with contributing author Bobby Majumder
Many industry experts, professional services firms, private equity firms and corporate acquirers believe 2014 will be a busy year for mergers and acquisitions. Reasons cited for this belief include: excess idle cash in the coffers of companies and private equity firms, continued low interest rates, favorable credit markets, improved signs of stability in the economy and the need and ability to make or exit investments. Results from a recent KPMG survey noted, “… 63 percent of respondents said that they planned to be acquirers in 2014.” A similar survey conducted by Financier Worldwide revealed, “… 70 percent of respondents anticipated that they would be involved in an acquisition in the coming year…”
Increased deal activity is great, but what interests participants in this increasingly active market is closing deals that are successful for all involved. However, this is often easier said than done. According to an article in Forbes, “[m]ost research indicates that M&A activity has an overall success rate of about 50 percent…” An article by a partner at Ernst & Young LLP states that, “judging from our M&A transaction and dispute experience … about one-third of all closed transactions end up in a dispute between the parties.”
Deals fail for many reasons, including regulatory issues, integration issues, economic factors and market factors. Another key reason is post-closing disputes, most often related to the purchase price adjustment process or due to unidentified risks at the target company. While economic and market factors are tough to work around, certain factors leading to transaction disputes can often be mitigated with careful planning and attention to detail prior to signing the purchase agreement. The five items discussed in this article are intended to help mitigate certain M&A disputes and risks related to bribery, corruption and the post-closing purchase price adjustment process.
1. Conduct Anti-Bribery/Anti-Corruption Due Diligence
You may have heard this before, and you may believe that you conduct cross-border deals with the appropriate level of anti-bribery/anti-corruption (ABAC) due diligence. You may actually have this covered if you are engaging a professional services firm that specializes in forensic accounting and investigations to conduct this diligence, and that firm works closely with your transaction legal counsel. However, having only your transaction counsel or financial due diligence team perform this diligence may not be enough. Alone, this also cannot cover this topic adequately to assist you, the buyer, in identifying and addressing these significant risks (e.g., successor liability) before you sign on the dotted line.
Make no mistake, the SEC and DOJ will not accept the “I didn’t know” defense when you do not perform adequate ABAC diligence pre-close and then discover ABAC issues post-close. The SEC and DOJ alluded to this fact in their November 2012 jointly released A Resource Guide to the U.S. Foreign Corrupt Practices Act (the “Guide”). The Guide makes it clear that there is an expectation that ABAC due diligence will be performed prior to the closing and that the results of the diligence should be documented and acted upon by the acquiring company. Failure to do so can result in stiff penalties, fines and/or imprisonment.
Pause. That flushing sound you hear is the deal value circling the drain when you face an SEC/DOJ enforcement action due to inadequate (or lack of) ABAC diligence.
In addition to cross-border transactions, make sure you perform ABAC diligence on any transaction with an international nexus. Just because the target company does not have international locations does not mean it does not sell, ship, provide services, etc. to locations outside of the United States. Such activities can involve customs agents, logistics coordinators and others, all representing potentially significant ABAC risks. Even the acquisition of a U.S. domestic company may need to involve pre-acquisition ABAC due diligence.
Do not skip this step. A small investment pre-close can potentially help avoid a large successor liability (or worse) post-close.
2. Use Specific Language in Purchase Agreements
The purchase agreement is where most post-closing purchase price adjustment disputes start. This is most often due to the use of vague or generic language in the purchase agreement, which sets the stage for a potential dispute after the deal has closed. Unintentional … probably. Avoidable … definitely.
Most purchase agreements (except for strictly asset-based acquisitions) include a purchase price adjustment clause, which is intended to allow parties to true-up the purchase price for relevant business activity between the time the deal was struck and when the deal closed. This adjustment is typically based on a financial statement metric such as net working capital (NWC) or earnings before interest taxes depreciation and amortization (EBITDA). This is one area in which generic or vague purchase agreement language can lead to disputes.
An example we have seen often in practice is the purchase agreement including a definition of GAAP simply as “U.S. generally accepted accounting principles,” or some minor deviation thereof, sometimes with “consistently applied” added. The first definition of GAAP is too generic for purposes of a post-closing purchase price adjustment based on NWC or EBITDA. For example, there is more than one GAAP acceptable method to determine the allowance for doubtful accounts or inventory reserve. Further, what if the target company’s historical financial statements are not in full compliance with GAAP?
In both of these examples, barring a provision requiring the purchase agreement calculations to be based on a specific GAAP acceptable method, either party is free to employ the most advantageous method in any post-closing purchase price adjustment. Instead of including a generic requirement to prepare calculations in accordance with GAAP, a specific definition can be included to clearly define the GAAP methodology, including a sample calculation if warranted (see item 3 below for further details).
In some cases, a target company may have a few minor deviations from GAAP in its historical financial statements that were never significant or material to its overall financials. However, in a carve-out transaction or in a purchase price adjustment process, such deviations, when corrected to comply with GAAP, may become very significant in terms of deal value. To avoid a dispute regarding these items, consider including a provision in the purchase agreement that reflects the parties’ agreement to either maintain these deviations or alter them for purposes of the purchase price adjustment calculations.
These are just a couple of examples, but this is an important purchase agreement drafting point to keep in mind on your next transaction. Spend a little time pre-close getting the detail included to avoid spending time arguing about it post-close.
3. Include Examples of All Purchase Price Adjustment Calculations
As noted above, purchase price adjustments are typically based on a metric, such as NWC or EBITDA, derived from accounts in the financial statements of the acquired company. Disagreements between the parties over these calculations occur due to differing views on the inputs to the calculation and/or the appropriate application of the relevant accounting guidance.
In reality, the accounting mechanisms provided in the purchase agreement to determine whether a purchase price adjustment is necessary should be straightforward unless there has been a substantial change in the target company’s operations prior to the closing date. Both parties will typically have agreed to an NWC target or an EBITDA amount to use for purposes of closing the deal and on which to base any post-closing purchase price adjustment. Presumably, both parties agreed on the inputs into that calculation, as evidenced by both signing the purchase agreement. So, why do many purchase price disputes occur related to these types of calculation? In our experience, it is because there is “wiggle room” on the part of the buyer and the seller in coming up with these post-closing calculations. By wiggle room, we mean that the NWC, EBITDA or other calculation was not fully defined in the agreement, down to the financial statement account level; more importantly, no example calculation was included as an exhibit to the purchase agreement.
The example calculation can be a generic example that simply lists the financial statement accounts to be included, as well as items or amounts in those accounts that may be excluded. Alternatively, the example calculation can be the exact one used to determine the target amount of NWC or EBITDA. The latter is preferable because it provides an actual amount used in the purchase agreement on which the parties agreed.
Including such a calculation may sound obvious, but it is not often done in practice. The inclusion of such a calculation will not mitigate purchase price adjustment disputes, because in certain cases the parties simply don’t agree on the accounting treatment for subjective items such as inventory reserves or allowance for doubtful accounts. However, including a detailed example calculation should mitigate unintentional misunderstandings regarding the items to be included in the calculation, avoiding unnecessary and costly post-closing headaches.
4. Use Earn-outs Wisely and Only When Absolutely Necessary
Earn-outs have long been a source of post-closing disputes, and the longer the earn-out period, the more likely there will be a dispute. Earn-outs are typically used when 1) a buyer questions the true value of the a target company as compared to the asking price, 2) the target company is new and doesn’t have a long enough track record to support the asking price or 3) there is expected volatility in the company’s forward results. As a compromise between what the buyer is willing to pay and what the seller ultimately wants to receive, the parties come up with an earn-out period, creating the opportunity for the acquired company to hit agreed-upon metrics (e.g., sales, profit, EBITDA) and “earn” the higher price over time, typically one to three years.
Using an earn-out provision can be a good way for both parties to achieve their goals. If the acquired company performs up to the seller’s claims, the buyer has acquired a valuable asset and the seller has realized a justifiable increased sales price. If the company does not perform as expected, the buyer has not overpaid for an underperforming asset and the seller—well, if this occurs, the seller was probably asking too much for the company.
So, the parties agree on the earn-out, and two years down the road it is time to perform the calculations and settle. Where is the problem? The company either hit or missed the target. The problem … see items 2 and 3 above as a starting point. In addition, many things could have changed over the earn-out period to impact the calculations, such as a change in the applicable accounting guidance that impacts how certain financial statements items should be recorded.
Longer earn-out periods create more opportunity for issues to develop, specifically regarding accounting and calculation of earn-out metrics. To assist in mitigating an earn-out dispute, the purchase agreement can include detailed provisions regarding the relevant accounting guidance and earn-out calculations (similar to the discussion in item 3 above).
Regarding the accounting guidance, it may not be good enough to include a provision that states that all amounts are to be calculated in accordance with applicable GAAP. What if certain accounting treatments historically used by the acquired company change during the earn-out period? What if the target company utilizes IFRS, but the agreement calls for U.S. GAAP? These issues can and do arise, and they create significant potential for a dispute when not properly addressed in the purchase agreement.
Other pitfalls with earn-outs not addressed in this article include a change in focus by the acquirer that de-emphasizes the product line acquired, poor integration and/or management of the acquired company and inadequate separation of accounting for the acquired company on a stand-alone basis. These are primarily legal issues that should be addressed in the drafting of the purchase agreement.
Earn-outs do serve a purpose, and sometimes it is the only way the two parties can move forward with a transaction. However, you should enter into a deal with an earn-out provision only when necessary and with your eyes wide open regarding the possible post-closing issues. Failing to address the potential earn-out pitfalls can cause problems later.
5. Include the Dispute Resolution Process Details in the Purchase Agreement
One final item to include in the purchase agreement is the dispute resolution process. The points above can and will help mitigate post-closing disputes and liability, but they will not eliminate disputes altogether. Including enough detail in the purchase agreement about the mechanics of the dispute resolution process will allow parties to focus their efforts on resolving the items in dispute rather than spending time and money resolving a dispute about the process.
The purchase agreement should, at a minimum, define who would arbitrate the dispute (e.g., a national accounting firm), the time period for submitting disputed items, which items can be submitted for resolution in arbitration and the number and type of submissions in the arbitration (initial submissions, rebuttal submissions, hearings, testimony, etc.). The selection of the arbitrator can be a lengthy process if no direction is provided in the purchase agreement, and if not properly addressed in the purchase agreement this selection can be artificially extended by one party to delay resolution of the disputed items. To eliminate some of this delay, the purchase agreement could specifically name the accounting firm that would serve as the arbitrator.
In short, the purchase agreement should include enough detail regarding the dispute resolution process to allow it to progress quickly and smoothly to resolving the items in dispute, rather than evolving into protracted negotiations or even litigation regarding the dispute resolution process itself.
Will your company or firm be a player in the 2014 rise of M&A? If so, consider these five items before you close your next deal. While the items discussed in the article cannot cover every potential post-closing dispute scenario, they can help you mitigate some of the most common post-closing disputes and lead to a more successful transaction.
About the Authors
Jerry Hansen is a Principal at Berkeley Research Group in their Dallas office. He is a forensic accountant with over 12 years of experience negotiating and resolving post-closing purchase price disputes, and performing anti-bribery/anti-corruption due diligence and investigations and other types of forensic accounting investigations. His clients have included numerous Fortune 500 companies, and he has resolved matters involving disputed amounts in the hundreds of millions of dollars. In addition, Jerry has over 12 years of combined industry experience in software revenue accounting, mortgage banking, and insurance claims.
Jerry was previously the Southwest Region leader of a Big Four public accounting firm’s Transaction Forensics practice, a specialty practice that focused on due diligence services (primarily related to anti-corruption and other forensic due diligence) and disputes and investigations that stemmed from contemplated and completed merger and acquisition transactions.
Jerry has experience in purchase price dispute arbitrations, anti-corruption due diligence, and forensic accounting investigations in a range of industries including technology, energy, transportation, manufacturing, software, food services, publishing, automotive, retail, staffing services, advertising, and financial services.
Jerry can be reached via email at email@example.com or via phone at 214-453-4211 or 972-741-5559.
Bobby Majumder is a partner in Perkins Coie’s Business practice and firm-wide co-chair of the firm’s India practice, which focuses on corporate and securities transactions primarily in the following industry verticals: energy (oil and gas, and coal), mining, healthcare, and information technology. He represents underwriters, placement agents, and issuers in both public and private offerings of securities; public and private companies in mergers and acquisitions (both cross-border and domestic); private equity funds, hedge funds, and venture capital funds in connection with both their formation and investments; and companies receiving venture capital and private equity funding.
Bobby has extensive experience in mergers and acquisitions involving companies in the information technology, telecommunications, mining, coal, oil and gas, and healthcare industries. He also has extensive experience in representing private equity, hedge funds, and venture capital funds in their investments in both public companies and closely held entities.