Perhaps you’ve heard this story before: A business owner closes on the sale of his or her lifelong business as the final step in a well-executed exit strategy. Before the celebration ends, unexpected post-acquisition disputes arise – often with the potential to send a significant portion of the financial payoff up in smoke.
Experienced forensic accountants typically see two types of significant post-acquisition disputes: net working capital adjustments and unrealized earn-out provisions. Understanding certain nuances of each is imperative before drafting your next purchase and sale agreement (PSA).
Net Working Capital Adjustments
PSAs customarily incorporate a preliminary calculation of the target company’s net working capital anticipated at the closing date. PSAs also typically allow for a trueup mechanism to adjust the purchase price for variations between this estimated net working capital and the actual net working capital delivered at closing. A final settlement between the buyer and seller is then achieved.
Disputes arise when significant purchase price adjustments are proposed. Here are a few themes surrounding net working capital disputes that have recently come across my desk:
- Working capital methodology as defined in the PSA erroneously excluded certain line items present on the closing balance sheet.
- Disagreement over values of certain accounting estimates.
- Seller represented the company’s financial statements are presented “in accordance with generally accepted accounting principles (GAAP) applied on a consistent basis throughout the periods,” yet GAAP adjustments occurred only at year-end, therefore the presentation of interim financial statements and closing balance sheet was not as represented.
Could these disputes have been prevented? Possibly. Responding to the examples from above, here are some considerations when drafting your next PSA:
- Clearly define the working capital methodology and explicitly state it excludes/ includes certain balance sheet line items, if that is the intent. The methodology should also be consistently applied for both the estimated and final net working capital calculations.
- Agree on a methodology to value accounting estimates. Disagreements often occur when the buyer and seller utilize different methodologies to value reserves, such as inventory obsolescence and uncollectible accounts receivable.
- Educate your client on what “in accordance with GAAP applied on a consistent basis throughout the periods” actually represents. Th e interpretation of this phrase (or similar wording) is the most contested accounting issue in a post-acquisition dispute.
PSAs may also incorporate earn-out provisions. Unfortunately, as remarked by the Delaware Chancery Court in Airborne Health, Inc. v. Squid Soap, “ … an earn-out often converts today’s disagreement over price into tomorrow’s litigation over outcome.” In other words, earn-outs tend to increase the overall purchase price, but also increase the likelihood of a future dispute.
Here are some examples of frustrations sellers may encounter in attempting to collect on earn-out provisions:
- Additional professional fees.
- Lack of custody of records necessary to audit subsequent operating results.
- Lack of involvement in business decisions and other financial matters affecting earn-out calculations (e.g., decreased marketing efforts, change in accounting methodologies, etc.).
Determine whether your client is willing to endure these headaches in hopes of achieving higher proceeds. If so, consider the following when drafting your next PSA involving earn-out provisions:
- Carefully draft a right-to-audit clause. Include the timing and frequency of such procedures. Also, consider whether the buyer should pay the seller’s professional fees should the audit identify a failure to remit the required earn-out payments.
- Connect the earn-out to a financial measure most appealing to your client. Sellers generally prefer revenue for simplicity, while buyers prefer EBITDA or net income for a more comprehensive financial measure of the acquisition.
- Expressly state the buyer’s duties in order to achieve the earn-out.
The magnitude of each dispute can vary greatly. I frequently see buyers request adjustments that represent 20 to 25 percent of the purchase price. You can help avoid this significant financial pitfall by considering the following when drafting your next PSA:
- Reduce risk due to significant unforeseen circumstances by limiting losses to the amount held in escrow or by utilizing a collar.
- Define whether losses should be dollar-for-dollar or a multiple of EBITDA (or other financial measure).
- Require that any disputed items be identified in reasonable detail within a specific window of time after closing.
- Set forth explicit procedures to resolve differences between the parties. Contemplate naming a specific accounting firm as a neutral arbitrator in the PSA. It can be challenging for parties to agree on an umpire once a dispute arises.
- Define, define, define. What is a onetime, non-recurring expense? At which threshold does the term “material adverse change” kick in?
- State who prepared the closing balance sheet (e.g., seller-prepared, buyer-prepared or jointly-prepared).
- Require that the buyer complete substantially all due diligence prior to closing. I have seen an executed agreement requiring the seller to provide critical due diligence information requests within five days after closing.
- If the seller knows the company’s financial statements are not presented in accordance with GAAP, confirm that all references to GAAP have been removed from the PSA.
The closing of an acquisition between a willing buyer and a willing seller usually results in a positive atmosphere. Conversely, the resolution of a heated post-acquisition dispute can leave both parties dissatisfied. By implementing best practices when drafting a PSA, you can avoid adding to the collection of cautionary tales. If you wish to seek guidance from an adviser experienced in such disputes, consider doing so prior to closing the deal. Ryan D. Stretmater