Let the Buyer (and the Seller) Beware
As mergers and acquisitions increase, disputes related to deals gone awry will surely follow. As a forensic accountant frequently called to assist attorneys in purchase price disputes, I have observed common threads throughout these matters. While the outcome of the disputes has varied due to the decision making body and each matter’s facts and circumstances, the underlying causes have been less varied.
It is no surprise that buyers tend to initiate litigation over issues of value; that is, differences between the perceived value of the company prior to acquisition and the perceived value realized. Sellers, on the other hand, often initiate litigation over purchase price ‘true-up’ issues or earn-out provisions. The following observations are offered for two purposes: (1) to provide M&A counsel, assisting in the acquisition and due diligence stages of a transaction, with information that might help your clients avoid future litigation; and (2) to provide M&A litigators with a primer on common underlying causes to purchase price disputes.
“Consistent Application of GAAP”
In many purchase and sales agreements, drafting counsel includes language stating that “U.S. generally accepted accounting principles (“GAAP”) must be applied on a basis consistent with the Company’s historical practice, as long as such historical practice complies with GAAP.” This language is commonly included for purposes of calculating the purchase price adjustment (A.K.A. net asset value adjustment, tangible net worth adjustment, or other defined terminology) and the earn-out provisions, if any exist. Such language is generally desirable to sellers since it affirms that the bases of accounting to be used post-transaction are the same as pre-transaction. It also gives the Seller some level of comfort that earn-outs can be achieved if certain performance targets are met. In basic terms, this language may assuage the fear of manipulation based on accounting methodology for the Seller.
Issues arise when the Seller and Buyer disagree over accounting methodologies and the interpretation of “consistently applied GAAP.” It is important to note that the Buyer is free to institute any GAAP-based accounting for its financial reporting purposes; however, it must be aware that historical GAAP (as employed by the Seller) might be required for purposes of calculating the purchase price adjustment or earn-out based on the terms of the purchase agreement.
The following examples have been selected from recent purchase price litigation matters:
Seller historically capitalized small tools into inventory and expensed them into cost of sales as they were utilized on jobs. Buyers changed the method to expense the tools directly since Buyers deemed the tools disposable. As a result, Buyers reported higher expenses and lower assets than Sellers would have under their historical methodology.
Seller historically accounted for its construction revenue based on the cost-to-cost percentage of completion method (job progress measured by comparing costs incurred to total estimated costs). Buyer changed the method to account for construction revenue based on milestones met (job progress measured by comparing milestones met (units delivered) to total milestones to be met). As a result, Buyers deferred recording revenue that the Sellers would have recorded under their historical methodology into a future period (beyond the earn-out period as defined in the purchase agreement).
Sellers historically valued its inventory using the first-in, first-out method, which means that the oldest inventory is deemed to be sold first (resulting in lower cost of sales in an inflationary environment). Buyer changed the inventory valuation method to the last-in, first-out method (resulting in higher cost of sales in an inflationary environment). As a result, Buyers reported higher expenses and lower assets than Sellers would have under their historical methodology, downwardly impacting the Seller’s earn-out prospects.
It is critical to note that the Buyer’s change in GAAP might be preferred to, or more appropriate than, the Seller’s historical accounting methods. Yet, if the Seller’s historical accounting method was in accordance with GAAP, it will likely be required to be used for the stated purposes. Though potentially cumbersome, Buyers might be required to calculate its financial information twice – once for financial reporting purposes, and once for purposes of calculating the terms of the purchase agreement. Whatever its plan for complying with the “Consistent Application of GAAP” terms post-transaction, the Buyers should obtain a clear understanding of the Sellers’ historical accounting methods and the potential impact of these methods during the due diligence phase of the transaction.
Changes in Estimates
While changes in GAAP might be obvious and more easily addressed, changes in estimates and the estimation process can be quite difficult. Sellers approaching a transaction might be incentivized to present its financial performance in a positive light, whereas, Buyers might be incentivized to adjust Seller’s financial performance in an overly conservative light. Financial statements prepared in accordance with GAAP include estimates, and such estimates can be the subject of much debate.
Once a Buyer has control of the acquired business, the Buyer has the ability to adjust or change the company’s estimates and estimation procedures. As with the changes in GAAP, these types of changes often lead to disputes since the parties might have conflicting objectives. The Buyer might want to ‘clean up’ the financial statements to present a highly conservative picture, with the motivation of demonstrating marked improvements in financial position and performance after the acquisition. The Seller, on the other hand, might desire a less conservative approach since its earn-out prospects are generally based on some financial position or performance metric.
Examples of these types of disputed items from recent matters include:
Buyers learned that one of the Seller’s major customers had filed for bankruptcy prior to the transaction’s closing. As a result, Buyers adjusted the closing balance sheet by writing off (or reserving) 100% of the accounts receivable related to that customer. This adjustment decreased the calculated closing net worth and affected the Purchase Price Adjustment. Seller disputed the 100% write-off citing the customer’s bankruptcy filing. The Sellers asserted that the bankruptcy filing demonstrated the customer’s ability to pay a large percentage of the customer’s debts, including the seller’s receivables, based on the restructuring plan filed. In addition, Seller contended that a factoring company was willing to pay a percentage for the receivables despite the customer’s bankruptcy.
Buyer noted that certain of Seller’s inventory had not moved (no sales) in the preceding year. As a result, the Buyer wrote off (or reserved) 100% of these inventory items. The Seller disputed the 100% write-off contending that there was residual value and that much of the inventory was not expected to move several times each year. Seller demonstrated that shortly after the write-off, portions of the inventory were, in fact, sold.
It is important to note that estimates included in the financial statements are to be determined based on the best available information at the time the financials are prepared. Significant risks can arise when information is either unavailable or difficult to obtain. Reasonable efforts should be made to gather the necessary information in the due diligence process, so that estimates may be addressed contemporaneously. Further disputes arise when buyers apply 20/20 hindsight and argue adjustments to estimates included in earlier financial statements. Many drafting counsel attempt to minimize such disputes by including language relating to changes in estimates, however, depending on the facts and circumstances, it can remain a very complex area of dispute.
Reliance on Interim and Historical Financial Information
A third common area of dispute involves the use of interim and historical financial information. Buyers tend to spend great amounts of time and energy examining interim and historical financial statements and supporting documentation in the period leading up to the closing date. The level of reliance that buyers can and should place on such information varies. During the due diligence process, Buyers have the opportunity to examine the seller’s operations, business relationships, reputation, contracts, personnel and financial reporting processes to gain an understanding of the potential risks and rewards of ownership. It is incumbent on the Buyer to take full advantage of this opportunity.
Disputes arise when Buyers discover, in many cases after closing, that the company it purchased is not exactly the company the Buyer thought it was purchasing. A common cause of this dispute is the level of reliance the buyer placed on the Seller’s interim and historical financial information. While it might be very appropriate in some instances to make projections based on interim or historical financial information to gain comfort on future performance, this is not always the case.
Examples of selected issues follow:
Seller’s interim financial performance was subject to seasonality. Buyer may have failed to take into account the fact that either majority of revenue has already been reported for the year or that it is yet to come. Buyer’s projections from such financial information might have produced skewed expectations.
Sellers’ businesses either benefitted or suffered from a one-time event. Buyers must evaluate the nature of the event and the extent of its impact, if any, on the future performance of the company. Without such consideration, the Buyer’s projections might have produced skewed expectations.
Seller’s business operated in highly competitive environment, subjecting its products and services to obsolescence risks. Buyer failed to take into account the competitive landscape and the security of the Seller’s intellectual property position before projecting historical financial performance into the future.
Seller’s business relied heavily on its strong relationship with major vendors or customers. Buyer did not consider the risk of losing such relationships due to the change in management or potential conflicts of interest post-transaction.
Seller had a limited number of personnel. In the process of assisting the Buyer in the due diligence process, Seller’s staff became distracted and was not been able to maintain operations, financial performance and reporting to the level it had in the past. As a result, projections from the interim financial statements might have differed from actual results.
Seller’s interim financial statements were unaudited. As a result, audit adjustments might cause actual results to differ considerably from projections or expectations gained from Seller’s interim financial information. Buyer may have benefitted by examining historical audited financial statements and related audit adjustments to understand the risks more clearly.
While these above risks have been included to inform potential Buyers, the same issues hold true for the Seller. Sellers must be aware that competition, continuing relationships, the due diligence process, and general business dynamics may impact their expectations leading up to the closing date and beyond. Purchase price adjustments are included in M&A agreements to protect both of the parties for these and other reasons. Thus, both Buyers and Sellers would be wise to keep such issues in mind throughout the transaction.
Both Buyers and Sellers should consider performing extensive due diligence procedures to obtain the clearest picture available of the potential transaction’s risks and rewards. Independent consultants can be of great assistance in the due diligence process, addressing risks in the areas of finance, accounting, operations, litigation history, and management integrity. Consultants not only assist management in ‘kicking the tires’ of the potential acquirer or target, but also serve as objective, disinterested parties, to mitigate the ever-present risk of the parties “falling in love” with the transaction. Not every company or management team has a long history of acquisitions or mergers, so experience with the ups and downs of transactions is critical.
Buyers and sellers do not typically approach a transaction with the anticipation of litigation; however, the reality is that some deals end up in court or arbitration. Candid conversations among counsel, their clients and consultants about risk areas prior to a transaction might reduce the need to litigate afterward.
Karen Fortune, CPA/CFF, MAcc – Partner
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