Leaving Working Capital After Leaving Your Business
During a healthcare M&A transaction many promises and negotiations are made in order to make the overall deal a success for both the buyer and the seller involved in the transaction. Usually in a healthcare transaction, the historic financials of the business are viewed as one of the most important pieces of the puzzle. However, what happens to the business after the transaction is an issue that needs to be considered during the initial negotiations of the deal. A company needs so much in capital in order to function at a base level on a year to year basis. It would only be obvious that the buyer and seller want the business to operate a high level with an abundance of capital at hand should the business’ lifecycle throw any unexpected curve balls to the new owner.
In steps the question of how much capital should be left in the participating business in the transaction after the original owner walks away. The Ambulatory M&A Advisor takes a look at how an owner can determine the proper amount of working capital to be left, if it should be left, and how these types of decisions can have an impact on the valuation and selling price of the business as a whole.
Rick Jenson, Managing Director with CBIZ Valuation Group says in all honesty, there really is no “proper” amount of capital to leave in business for the new owner.
“By that I mean that this is usually simply part of the negotiations. If the new owner wants to include working capital as part of the purchase price, that can be done. Typically, a targeted number of working capital is established, to which the actual working capital at closing will be compared. The purchase price is then adjusted upward or downward depending on any excess or shortfall to the target,” Jenson says.
“Conversely, the working capital can be retained by the seller, theoretically reducing the purchase price with the buyers replacing the working capital to a level he/she believes is appropriate for the business via a cash injection. The latter is usually reserved for relatively small deals with fairly simple business models (such as personal services, etc.)”
Mark Dietrich, CPA, ABV says that typically, in a small business or medical practice, the parties are not transferring working capital.
“However, if you use the Discounted Cash Flow or Capitalization of Cashflows model to determine what the value is, definitionally, the result is the market value of invested capital on the right hand side of the balance sheet or long-term debt plus equity,” Dietrich says.
“On the left hand assets side, it is net working capital plus fixed assets plus intangible assets. The value of this formula is if the buyer is not buying working capital, then you need to subtract the value of working capital from the valuation. Assume instead you are looking at a larger transaction like an ASC, where a buyer is buying 51 percent of the equity. With an equity transaction like that, the working capital is going to transfer by definition because they are not buying assets they are buying equity.”
Jarrod Barraza, Senior Associate, HealthCare Appraisers Inc. says that when determining the amount of working capital to be left in a business, owners need to remember that working capital can either be included or excluded in a transaction setting.
“If the purchaser has access to more efficient sources of working capital, the transaction may be structured to exclude working capital, generally lowering the transaction price. The purchaser would then inject required working capital into the business upon closing,” Barraza says.
In addition, Barraza says if working capital is included in a transaction, a normalized level agreed upon by both parties is most proper. The optimal amount of working capital depends on industry and historical, operational characteristics of the entity being purchased.
For example, entities with long collection cycles and/or high inventory and supply requirements may need higher levels of working capital to maintain operations, he says.
Barraza says that owners need to keep in mind that there is no obligation to leave money in the business and, in fact, some purchasers stipulate that working capital be excluded from a transaction.
“If the purchaser has a more efficient means of managing working capital resources,this may be one of the sources of value a purchaser identifies during initial due diligence. Each transaction is different, and working capital is another point of negotiation during the process,” Barraza says.
As far as the seller being obligated to leave working capital for the new owner of the business, Jenson says most deals include working capital for ease of transition and management. However, depending upon the nature of the business and the negotiations, it is possible to start fresh via a cash injection.
Stephen Diagostino, CPA with Somerset CPAs says that when looking at a larger transaction like an ASC, where a buyer is buying 51 percent of the equity. With an equity transaction like that, the working capital is going to transfer by definition because they are not buying assets they are buying equity.
“Determination of working capital to remain in the business for the new owner is part of the negotiations and value/purchase determined for the business, along with the structure of the transaction. Working capital to run the business as a rule of thumb may be 30-90 days of revenues also dependent on payors and future growth plans,” Diagostino says.
“If a purchaser is not also buying the existing working capital, they would then need infuse with their own funds needed working capital to sustain the business. If working capital is not part of the transaction, this will have a negative impact on value, however, a shortfall of working capital would also have a negative impact on value and any determined excess working capital would be a positive impact to value.”
As far as when the bridge to discussing remaining working capital is crossed, Jenson says this depends upon the nature of the business. It can be fairly early in due diligence or negotiations, or alternatively may be one of the last things discussed. This can be impacted by the materiality of the working capital, liquidity needs of the business, impending expenditures, debt and capital structures, and the like.
How Working Capital Impacts Value
Barraza says that when determining how much the decision to leave capital in the business or not affects value, generally speaking, leaving money in the business would increase the transaction price when compared to not leaving money in the business.
“Purchasers expect to pay less to acquire a business that needs a working capital injection compared to a “turn-key” operation with working capital remaining. For valuation purposes a normalized level of working capital is assumed when calculating free cash flow irrespective of whether working capital is included or excluded in a transaction. A normalized level of working capital would then be subtracted from the value of invested capital to determine the value of a business if working capital is to be excluded in a transaction,” Barraza says.
Diagostino adds that working capital in a valuation is determined based on current assets and current liabilities of the business, along with future growth considerations for the business to determine if the business has an appropriate level of working capital, a shortfall or excess.
“Typically, the negotiations and due diligence will establish an appropriate and necessary level of working capital to run the business as it is then being managed. Differences between that level of working capital and what is in the business would normally lead to additions or reductions to the valuation/purchase price,” Jenson says.
“An appropriate level of working capital can be established through an analysis of the company’s history (including seasonality), industry benchmarking, and how the business is currently being managed. Once established, the difference between this appropriate level and the actual level of working capital usually becomes a negotiable item increasing or decreasing the purchase price. Future working capital needs are typically accounted for in the company’s forecast as the present value of the future increases or decreases to the established target – thus, theoretically further increasing or decreasing the valuation.”
While all of this is important to both buyers and sellers in a healthcare transaction, Jenson says that he believes that this process of dermining working capital left in a business should be a collaborative, yet negotiated, effort during the due diligence and formal negotiation phases.
“Ultimately, the purchasers must be happy that the business can transition smoothly to the way that it will be managed under their ownership,” Jenson says.
If you would like to learn more about the concepts covered in this article, want to sell your business or discuss how Ambulatory Alliances, LLC might be able to help you out, contact Blayne Rush, (469)-385-7792, or Blayne@ambulatoryalliances.com.
If you have suggestions for future topics, email Blayne@ambulatoryalliances.com.