Knowledge and Insights

The process of selling your business is an intense process, and it can be difficult to navigate the mergers and acquisitions (M&A) landscape. There’s no doubt that you and your deal team of advisors will work long hours and late nights to compile data, present a confidential information memorandum (CIM) about your business, meet with potential suitors, negotiate a letter of intent (LOI), complete due diligence, and settle on final terms of the sale and purchase agreement (SPA), all while trying to conduct business as usual.

It’s important to note that the closing table doesn’t always mean the end of dealings between the buyer and seller. At exit, the conditions of sale may come with ongoing obligations, such as requiring that you participate in the business for a few more years, especially if you agreed to stay on to consult or if the buyer still owes you money. During this period, the mental and emotional impacts of having to let go of your “baby” will set-in and you will likely need some time to adjust. It could also denote the start of a post-closing dispute because SPAs typically include elements that directly impact the purchase price and/or future payments after the closing takes place.

For the seller, understanding the implications of post-close deal elements and uncertainties should be considered prior to and during the period of the new owner gaining comfort and bringing in their team, where your continued involvement may become less necessary and even less welcomed. Although there are other considerations, here are three general items that have been known to lead to post-closing disputes: (1) representations and warranties; (2) working capital adjustments; and (3) earnout payments.

REPRESENTATIONS & WARRANTIES (R&W)

In the event of a concerned or prudent buyer, an SPA may involve an escrow holdback, where a portion of the purchase price is held after the closing for a period of time to be available to the buyer in the event of a R&W breach. A representation is an assertion as to a fact, true on the date the representation is made, that is given to induce another party to enter into an agreement. A warranty is a promise of indemnity if the assertion made is false, subject to negotiated exclusions and limits. R&Ws may address areas such as continuing normal operations through the closing, financial statements, capitalization and material contracts, along with other compliance, regulatory and reporting topics.

For post-closing disputes stemming from allegations of improper R&Ws, attorneys and accountants often come together to devise a solution. SPAs typically include accounting arbitration provisions that set forth how post-closing disputes will be handled. Given the complexities associated with the disputed items and the arbitration process itself, buyers and sellers often engage their own law firm and CPA firm to assist them in reaching a settlement, or in a worst-case scenario, preparing for arbitration.

WORKING CAPITAL ADJUSTMENTS

Working capital is principally defined as current assets minus current liabilities. While this financial metric seems straightforward, the calculation itself is often subject to robust pre-closing negotiations and post-closing disputes.

Working capital provisions in SPAs attempt to address the buyer’s need for sufficient working capital to operate the business at closing. Because it’s difficult to determine the exact working capital of a company at the closing table, a post-closing working capital adjustment (i.e., true-up payment) may be necessary if Actual Working Capital ends up being higher or lower than the Working Capital Target at closing.

WORKING CAPITAL TARGET

Based on historical financial metrics and other means, the buyer often estimates a Working Capital Target (i.e., an agreed-upon amount) to be available at closing. Working capital can fluctuate even over a short period due to market, industry, and company-specific situations outside of the buyer’s and seller’s control. The negotiation of the Working Capital Target amount can start at the LOI phase, be adjusted during the due diligence process, and then memorialized in the SPA.

ACTUAL WORKING CAPITAL

Following the closing, the buyer typically calculates the Actual Working Capital in a manner and timeframe (e.g., 60 or more days) set forth in the SPA. If the Actual Working Capital is higher than the Working Capital Target, a working capital adjustment may be due to the seller instead of the buyer.

An SPA might require that the working capital calculations be made in a very specific way, such as “…in accordance with Generally Accepted Accounting Principles (GAAP), consistently applied in line with the company’s historical practices…”, or some variation thereof. However, what happens if the company did not historically record current assets and current liabilities in accordance with GAAP? This situation is further complicated by the allowable use of GAAP accounting estimates in working capital calculations that lead to different, but still reasonable judgements being made by the buyer and seller.

Generally, the inputs to the working capital calculations that are subject to significant judgment include inventory (and a reserve for obsolete inventory) and accounts receivable (and an allowance for doubtful accounts). When assessing working capital adjustments, it’s important to consider the company’s historical accounting practices as well as a comparison of estimates to actual results.

EARNOUT PAYMENTS

Another post-closing item often in dispute is the earnout payment calculation. Earnout provisions in SPAs allow the seller to obtain additional payments from the buyer, above and beyond the purchase price, if certain financial metrics are met after the closing takes place. Ambiguous language in the SPA tends to be the culprit when it comes to post-closing disputes in connection with earnout calculations.

As with working capital adjustments, the SPA will likely reference “GAAP, consistently applied…” or some variation thereof when discussing earnout payments.  However, other factors should be considered when assessing whether an earnout payment was triggered, such as the transaction costs incurred, amortization of goodwill and whether any operations were discontinued post-closing.  It’s also important to determine whether the buyer operated the company consistently and in-line with the seller’s historical practices and to what extent the buyer’s failure to do so impacted the earnout requirements.

If you’re interested in adding an experienced transaction advisor to your M&A team, or would like to learn more about how Mercadien can help you through the M&A process (before, during or after the sale), contact us today.

DISCLAIMER: This advisory resource is for general information purposes only. It does not constitute business or tax advice and may not be used and relied upon as a substitute for business or tax advice regarding a specific issue or problem. Advice should be obtained from a qualified accountant, tax practitioner or attorney licensed to practice in the jurisdiction where that advice is sought.