement on a
monthly basis leading up to the closing. 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. Likewise, in an age of RACs, MICs and
ZPICs, accounts receivable can remain in play for
a long period of time.
We Can Help
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. u
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