Word to the Wise: How to Avoid Post-Closing Disputes
The deal is done. The terms agreed to. The paperwork signed. But there may be more negotiating to come.
Many mergers and acquisitions include post-closing purchase price adjustments—financial issues that must be addressed before the deal is concluded. These adjustments are typically negotiated as part of the contract, and the wording of these provisions can make a significant difference in how they are settled.
Two Types of Adjustments
While post-closing adjustments vary among transactions, some are commonly disputed:
Working capital: Net working capital adjustments are among the most complicated and often require extensive negotiation. The idea here is that buyers expect a certain amount of working capital to continue running the business after closing. This amount is specified and is based on historical operation of the business.
Typically, within 30 to 60 days of closing, a final balance sheet is prepared showing the actual amount of working capital at closing. If this amount is less (or more) than the targeted amount, the seller may be required to make up the difference to the buyer (or vice versa).
Earn-outs: Earn-outs are often used when the parties are motivated to complete the deal but can’t agree on price. With an earn-out clause, the buyer and seller agree to post-closing performance targets using specific measures. If the targets are met over the earn-out period, the seller earns additional payment.
Earn-out provisions typically include the right to audit, allowing a CPA to audit the financial statements that determine the earn-out payments.
The most common disputes related to working capital involve standards of accounting: Should the standard be generally accepted accounting principles (GAAP) or some variation thereof that more accurately reflects the standard used for the company’s historical financial statements?
The application of the agreed-upon standards then comes into play. These disputes involve more nuanced interpretations of specific accounting principles as they apply to the treatment of revenue recognition, cash, accounts receivable, deferred tax assets, costs, and so forth.
Sellers often represent that the company’s financial statements have been prepared in accordance with GAAP consistently applied. Buyers may suggest that adjustments are necessary to achieve a “better” GAAP presentation.
For earn-out calculations, disputes can center on whether the buyer acted in good faith to achieve the performance targets specified. Other disagreements focus on whether earn-out conditions have actually been met and, commonly, how GAAP applies to the earn-out calculation.
In both cases, valuation and accounting experts are often called upon to provide an opinion about the specific circumstances.
Thoughtful and precise drafting of purchase agreement verbiage can help avert these disputes. Define, define, define. The more specific the language, the fewer opportunities arise for disagreement.
Also consider including a sample calculation showing how each of the post-closing items would be handled using specific calculations.
Finally, set forth specific procedures to resolve disputes, and if the agreement calls for an independent expert to review the matter, be sure to detail the scope of work.