The year 2014 is expected to be a strong one for merger and acquisition (M&A) activity. Several factors are contributing to a deal-friendly environment such as inexpensive debt capital, strong stock prices and cash-heavy balance sheets that provide the currency needed to enter into deals. In addition, overall macro-economic strength continues to build. Against this backdrop, there is pent-up demand among those who wish to grow through acquisitions after years of standing on the sidelines during a slow economic recovery.
An increase in M&A activity will also inevitably increase post-acquisition disputes. These disputes may arise from:
- alleged misrepresentations about customers, contracts, revenues, costs, assets and liabilities;
- differing interpretations of applicable deal-pricing metrics, working capital calculations and other issues giving rise to purchase-price adjustments; and
- disagreements about purchase price allocations, access to escrowed funds, earn-outs and other forms of contingent consideration.
Needless to say, most parties would prefer to avoid–or at least minimize–the disruption and expense associated with transactional disputes on the back end of a deal. Improved outcomes may be attained through increased due diligence at the front end and more thoughtful agreement drafting as related to financial provisions.
Effective due diligence exercises often include a quality-of-earnings analysis in which factors that directly affect the income statement are analyzed. Revenue reliability, pricing, customer segments, customer concentration and the recurring (or non-recurring) nature of revenues may be primary considerations. In addition, the incremental and on-going nature of costs that must be incurred to support acquired revenues would be analyzed. At the end of this exercise, buyers should understand the additional operating profit and cash flow that can be reasonably expected if they enter into the deal.
Buyers may also want to take a closer look at the assets and liabilities being acquired to avoid potentially unpleasant surprises after closing. This analysis may help buyers better understand the accounting and economic values for financial, tangible and intangible assets being acquired, along with any debt and contingent liabilities being assumed.
Effective due diligence, coupled with agreement drafting that considers important financial provisions, can help prevent post-acquisition disputes from occurring and/or escalating. Some specific provisions to consider in transactional documents include:
- specific criteria or dollar values for establishing materiality levels;
- applicable accounting standards and methods which may encompass GAAP and non-GAAP approaches;
- formulas and calculation approaches for determining purchase price adjustments;
- specifications of the duties of sellers and buyers in providing pre- and post-closing financial information as relevant to purchase price adjustments and tax filings; and
- provisions that identify an individual or firm to assist in resolving financial disagreements as a neutral arbiter.
Unfortunately, even the most talented deal lawyer cannot anticipate, and help transacting parties avoid, all potential sources of deal dissension. As a result, some level of disagreement in the aftermath of M&A transactions is inevitable and may result in breach-of-contract claims. When these problems arise, parties may settle disagreements on their own, arbitrate or go to court. The transactional documents may speak to these situations through arbitration and venue provisions.
In deal-related litigation, breach-of-contract claims against buyers usually involve allegations of underpayment and may simply seek full payment. However, breach-of-contract claims against sellers may also claim alleged misrepresentations, or even fraud. The unhappy buyer in this situation may seek compensation through a “benefit-of-the-bargain” claim which is essentially an attempt to obtain a purchase-price adjustment through judicial means based on the reduced value obtained.
Dependent on the claims, resolving post-transaction disputes may require the support of financial professionals with expertise in business valuation, asset valuation, damage analysis, financial accounting and forensic accounting. It is important to remember that enlisting the support of such professionals early in the process to provide support in due diligence, valuation and articulating deal provisions may prove beneficial (and less expensive) to the extent that such support assists in avoiding disputes after closing.