Low interest rates, buyers sitting on record levels of investable cash, and a shortage of sellers are key factors driving one of the most competitive mergers and acquisitions (M&A) markets in recent history. In the rush to grab opportunities as they arise, key details often get left out of the purchase-agreement terms. This can result in expensive litigation when the parties discover unpleasant surprises after the agreements are signed.
The following is an exploration of common transaction discrepancies, considerations to improve your purchase agreement, and how an independent accountant can help companies resolve these issues.
Closing Adjustments Trends
Parties have been dedicating increasing amounts of attention and time to defining closing adjustments to limit the amount of latitude buyers and sellers have when coming up with post-closing calculations. Typically, most transactions are based on the company being delivered with the following criteria:
- On a cash-free, debt-free basis
- With a normal level of net working capital (NWC) needed to operate the business without additional contribution
- With each party paying their own transaction expenses, such as advisor fees, brokers’ commissions, or spreads
At times, parties use earn-out provisions, a contractual agreement to pay some or all of the purchase price if certain milestones are achieved post-close, to bridge the valuation gap. As such, parties could potentially need to reconcile five or more accounts and items after the transaction.
The cash, debt, and transaction expense components are typically easier to reconcile. NWC calculations and earn-out provisions, however, require more definitions and precision due to the number of accounts included in their determination. To address these potential complications, parties can define NWC and the earn-out provision, including a sample calculation, in the purchase agreement.
Common Causes of Closing Adjustment Disputes
The causes of a dispute can vary between NWC closing adjustments and earn-out provisions. Following are examples of how the lack of specificity can lead to confusion.
For NWC, lack of description regarding how the accounting estimates, such as bad debt expenses and inventory reserves, are calculated often results in disputes.
Too often, the buyer and seller rely on a general definition stating that the earn-out and NWC calculations are prepared in accordance with generally accepted accounting principles (GAAP). However, GAAP provides the framework for certain accounts but not the formula.
For example, GAAP requires that accounts receivable (AR) be valued at net realizable value, meaning net of potential bad debts; however, GAAP doesn’t specify how the bad debt reserves should be calculated.
Earn-Out Provision Adjustments
For earn-out provisions, the duration of the earn-out provision and post-close changes in business and operations often result in disputes. Typically, earn-out provisions are for longer periods—anywhere from one to multiple years—which makes it difficult to account for various business changes when calculating the provisions.