Mergers and acquisition (M&A) transactions can be complicated and full of uncertainties. Both buyer and seller do their best to protect themselves with legal agreements about how “post-closing” disputes will be handled. Both problems in structuring these agreements and the fundamental business itself can lead to disagreements involving the financial aspects of the deal. This article is a summary of the types of issues that can arise in M&A disputes.
Post-closing purchase price adjustments
In a typical M&A transaction, the target company’s purchase price will be negotiated as a multiple of earnings (often using EBITDA - earnings before interest, taxes, depreciation and amortization). Most deals are on a “debt-free, cash-free basis,” meaning the seller retains all cash on the balance sheet and is responsible for paying off any long term debt, (think what happens when you sell your house). An often misunderstood component is how to handle inventory and accounts receivables and payables –collectively “working capital.” Often times a buyer and seller agree on a normalized amount of working capital based on a monthly average – a working capital benchmark. This is the amount of working capital required to run the business and included as part of the purchase price.
At closing, a closing balance sheet is provided and any differences to the actual working capital and the benchmark are netted out of the purchase price. There is an agreed upon period of time (usually 60 or 90 days) for the buyer to determine the actual working capital as of the closing and provide the seller with a “true-up” calculation. The legal documentation will spell out how to handle any disputes arising from working capital items and how to seek indemnification for any deficiencies.
Common issues in working capital disputes result from the use of the correct accounting basis (generally accepted accounting principles (GAAP) versus consistency using non GAAP methods), accounts receivable and allowances for doubtful accounts, inventories and related valuation reserves, warranty accruals, contingent items (with respect to their being probable and estimable), and general differences concerning the realization of assets and the existence of obligations.
To illustrate a typical purchase price adjustment dispute over working capital, assume that a seller’s warranty reserve, measured in accordance with GAAP by the seller’s accounting firm, results in an under accrued liability as assessed by the buyer’s accountants. Note here that financial statements under GAAP aren’t always black and white – they can include estimates, and the reasonableness of the estimates can be at issue in the dispute. The dispute resolution will depend on the facts and circumstances of the case, for instance the question of consistency with past practices versus the accuracy of a GAAP presentation.
Working capital claims are typically measured on a “dollar for dollar” basis (by the amount of the difference), but if an under accrual such as the warranty reserve in this example is ongoing, a case can be made that the seller fundamentally misrepresented the company’s historical profits. Thus it can be measured “at the multiple,” meaning that the understated amount will be multiplied by the transaction’s EBITDA multiple to determine a purchase price adjustment.
Subsequent events that happen after the closing can cause issues in post-closing purchase price adjustments. Under GAAP, a “recognized subsequent event” is an event about which additional information becomes available that, under GAAP, is used to adjust financial statements on a prior date. The key considerations for a “fact finder” (court or arbitrator) are (a) what was “known or knowable” on the closing balance sheet date, and (b) whether the seller’s position is reasonable given that knowledge. A buyer will typically negotiate to hold the books open for as long as possible to fully consider subsequent events.
M&A agreements often contain “earnout” provisions that are a contingent element of the acquisition’s purchase price. These earnouts often bridge the gap between what a seller wants to receive and what a buyer is willing to pay, but are inherently complicated. The contingent element of consideration is determined based on the acquired company’s performance against certain criteria or benchmarks defined in the M&A agreement. Earnout criteria can be financial or non-financial (for example, regulatory approval for a new product), and typically can only increase the purchase price. Earnouts can be an effective negotiating tool when a buyer and seller have differing perspectives on the outlook for the target business, however they are also fraught with uncertainties.
Common M&A earnout disputes include post-closing accounting differences and the post-closing operation of the target business by the new owners. Arguments can be made that the business was subsequently managed to minimize its performance measures and in turn lower the earnout payment. Changes in accounting and business structure, such as combining the target business with other divisions of the buyer’s business and allocating costs differently, can further cloud the analysis. Due to these complexities, sellers tend to prefer a performance benchmark subject to less potential for manipulation, such as revenues, while buyers prefer a benchmark based on the bottom line – the target’s post-close profit.
Further gray areas in earnout disputes center around clauses in the M&A agreement such as “the purchaser shall operate the business in a manner consistent with its past practices and operations,” and “unusual and non-recurring items will be excluded from the earnings calculation.” Unless these items are anticipated in advance (e.g. transaction costs, intangible asset amortization, goodwill impairment) and carefully outlined in the agreement, they can be used to negate the purpose of the earnout provision.
Material adverse change
Material adverse change (MAC) clauses provide a means to terminate an M&A agreement if such a change (as defined in the agreement) occurs. MAC can be defined as changes in the target company, in the industry, or both. Buyers prefer broad MAC definitions and sellers prefer the opposite.
To activate an MAC clause, the buyer will typically need to establish (a) the event’s significant impact on the target, (b) the event’s duration, (c) the event’s disproportionate effect on the target as compared to the rest of the industry, and (d) whether the buyer seeking to avoid the transaction knew of the event prior to entering the agreement.
The significance of a MAC to the target’s financial performance can be assessed by comparing its actual performance and post event projections to historical and projected performance at the time the agreement was signed.
To determine the event’s impact on the target versus the industry, its performance metrics (revenue growth, profitability, financial ratios) can be compared to similar companies in the industry and to the industry’s performance generally. Even in cases where a MAC is not established, the buyer may still be able to rescind the deal based on a breach of seller representations and warranties related to condition of the business at time of closing. Alternatively, analysis may be able to establish that the actual value of the company is significantly less what was previously represented by the seller.
The operative language for these provisions in M&A agreements varies, but typically includes words such as indemnify, hold harmless, pay and reimburse. Indemnification provisions can cover representations and warranties, covenants and other items such as pending taxes or litigation. Common limitations of indemnity provisions include time elements, types of eligible/ineligible claims, baskets and thresholds (lower and upper limits for indemnity to apply), caps and ceilings, and setoffs (for example tax benefits and insurance proceeds). Indemnification provisions are required in almost all transactions regardless of size or complexity. It is imperative for sellers to have them capped at some dollar amount, and to have a set time period in which to make any claims.
Common disputes regarding a breach of a seller’s representations and warranties involve assurance that financial statements are in accordance with GAAP, disclosure of material information about the business, no “material adverse change” (as defined in the merger agreement), and operation of the business as usual in the “ordinary course” during the “period of acquisition.”
Damages for indemnification claims involving representation and warranty disputes employ a “benefit of the bargain” measurement, defined as “a measure that awards the plaintiff the difference between the gain had the misrepresentation been true and what the plaintiff actually received. (Source: Litigation Services Handbook, 4th Edition, 18.7)
For example, assume that a firm was sold for a multiple of 6 times earnings of $100 million, $600 million. Subsequently a lawsuit was filed for a product defect – total damages of $20 million resulted, including legal fees. In addition, ongoing annual raw material costs increased by $5 million to cure the defect. From the plaintiff’s standpoint (arguing that the product defect was “known or knowable” in advance), damages with two elements are asserted: (1) a one-time purchase price reimbursement of $20 million, and (2) a second reimbursement of 6 times $5 million, $30 million to account for the company’s ongoing reduced earnings.
A more “gray” example of a “benefit of the bargain” issue is the undisclosed loss of a significant customer of the target. Questions to be addressed to get to the heart of a damages measurement include whether the customer will be replaced (and when), if the departure is part of normal customer turnover, and if the customer is an important component of value for the firm (i.e. profitable). The answers to these questions will help determine whether there are damages at all, and if so, whether they are non-recurring or recurring (resulting in loss of business value).
Benefit of the bargain disputes are different from disputes over business valuations in that they can use the benefit of hindsight (known as the “Book of Wisdom” in intellectual property disputes) to assess what actually happened with respect to a specific claim. While a business appraisal considers only what is “known or knowable” at the time of the valuation, a M&A dispute can assess, for example, whether the business grew substantially more than projected following the transaction, thereby delivering the “benefit of the bargain” to the buyer despite the loss of an individual customer.
Post-acquisition disputes usually involve some form of investigative financial techniques, lending themselves to skills possessed by some financial experts. More often than not these disputes also involve business valuation principles. Experts who possess both sets of skills can contribute valuable insights to assist the parties in resolving merger and acquisition related disputes.