INTRODUCTION

Buyers and sellers of businesses invest significant effort in negotiating the purchase price of their transactions. Notwithstanding all that pre-transaction effort, a significant proportion (anecdotally, perhaps as high as one-third of all closed transactions) end up with a dispute between the parties.

Given the nature of our work as forensic accountants, we tend only to see the “bad deals”, however, even in the case of a transaction that ends in a dispute, one typically finds evidence of an extensive pre-deal disclosure and due diligence process incorporating detailed analyses of past performance, earnings multiples, book values and cash flow projections. In this article, we provide recommendations on the measures that parties should consider applying to avoid transaction disputes in the first place and further steps to alleviate the impact of transaction disputes if they do arise.

PRICING DISPUTES

Parties often disagree on the application of purchase price adjustments, whether they are negotiated via completion accounts or a locked-box mechanism. 

There will always be uncertainty in the pricing adjustment process because the circumstances of the buyer, seller and target are subject to change between the signing of the purchase agreement and the closing of the transaction. Before signing the contract, parties might find that an investment of effort and advice from lawyers and accountants experienced in transaction disputes, can reduce the occurrence and the complexity of the arguments around the determination of the consideration payable at completion.

Experience suggests that pricing disputes often arise as a consequence of disagreements around matters such as the definition of working capital, the application of Generally Accepted Accounting Principles (“GAAP”) and the consideration of subsequent events.

Disputes may be avoided altogether (or rendered substantially less adversarial) if the parties can agree in the purchase agreement matters such as:

1. precisely which items should fall within the definition of working capital (including classification of items as either current or non-current);
2. proforma examples of anticipated purchase price adjustments;
3. the parameters around the application of judgement in connection with matters such as provisions for doubtful debts and slow-moving stock; inventory valuation and taxation;
4. what constitutes permitted leakage; and
5. how long after closing will it be appropriate to consider subsequent events such as the collection of receivables and the outcome of pending litigation.

As an example of the potential impact of poor contractual drafting, we recall a dispute that turned almost exclusively around the application of a clause that required the calculation of an earn-out provision based on earnings before interest, taxes, depreciation and amortization (“EBITDA “) under US GAAP. Once the dispute had arisen, the parties realized, too late, that EBITDA is not a term defined under US GAAP. 

Errors like this are easily made in the often-stressful contract negotiation period with the drafting of poorly thought out or standardized “midnight clauses”, being clauses that can be left until late in the day for attention such as those relating to the resolution of disputes and the provision of representations and warranties.

Every deal is different; thus, the temptation to rely upon boilerplate clauses, representations and warranties should be avoided. If a deal ends up in a dispute (as so many do) these will be the most critical elements of the contract. 

ENHANCED DUE DILIGENCE PROCEDURES

Operational/financial due diligence can be significantly enhanced by the application of further procedures covering areas such as:

1. understanding the accounting policies applied in the various management accounts and financial statements produced by the target company;
2. scenario testing completion statements based on the accounting policies of both the target company and the acquiring company;
3. anti-bribery and anti-corruption screening;
4. integrity due diligence directed at key individuals and counter-parties; and
5. leverage of forensic data analytics to highlight potential fraud and compliance risks.

EXPERT DETERMINATION

Expert determination is a form of contractual alternative dispute resolution that is particularly well suited to some types of transaction disputes. As the reader will be aware, the process involves the parties submitting their dispute to an independent decision-maker (acting as an expert, not as an arbitrator) and agreeing under the contract that the determination of the expert will be binding on the parties. 

Parties might consider investing more time in the drafting of the expert determination clause. A loosely drafted expert determination clause may be exploited by a party determined to delay or frustrate the process. Whereas a carefully drafted clause (which is much easier to agree before a dispute exists) can be as prescriptive as the parties wish to make it allowing, for example, for pre-deal agreement of the identity of the expert (or the expert’s firm) and the timing and conduct of the process.

The process of expert determination is particularly well suited to transaction disputes involving working capital adjustments and earn-out payments, which tend to rely on accounting calculations.

CONCLUSION

Disputes commonly arise when a buyer discovers (after the closing date) that the asset it has acquired is not the same as the asset it thought it was buying. Perhaps, because a liability emerges of which the buyer was not aware before the purchase. Or projections or forecasts relied upon by the buyer turn out to be manifestly unachievable. 

There is an inherent information asymmetry in the negotiation of a transaction, usually in favor of the seller, who inevitably knows more than the buyer about the business that is being sold. 

However, one assumes that neither party wants a transaction to end up in a time-consuming and potentially costly dispute. Careful consideration of some or all of the matters described above can help close the information gap so that both parties are more equally informed when they strike their bargain.  This can help reduce the chance of disputes arising in the first place. Whereas, an investment of time in the drafting of the contract should reduce the amount of effort and expense that is necessary to expend on a transaction dispute when one does arise.

Borrowing the words of Benjamin Franklin, “An ounce of prevention is worth a pound of cure,” and in the arena of transactions, care taken at the deal stage to consider the issues discussed in this article can go a long way to mitigating the risks of lengthy and costly disputes.