An ounce of prevention: hints to help avoid post-acquisition disputes
June 2015 | EXPERT BRIEFING | LITIGATION & DISPUTE RESOLUTION
All too often, the acquisition of a business does not end at the closing. The signing of contracts and shaking of hands too commonly only leads to a new stage of the deal: the post-acquisition dispute.
According to a 2013 study by a leading shareholder representative firm, post-acquisition disagreements are frequent, expensive, time-consuming and contentious. Two-thirds of privately-held company sales result in some form of post-closing dispute. The claims asserted in these disputes average 30 percent of available escrow dollars, and one out of every five claims exceeds half of the escrow. Almost a third of all claims are filed during the last week of escrow, and disputes last an average of five months. One out of every eight claims ends up in litigation or arbitration.
Over half of all post-acquisition claims involve alleged breaches of representations and warranties and purchase price adjustments comprise another quarter of all disputes. The most common breaches of representations and warranties involve tax issues, undisclosed liabilities or intellectual property disputes. The amount disputed varies with the subject matter: fraud claims average 100 percent of the escrow; breaches of fiduciary duty average almost half; and customer contract disputes average over a quarter of the escrow.
Given these statistics, parties considering an acquisition must be aware of common problems and adopt a strategy to avoid them. This article will discuss some of the major issues that commonly arise after closing, and recommend some possible steps to help to minimise the likelihood of, and distraction caused by, post-acquisition disputes.
Types of post-acquisition disputes
Purchase price adjustments. Many private acquisitions involve post-closing purchase price adjustments, or ‘true ups’. Because the acquirer typically values the acquired company based on its historical financial statements, they often demand contractual provisions designed to adjust the purchase price after closing for fluctuations in the target’s balance sheet between the date of the historical balance sheet and closing. Often these purchase price adjustments are not subject to any cap on the amount of the claim.
Disputes can occur because valuation is complex and each party has a different objective when calculating the value of a business: purchasers typically seek the best deal while sellers try to maximise the price received. In addition, the parties can utilise different calculation methods that result in vastly different results. For example, parties to an acquisition frequently dispute whether the purchaser should use Generally Accepted Accounting Principles (GAAP) or a historical method of valuation where the purchaser values the company using the same method used by the seller. A historical method helps to maintain consistency with past practices but may conflict with industry practice or the purchaser’s usual practice. On the other hand, GAAP is subject to differing interpretations and applications, and parties often fail to delineate acceptable parameters prior to closing. This inherent uncertainty can lead to purchase price showdowns after closing.
Earnouts. Earnouts are payments by the purchaser to the seller based the company’s performance after closing. Usually the purchaser who controls the company’s after the acquisition and who profits when earnouts are not paid, prepares the initial earnout calculation. Sellers who do not receive expected earnouts may argue the purchaser took action to deliberately miss milestones. Earnouts based on sales to particular customers may involve conflicts of interest because the purchaser may have an incentive to avoid selling to these customers.
Earnouts are an increasingly common component of purchase agreements, appearing in over a third of all acquisitions. Earnouts also have the potential for significant post-acquisition disputes because they account for up to 40 percent of potential proceeds and extend on average 36 months beyond closing.
Working capital disputes. Working capital is the difference between the company’s current assets and its current liabilities. Private company deals often involve precise targets for working capital at the time of the closing and require payments depending on whether these targets are met or exceeded.
Breaches of representations and warranties. Alleged breaches of representations and warranties are the most common issues that arise after closing, accounting for 57 percent of post-acquisition disputes. Disputes over such breaches are usually resolved in court. Because this article focuses on problems that occur after closing and can be avoided with careful negotiation and preparation, we will not further discuss breaches of representations and warranties.
Accompanying legal provisions
Purchasers frequently require the seller to place some percentage of the purchase price in an escrow account as insurance against misrepresentations or breach of warranty. Unfortunately, even this widely-accepted practice engenders frequent disputes. Disputes commonly arise over the amount placed in escrow, the duration of the escrow and the indemnification threshold. Purchasers want an escrow account that has sufficient funds and an adequate duration to cover all potential disputes. Sellers on the other hand want to minimise the amount of money tied up in escrow and want to limit payouts by imposing threshold amounts below which the escrow cannot be accessed.
Parties frequently agree on a ‘basket’: the threshold amount that the purchase price dispute must reach before it can be formally contested. Baskets can be deductible, with the seller only responsible for amounts that exceed the threshold; first dollar, with the seller responsible for all losses once the threshold is reached; or a combination of the two.
Business acquisition agreements frequently include mandatory arbitration agreements to avoid the expenses involved with litigation. Nevertheless, even such well-established practices can give rise to disputes. Prudent parties can avoid post-acquisition clashes over arbitration if they settle a few issues during negotiations.
Issues to discuss before closing
Do your homework. Conduct due diligence on the accounting policies, and practices of the acquisition target. Acquisitions of companies generally involve many demands for time and attention, but this is important. Time spent doing due diligence before closing can save much more time and money spent disputing issues after closing.
Define key terms. Make sure your terms are precise and narrow, with as little room for interpretation as possible. Use examples to illustrate complex issues.
Decide on controlling standards. Agree in advance whether the post-closing valuation will be performed according to historical practice or GAAP, and which will prevail in the event of a conflict. Making sure these practices are sufficiently well defined with exact definitions and parameters will help avoid clashes over purchase price adjustments.
Keep calculations simple. Avoid mid-period transitions, if possible. This will avoid the need to make adjustments to approximate historical calculations. Ensure consistent sources of data between the pre-closing and post-closing valuations. In particular, merging companies present special challenges, including how value should be allocated to each. Limit the number of variables. There is a greater risk of error and therefore a greater risk of dispute as the number of moving parts increases.
Minimise discretion and subjectivity. Decisions that involve subjective assessments or discretion will almost always be decided in the way that most benefits the deciding party. Setting minimum requirements and concrete standards minimises this imbalance. Use objective rather than aspirational language. Avoid the use of terms such as ‘good faith’ and ‘actively participating’ that are difficult to define and are open to interpretation.
Decide on dispute resolution. Ensure each party has audit rights and access to all necessary information. Always include a mediation provision. One of the parties may decline to participate, but having a provision in the purchase agreement requires the parties at least to discuss the topic. Decide on the forum for dispute resolution. Arbitration is usually less formal, quicker and less expensive than litigation, but may not be able to provide the relief sought.
James D. Dasso is a partner and Michael J. Casner is an associate at Foley & Lardner LLP. He can be contacted on +1 (312) 832 4501 or by email: firstname.lastname@example.org. Mr Casner can be contacted on +1 (312) 832 5766 or by email: email@example.com.
© Financier Worldwide
James D. Dasso and Michael J. Casner
Foley & Lardner LLP