Techniques for Avoiding and Resolving Post Merger and Acquisition Disputes
June 21, 2019
By James J. Agar and David E. Greenberg
The owner and the prospective acquirer of a business negotiate the deal terms, including the price. The agreed-upon transaction date arrives, the deal is executed, and everyone moves on. It’s a simple concept that, in reality, often doesn’t work that smoothly. Buyers and sellers often see their interests intertwine, resulting in conflicts that may last for months, or even years, after the ink on a deal is dry and the keys have been handed over.
Why? The reasons are many, but a pair of purchase-consideration components stand out:
- The first is a balance sheet metric, often working capital or some derivation thereof. Such provisions typically call for an after-closing purchase-price adjustment that is equal to the overage or underage of the actual metric on the closing date versus a target or interim estimate. Because of reporting cycles and the time required for the buyer to scrutinize the seller’s transaction-date representations, the balance sheet metric-derived portion of the purchase price isn’t usually determined with finality until several months after the transaction’s closing.
- The second is an earn-out provision whereby the buyer pays the seller an amount at a set post-transaction time that is generally derived from the acquired entity’s performance after the acquisition. An example of this is language requiring that one-half of the first post-transaction-year’s earnings before interest, taxes, depreciation and amortization (“EBITDA”) be paid to the seller three months after the close of that year.
Clearly, the inclusion of a balance sheet metric and/or earn-out provision in the transaction agreement can lead to one or more disputes after the transaction agreement is executed. And since such controversies generally arise from the appropriateness or applicability of accounting treatments (e.g., “Are the working capital and EBITDA calculated appropriately?”), both parties should proactively develop a clear and mutual understanding of the governing accounting principles.
Indeed, disagreements regarding applicable accounting principles, including generally accepted accounting principles (“GAAP”), often originate in ambiguous transaction agreement wording and are a leading source of post-M&A disputes.1 According to Kulikov:2
“Certain factors leading to transaction disputes can often be mitigated with careful planning and attention to detail prior to the signing of the purchase agreement. The language of the purchase agreement must be specific. For example, detailed provisions regarding the relevant accounting guidance and earn-out calculations may assist in mitigating an earn-out dispute.”
Koenig and Vogel echo:
“A high percentage of [purchase price adjustments] results in post-closing disputes for reasons that include imprecise formulas and definitions and the vagaries of GAAP rules.”
Advisors and transaction principals should, therefore, consult with accountants who are well-versed in GAAP to help craft relevant transaction-agreement language that minimizes uncertainties and unintended-consequences risk.
Examples of considerations of which parties and counsel must be aware:
- What exactly is GAAP? Rather than being an inflexible, one-option “book of rules,” GAAP is a set of standards oriented toward the achievement of relevance, reliability, and representational faithfulness in accounting and the ensuing financial reporting. GAAP provides acceptable alternatives for the presentation of most elements of information that are intended to be conveyed. For example, an acquired entity may have historically chosen, at the then-owner’s direction, to value its inventory using a last-in, first-out (“LIFO”) method, while the new owner had always employed a first-in, first-out (“FIFO”) method. Both LIFO and FIFO are acceptable approaches under GAAP. In a world of changing prices, however, LIFO and FIFO will each result in a different inventory valuation amount. As such, buyers and counsel must understand that their preferred GAAP alternative regarding a particular accounting presentation or disclosure is not necessarily the only acceptable GAAP.
- Whose GAAP will be employed? Parties will often employ language that attempts to narrow the GAAP applications that they agree are appropriate for their transaction, often specifying that the applicable GAAP for purposes of balance sheet metric and earn-out calculations should be consistent with the target’s historical application. After closing, however, the buyer may discover that certain accounting treatments historically applied by the seller/target were not GAAP compliant. For example, the newly acquired company may never have historically reserved against accounts receivable for estimated bad debt expense, when GAAP would have dictated that the recording of such an entry is appropriate. In such a case, the buyer may be tempted to try to adjust the balance sheet metric by applying its own GAAP-compliant methodology, rather than applying a more historically appropriate methodology to the acquired company’s books. Continuing this scenario, assume that 7.5% of the acquired company’s accounts receivable are judged to be uncollectible—even though the seller never took appropriate reserves—but the acquirer itself has a 20% reserve rate based on its own historical bad-debt experience. Had the parties specified the appropriate method for dealing with situations when historically applied principles are determined to be not GAAP appropriate, they could have avoided questions of how to make appropriate adjustments.
- What about departures from GAAP or inconsistencies in the transaction agreement? A transaction document may provide, for example, that working capital is determined in accordance with GAAP, using a certain formula, and then present a formula that excludes the current portion of long-term liabilities. Herein lies the inconsistency: GAAP-compliant working capital includes the current portion of long-term liabilities as part of current liabilities. Under GAAP, working capital equals all current assets less all current liabilities. In this scenario, the seller is likely to view the appropriate working-capital calculation as exclusive of the current portion of long-term liabilities, thereby increasing working capital—and, ultimately, the selling price—while the buyer would be expected to take an opposite position. Had the parties been more specific with their language (i.e., explicitly acknowledging that the current portion of long-term liabilities is to be excluded from the working-capital calculation; or stating that in cases in which the given examples are not GAAP compliant, GAAP prevails), uncertainty could have been avoided.
- How about timing considerations? The transaction date likely will be at a point other than year-end, at which time many companies book year-end entries that accrue for (recognize and book estimated) expenses incurred throughout the year for which bills have not yet been received. Take, for example, audit fees. Say an organization pays its audit fee for Year 1 in February of Year 2, and that audit fee is estimated to be $60,000. Year 1 GAAP-compliant financial statements would reflect an anticipated audit fee (“accrued audit fees”) of $60,000, which, in reality, was recorded at year-end but, if done “by the book,” would have been recognized at $5,000 per month at the end of each month in Year 1. Yet, the company’s audited year-end financial statements reflected the full $60,000 audit fee estimate, because the entire Year-1 estimated audit fee was recorded by year-end (the date/end date of the financial statements). If the transaction agreement cites GAAP as historically applied as the governing principles over the determination of working capital, and the transaction date on which the company is purchased is June 30, Year 2, a dilemma arises. Why? Historically, the acquired entity did not accrue audit fees as of June 30, yet GAAP-compliant interim financial statements would have reflected such expense. If the parties had provided that such interim financial statements must reflect adjustments of the type normally booked at year-end in order to be GAAP conforming, then their path would have been clearer.
- Which expenses count? Agreements that contain post-transaction, performance-based earn-out provisions may result in total purchase consideration that is subject to uncertainty for many years. Say that the sellers are entitled to an earn-out (additional payment beyond the purchase price) equal to one-half of the first post-transaction year earnings from a former subsidiary now owned by the buyers. Here, the sellers hope that earnings during the earn-out period are as high as possible, while the buyers—who have an implicit advantage as they control the acquired entity’s management and financial reporting—have a completely opposite objective. The buyer has opted to book its own acquisition costs into the target company’s financial statements, which is GAAP appropriate in the determination of earnings, thereby reducing those earnings and, by extension, the earn-out payment that is obligated to be paid by the buyer to the seller. Logically, the seller will posit that a fundamentally fair earning calculation should exclude such acquisition costs because they are not attributable to the acquired business’s operations, but rather the way it financed the purchase. If the buyer and seller (and their advisors) had been explicit as to the treatment of such costs, there would be little room for this post-transaction dispute.
- Is that it? No. The preceding illustrations provide a flavor for issues that can arise from ambiguities in transaction agreements where the risk of divergent interpretations coming to fruition could have been minimized with proper planning.
When such disputes do occur and can’t be resolved within the agreement-contemplated timeframes, transaction parties rightly find themselves asking questions such as:
- Who can help with negotiations? A party to such a dispute, and its counsel, may wish to consider seeking assistance from an accountant who can analyze the strengths and weaknesses of that party’s position, as well as that of its adversary, and provide objective advice for use in negotiations. A deal principal and its legal representative may even desire that the accountant assist in another attempt to negotiate a resolution with the counterparty.
- What if the problem still can’t be resolved? Generally, transaction agreements provide that if the parties cannot achieve mutually acceptable resolution regarding working capital or earn-out disputes they proceed to formal dispute resolution, which often involves the appointment of a final decision maker who may be described, for example, as an arbitrator, accounting neutral, independent accountant, or accounting referee (the “neutral”). An accountant who is well-versed in this type of dispute resolution process may be retained to testify before the neutral, provide consulting advice to the parties, assist in crafting the proceedings’ protocols, and/or evaluate the credentials of potential neutrals.
- Who should serve as the neutral? Parties are well-advised to vet neutral candidate organizations for independence and competence during the agreement-crafting process as well as designate such firm, and possibly an associated individual, as the default neutral in the transaction agreement itself. But even if such consideration is not made until after the parties have already become embroiled in such a dispute, they should consider organizations whose transaction-dispute-resolution specialists possess experience in neutral roles and that have the requisite GAAP and relevant industry expertise. It is also important that they avail themselves of as much information as they can about the candidates such as each one’s reputation as a contract language “strict constructionist” versus “equity seeker,” an ability to resolve procedural issues, fairness in the resolution of discovery battles, an even temperament to both buyers and sellers, depth of technical knowledge, and access to industry expertise.
Transaction parties may reduce, but not eliminate, uncertainty early on through the establishment of clear and definitive contract language addressing areas that are otherwise often fertile ground for the growth of disputes. When such disagreements do occur, it is critical that parties and counsel consider retaining a qualified accountant to assist them through the resolution process.