M&A Transaction disputes can be a costly and time-consuming affair. So, how do you avoid them?
The best way to evade these disputes is to prevent them from happening in the first place. While it's generally fun to tease the accountants and attorneys in the room, this is where your advisors can help steer clear of unnecessary chafe after the transaction closes. When drafting the four corners of the legal documents and accompanying exhibits, unambiguous contract language and comprehensive disclosure schedules are key to reducing subjectivity in an M&A transaction. By addressing potential issues before the deal closes, buyers and sellers can work collaboratively to prevent disagreements from escalating into full-blown disputes that require third-party arbitration and result in significant legal costs.
During diligence and all the way leading up to the date of closing, various pieces of information are disclosed. This includes financial statements, tax returns, customer lists, and leases, just to name a few. When a buyer thinks that the seller has misrepresented the business through inaccurate or missing disclosures, conflicts may arise. In these instances, buyers may seek an indemnity claim to recover damages by arguing that the valuation (and purchase price) would have been lower if they had received accurate information.
As a practical example, the phrase "financial statements fairly present in all material respects the financial position of the company in accordance with generally accepted accounting principles (GAAP)" can be riddled with subjectivity. What if GAAP can result in multiple forms of accounting treatment? Does consistency with past practice matter? What if the financial statements don't include footnotes? While it may seem to be a matter of legalese to the layperson, these are the nuances that are critical to navigate.
In recent years, many transactions have included representations and warranties (R&W) insurance. Previously, this type of insurance only made economic sense on larger transactions but has recently become more prevalent in the lower-middle market. R&W insurance can be bought by either the buyer or the seller, though buy-side R&W insurance is the most common. The main benefit of R&W insurance is that it enables the buyer to file their claims (breaches) with the insurer instead of pursuing compensation directly from the seller. Further, in most cases, sellers can reduce or eliminate their liability for indemnification claims with the existence of R&W insurance. This can allow for a "clean exit" that many sellers desire.
Another common area of dispute is net working capital. Specifically, the post-closing adjustment to net working capital, which occurs 30-90 days after the transaction closes. Despite the use of specific net working capital escrows, the post-closing adjustment may exceed the escrow amount. In those cases, it is not uncommon for disputes to arise. As we have previously discussed in our blog article Net Working Capital – When Creativity Meets Logic, these issues can be mitigated by including detailed illustrative exhibits in the purchase agreement, along with explicit definitions that make clear the measurement methodology.
Earnouts tend to be another hotly contested item once the dust of the transaction has settled. Fundamentally, earnout structures are designed to help a buyer and seller bridge a valuation gap. If the company achieves the agreed-upon earnout hurdle(s), the seller can receive additional consideration. While it is likely obvious, the reason that earnouts can result in legal disputes stems from the fact that the earnout metric must be measured according to agreed-upon terms. This can be impacted by the accounting treatment utilized as well as the manner in which the company was operated post-transaction. For example, if the new owners intentionally took actions to skirt the earnout, is that addressed with certain legal guardrails in the agreements? What if there was a change in accounting principles?
To prevent post-acquisition disputes from happening, it is crucial for buyers and sellers to work collaboratively to address potential ambiguities and inconsistencies while drafting agreements. This process should involve legal counsel, accounting, and tax advisors. If there is an issue with the language in the agreements, it is always best to sort that out before the deal has closed. If terms are unclear, third-party arbitration can be a coin flip. And an expensive one at that.
It cannot be stressed enough that your legal and accounting advisors should be seasoned M&A professionals. Ideally, once the signatures are dry and funds have been wired, the purchase agreement should sit on a shelf collecting dust for eternity. If that happens, it usually means that the legal documents appropriately reflect the agreed-upon terms between buyer and seller.
