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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. 4 AHLA Health Care Transactions Resource Guide
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. healthlawyers.org 5
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Page 3: Minimizing Working Capital Disputes

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