Navigating the Dangers of Post-Acquisition Disputes
Key Details: Mergers and acquisitions (M&A) deals refer to the consolidation of companies or their major business assets through financial transactions between a buyer and seller. Possible outcomes can include but are not limited to a firm acquiring and assimilating another, merging to form a new entity, acquiring significant assets, making a tender offer for shares, or executing a hostile takeover. M&A deals can be motivated by various strategic reasons, including expanding market share, diversifying products or services, entering new markets, or eliminating competition. M&A deals can be complex and often involve various legal, financial, and regulatory issues. Additionally, M&A transactions are typically facilitated by investment bankers, lawyers, finance professionals and other specialized advisors where preliminary discussions and non-disclosure agreements are typically used to initiate the process.
However, a buyer and seller that close an M&A deal can have disagreements over a multitude of reasons that can leave one or both parties dissatisfied. This may escalate into a post-acquisition dispute with high legal fees and increased tension. As such, businesses undergoing an M&A transaction are encouraged to understand some of the more common post-acquisition dispute topics as well as leverage the below solutions to lower the probability of a post-acquisition dispute. For further information and expertise, contact Ryan & Wetmore today.
What is a Post-Acquisition Dispute?
A post-acquisition dispute is when a conflict arises between the buyer and seller, after an M&A deal is closed. Disputes can stem from various of reasons, such as a disagreement over the terms of the acquisition, misrepresentation of the target company's financial or operational status, or the failure to meet performance targets or earn-out agreements. Post-acquisition disputes can be complex and can have significant financial and reputational consequences for both parties involved. Businesses that intend to or are currently undergoing the M&A process are encouraged to understand the most common types of post-acquisition dispute topics, solutions to prevent disagreements, and action items to consider before a deal closes.
Common Types of Post-Acquisition Dispute:
- Disputes on Earnout
- Disputes on Representations and Warranties
- Disputes on Working Capital
An earnout is a financial arrangement included in an M&A transaction where a portion of the purchase price is contingent upon the future performance of the business. Between the buyer and seller, an agreement is reached, called a target, which is a predefined goal that the acquired business is expected to achieve. Sample targets can be metrics such as revenue, net income, or other key performance indicators (KPIs) that serve as benchmarks for determining the success of the business. The achievement of these targets can impact the final purchase price and the amount paid to the seller in the transaction. This agreement is intended to be beneficial for both the buyer and seller in which, the seller benefits from the business’ success after the sale, while the buyer can adjust the final price based on the actual performance. However, earnouts can be complex and lead to disputes if the targets or payment formula are not well-defined or if the buyer and seller have different expectations regarding the business's future. Earnout disputes typically take two forms:
- The buyer and seller disagree on whether a target has been met.
- The buyer and seller disagree on the payment required as laid out in the original agreement.
When an earnout is tied to a performance metric, disputes may arise if the terms are not precisely defined and communicated. Such conflicts often involve the buyer's management of the business during the earnout period. For instance, if the buyer makes changes to the acquired business that differ from the seller's previous operations and adversely affect certain performance metrics, there may be conversations about how much the seller may be entitled to receive. Below are common problems with earnouts:
- Definition of gross profits, cost of sales, and whether the inclusion of fringe and overhead is accurate.
- Differences in prior accounting methods between the seller and buyer such as cash versus accrual or complicating factors relating to accounting records after the closing date. If the buyer is unable to maintain distinct books and records for the acquired entity, it may lead to inaccurate measurements during post-closing performance evaluations.
- Revenue recognition challenges due to recent accounting pronouncements, making it more complex for sellers with necessary accounting staff to compile. This may result from the lack of synergy between the two accounting departments.
- Allocation of costs from the seller to the new buyer's divisional operation
- Loss of control by the seller once the entity is sold, potentially affecting performance
- Loss of key personnel after the sale, making it difficult to achieve earnout goals
- Duplicate customers in the buyer/seller relationship, causing disagreement about sales credit
Earnout disputes can arise from imprecise contract language, which means buyers and sellers should work together to address points of ambiguity and inconsistency, such as defining metrics used, as well as accounting principles and methods applicable to calculating those metrics, while drafting agreements to reduce friction later in the process. This collaboration should involve not only legal counsel, but also accounting and tax professionals who can make sure the contract terms comply with the information identified in due diligence.
Imprecise language may include the following; as such, businesses going through the M&A transaction process are encouraged to work with legal counsel to ensure all definitions are adequately recorded and agreed upon by all party members:
- The definition of gross profit and the costs of sales.
- The definition of revenue and revenue recognition practices.
- Allocation of overhead costs.
- The contract period for the earnout.
- Whether overages and underage's from the first period of the earnout are carried over into the second or third periods of the earnout.
- The accounting software that is used to compute the earnout.
- Working Capital Disputes:
Working capital is the amount of current assets (e.g., cash, accounts receivable, and inventory) that a company has to cover its current liabilities (e.g., accounts payable and accrued expenses) and ongoing operations. In an M&A transaction, the buyer and seller typically agree on a target level of working capital for the acquired company, which is used to calculate the final purchase price. Common disputes with working capital include:
- Accrued expenses received after closing and if they should be included in the working capital calculation
- State and local taxes that are not accrued
- Insurance audits
- Deferred revenue
- Amounts billed to customers for work completed
- Bad debt reserves
- Revenue recognition issues
- Warranty liabilities
- New lease standards for right-of-use assets
- Accrued pension and profit-sharing liabilities
- Accrued bonuses
- Accrued payroll
- Benefits and payroll taxes on accrued benefits
- Costs related to stock options and related items
Disputes concerning working capital often occur when the buyer and seller cannot agree on the amount of working capital the acquired company should have possessed at the transaction's closing date, which can influence the ultimate purchase price. If the actual working capital falls short of the agreed-upon target, the buyer might request a reduced purchase price or other compensations from the seller. It is crucial to recognize that disputes can also stem from changes in working capital due to unclear or imprecise M&A agreement language about the components included in the calculation. Factors such as varying accounting methods (e.g., not adhering to GAAP) or alterations in the business between the transaction's signing and closing can give rise to these disputes.
- Representations and Warranties:
During the M&A process, buyers and sellers exchange various pieces of information such as customer lists, financial statements, tax information, and contracts. However, disputes can arise when a buyer has reason to suspect that the seller has misrepresented aspects of a business through a lack of disclosure. The buyer may seek to recoup costs, arguing that an accurate picture of the business could have altered their initial purchase amount.
For example, many agreements include standardized language that the closing balance sheet “shall be prepared in accordance with GAAP and consistent with past practices, policies, procedures, and methodologies.” But what happens when the seller’s past practices diverge from GAAP? By defining in advance which standards prevail in the event of such inconsistency, buyers and sellers can prevent a disagreement due to different interpretations of the balance sheet. Additionally, when dealing internationally, understanding which standards to apply and ensuring both parties are aware is imperative to a smooth transaction process.
Currently, many transactions incorporate representations and warranties (R&W) insurance. The buyer or seller can be the insured party, but buyers are usually insured. With a buy-side R&W insurance policy, when a dispute arises over R&W breaches, buyers can turn to the insurer to make claims, rather than attempting to recover losses directly from the sellers. In most cases, R&W insurance can reduce or eliminate the sellers' liability for indemnification related to R&W breaches.
Post-acquisition disputes can ruin the relationship between the buyer and seller financially and reputationally. To mitigate these risks, it is essential to address potential issues early on by implementing proactive measures. The following proposed solutions can assist both parties in averting expensive and lengthy disputes in the future: agreeing to performance metrics, ensuring precise contract language, establishing identification and agreements, and hiring trusted and professional advisors.
Proposed Post-Acquisition Dispute Solutions:
- Agree to Performance Metrics
- Ensure Precise Contract Language
- Indemnifications and Agreements
- Hiring Trusted and Professional Advisors
- Agree to Performance Metrics:
The metrics used to measure performance, as well as the accounting principles and methods applicable to calculating those metrics, should be defined in the agreement without ambiguity. Areas that deal with how operations should occur and how deviations are handled should be outlined within M&A contracts. When lowering the risk of earn-out disputes specifically, it is important to be clear on what area of the business is being measured, what constitutes optimal performance in that area, and finally what is an agreed upon earnout when a metric deviates from the norm. Additionally, it is crucial to explicitly define key terminology within the agreement to ensure a shared understanding between the parties and minimize the potential for misinterpretation or disagreement in the future.
- Ensure Precise contract language:
Contract language is the biggest point of contention when post-acquisition disputes occur. Buyers and sellers must work together to address inconsistencies and ambiguities while writing the terms of M&A deals. This attention to detail in language will help reduce friction later in the process. Defining clear key terms, processes, and contingencies can help companies minimize subjectivity and prevent post-acquisition disputes. Specifically, when talking about contingencies a good note is to address any indemnification claims for breaches, especially when dealing with representations of warranties. Furthermore, in M&A transactions the buyer and seller must use precise contract language to agree on a target level of working capital for the acquired company. This is included to determine the calculation of the final purchase price. It is important to note that because working capital is based on current assets and liabilities, going over what is explicitly included and excluded, and clear definition of those items goes into the process of outlining target metrics.
Additionally, the parties discussing a contract should agree on the transaction structure. For instance, a possible transaction structure that could be discussed is a cash-free, debt-free approach (CFDF), where the seller would pay off debt obligations but would be able to keep excess cash in return and the buyer does not assume any existing debt from the seller, however would not keep any excess cash. Both parties should determine whether these debts should be excluded or if cash should be factored into the final payment calculation.
- Indemnification and Agreements
Examining and agreeing upon specific factors during M&A transactions is crucial to avoid disputes in the future. In addition to identifying representations and warranties, parties should carefully consider items such as accruals, allowances, loss contingencies, cut-off periods, accounting policies, allocations of expenses, tax assets and liabilities, and materiality. Failure to properly address and agree upon these factors can lead to disagreements and potentially lengthy disputes. Therefore, it is important to include these items in the due diligence process and negotiations to ensure a smoother and more successful M&A transaction. Moreover, the buyer should also conduct site visits, interviews with key personnel, and analysis of the target company's industry and market position. This can ensure, buyers are properly doing due diligence when fully identifying a business’s assets and liabilities.
- Hiring trusted lawyers and professional advisors
During M&A agreements and disputes, it is important to involve a range of professionals, including legal counsel, accounting professionals, tax professionals, and business valuation experts. Legal counsel can help ensure that the agreement is properly structured and that the parties' interests are protected. Accounting professionals can help with due diligence, financial analysis, and the creation of financial models. Tax professionals can provide advice on tax implications and help structure the transaction in a tax-efficient manner. Business valuation experts can help the parties understand the value of the business and ensure that the purchase price is fair. Involving a team of professionals can help ensure that all aspects of the transaction are properly considered and can help minimize the risk of disputes arising later. These professionals can all assist the involved companies determine equitable earnouts, proper representations and warranties, and what is included in working capital to determine a proper valuation of a business.
Steps Towards Resolution
Here is a breakdown of steps towards resolving disagreements during an M&A transaction:
- Preparation: Both parties should perform preliminary assessments of the matter(s) in dispute.
- Assessment: Thoroughly assess relevant documents regarding the disagreement. Form a basic understanding by reading transaction documents, financial statements, and lists of representations and warranties.
- Reviews: Each party reviews the other's respective positions on the matter(s) in question to build a comprehensive list of facts. Utilize neutral third party experts and advisors to gain insight into what matters of each party's position are considered a fact and what is admissible.
- Analysis: Carefully go over each party's presented facts over disputed items. Analyze the transaction agreement and associated documents. Finally, compare to the agreed upon accounting principles and practices.
- Final Reporting: Document any discovered evidence, create an overview analysis of the methodology used, and create any finalized documentation.
Conclusion and Action Plan
When talking about the nature of post-acquisition disputes it cannot be stated enough that the best way to avoid these types of situations is to take preemptive action during the planning phase. When discussing an M&A deal:
- Conduct thorough due diligence to identify and address potential issues before closing the transaction.
- Use precise language in representations and warranties to avoid ambiguity and subjective interpretations.
- Clearly define key terms, processes, and contingencies in the M&A contract.
- Engage legal counsel and accounting/tax professionals to ensure compliance with regulations and agreements.
- Agree on performance metrics and define accounting principles and methods for calculating those metrics in the contract.
- Consider incorporating R&W insurance to reduce or eliminate sellers' liability for indemnification related to R&W breaches.
- Establish a dispute resolution process in advance, such as mediation or arbitration, to avoid costly and time-consuming litigation.
Ryan & Wetmore provides M&A transaction advisory services that can help avoid disputes as well as can help advise in the case a dispute occurs. Talk with one of our advisors or look at ryanandwetmore.com for more info.
Today’s Thought Leaders
About Tessa Lucero-Bennett
Director, CPA & MBA
Tessa is a Director at Ryan and Wetmore. Tessa has over 20 years of experience serving and advising businesses in all phases of the organizational life cycle. Her experiences range from traditional accounting and tax services to complex consulting services, including business planning, financial budgets and projections, benchmarking and financial trends, M&A support and analytics, internal controls assessment, development of best business practices, and financial training for top management levels.
About Rosie Cheng
Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.