Understanding Working Capital Adjustments: A Cheat Sheet for HealthTech Founders

Working capital adjustments are a critical component of a mergers and acquisitions (M&A) transaction, particularly for HealthTech founders selling their company. They ensure the buyer receives a business with a normalized level of liquidity to continue operations without needing an immediate cash injection.

The adjustment mechanism prevents either the buyer or seller from gaining an unfair advantage due to fluctuations in the company's short-term assets and liabilities between the time a price is agreed upon and the deal closes. 🤝

What is Working Capital?

Working capital is a measure of a company's short-term financial health and operational efficiency. It represents the funds available to cover day-to-day operational needs. It's calculated by subtracting current liabilities from current assets.

Working Capital=Current Assets−Current Liabilities

Current Assets are items that can be converted into cash within one year, such as cash, accounts receivable (invoices owed by customers), and inventory.

Current Liabilities are short-term debts and obligations due within one year, such as accounts payable (invoices owed to suppliers), short-term debt, and accrued expenses (e.g., salaries, taxes).

For HealthTech companies, current assets may include accounts receivable from insurance companies or hospitals and prepaid expenses for software licenses. Current liabilities might include accrued payroll for medical staff or deferred revenue from multi-year contracts.

The Working Capital Adjustment Process

In M&A, the deal's purchase price is typically based on a multiple of earnings (like EBITDA), which assumes the business has a "normalized" level of working capital to maintain that level of earnings. Since working capital fluctuates, a purchase price adjustment mechanism is included in the sale and purchase agreement (SPA).

1. Setting the Target

A Target Working Capital ("the Peg") is a benchmark amount of working capital that both the buyer and seller agree upon. This is usually based on an analysis of the company's historical working capital levels over a specific period (e.g., the last 12 months), considering factors like seasonality or recent growth. For a HealthTech startup, this might mean averaging the monthly working capital during a period of rapid growth to establish a realistic baseline.

2. Calculation and Adjustment

The adjustment is a dollar-for-dollar change to the final purchase price.

If the Actual Working Capital at closing is higher than the Target, the buyer pays the seller the difference. This is because the seller is delivering more short-term value than expected.
If the Actual Working Capital at closing is lower than the Target, the purchase price is reduced, and the seller effectively "pays" the buyer the difference. This ensures the buyer is not forced to immediately inject cash to keep the business running.

Example for a HealthTech Founder

Let's say a HealthTech company has the following:

Target Working Capital (agreed upon): $1,000,000
Estimated Working Capital at closing: $950,000
Final Working Capital at closing: $980,000

At closing, the initial payment would be reduced by $50,000 to account for the estimated shortfall. After the final numbers are tallied (post-closing, typically 60-90 days later), the company's working capital is found to be $980,000.

Since this is still below the target, the final purchase price is adjusted down by $20,000 ($1,000,000 - $980,000). The seller would have to pay the buyer $30,000 ($50,000 - $20,000) to settle the final adjustment.

Common Pitfalls for HealthTech Founders

Founders often focus on the headline purchase price and overlook the impact of the working capital adjustment. Being prepared can prevent significant value leakage.

Manipulating Working Capital: Buyers are wary of sellers who try to artificially inflate working capital before closing (e.g., aggressively collecting receivables while delaying payments to suppliers). This can lead to disputes and reputational damage.

Overlooking Non-Operational Items: The working capital calculation should be limited to the core operating accounts. Be sure to exclude non-operational items like excess cash, short-term debt, and one-time transaction-related expenses, as these are typically handled separately in a "cash-free, debt-free" deal structure.

Lack of Proactive Management: Failing to manage working capital effectively in the months leading up to a deal can result in a significant negative adjustment. For HealthTech, this could mean not diligently pursuing accounts receivable from payers, or letting inventory of physical devices build up unnecessarily.

To discuss any of these points and how Nelson Advisors can help your Healthtech company, please email [email protected]