Preventing Post-Acquisition Disputes
The recent battle between Elon Musk and Twitter highlights a familiar challenge in the M&A lifecycle: disputes between buyers and sellers after a deal has been struck. The Musk-Twitter dispute was unusual in that the deal had not yet been finalized—most disputes occur post-transaction—yet it shares much in common with the disagreements that result in post-acquisition disputes arbitration.
The best way to resolve these disputes is simple: avoiding them in the first place. The careful use of precise, comprehensive contract language—not only defining terms, but also detailing procedures, contingencies and the like—is key to resolving ambiguity and reducing subjectivity early in the M&A process. By addressing these issues as they arise, buyers and sellers can work together to solve potential disagreements before they escalate into full-blown disputes that require third-party arbitration and hefty legal costs.
Post-acquisition dispute timeline
1. M&A agreement
2. Post-closing period
3. Disputation period
4. Good faith negotiation period
Representations and Warranties
Throughout the M&A process, buyers and sellers represent various facts, such as customer lists, large contracts, financial statements and tax information. A dispute may surface when a buyer believes that the seller has misrepresented the business with these disclosures, or lack thereof. The buyer will move to recoup costs, reasoning that had they received an accurate picture of the business, they would have paid less for it.
If a seller represents that the “financial statements fairly present in all material respects the financial position of the company in accordance with generally accepted accounting principles (GAAP), that language may not be clear enough to avoid the subjective determinations required by GAAP. For instance, what is considered “material?” By precisely defining the terms, companies can account for these issues before they occur.
Today, many transactions include representations and warranties (R&W) insurance. Either the buyer or seller can be the insured party, but most of the time, the buyer is insured. Under a buy-side R&W insurance policy, when a dispute arises related to breaches of R&W, buyers can bring their claims to the insurer, rather than attempting to recover losses directly from the sellers. In most cases, R&W insurance can reduce or eliminate sellers’ liability for indemnification for breaches of representations and warranties.
A working capital dispute arises when buyers and sellers disagree over the post-closing working capital adjustment to the purchase price. A buyer reviews financial information before a deal is concluded, but in the time before the transaction closes, the working capital is often updated to reflect the company’s latest financial condition. Disputes often arise related to the change in working capital because the M&A agreement language is not clear or precise enough on the components to be included in the calculation. Such disputes are usually arbitrated by a national accounting firm.
For example, many agreements include standardized language that the closing balance sheet “shall be prepared in accordance with GAAP and consistent with past practices, policies, procedures, and methodologies.” But what happens when the seller’s past practices diverge from GAAP? By defining in advance which standards prevail in the event of such inconsistency, buyers and sellers can prevent a disagreement due to different interpretations of the balance sheet.
An earnout structure enables a seller to collect additional payment post-acquisition if certain targets, typically financial, are met. Earnout disputes generally take two forms:
• The buyer and seller disagree on whether a target has been met;
• The buyer and seller disagree on the payment required as laid out in the original agreement.
An earnout in which the seller is set to be paid based on a performance metric may result in a dispute if the terms are not clearly stated and explained. The metrics used to measure performance, as well as the accounting principles and methods applicable to calculating those metrics, should be defined in the agreement without ambiguity.
Many earnout disputes are related to the manner in which the buyer operated the business during the earnout period. For instance, did the buyer operate the business consistent with the seller’s past practice? Did they operate in a manner that did not allow for the earnout to be achieved? These areas must be addressed with specificity in the contract to eliminate subjectivity and avoid a dispute.
All of these scenarios stem from imprecise contract language. Buyers and sellers must work together to address points of ambiguity and inconsistency while writing agreements to reduce friction later in the process. This process should involve not only legal counsel, but also accounting and tax professionals who can make sure the contract terms comply with the information identified in due diligence. By clearly defining not only key terms, but also processes and contingencies, companies can minimize subjectivity and prevent post-acquisition disputes from happening.
For Legal Practitioners
Both buyers and sellers can strongly benefit from trusted advisers representing them. During the initial M&A agreement, legal practitioners and accounting professionals can help ensure contract language is comprehensive and precise. That is the best way to avoid arbitration disputes post-transaction altogether.
For legal practitioners who support the entire acquisition lifecycle, the most critical area of focus should be conducting due diligence. Between evaluating material contracts and assisting with regulatory approvals, legal practitioners play a critical role in this process. They can help expose risks and enable the buyer to make a more informed decision.
Should the deal reach arbitration or court, an independent accountant may be called in to serve as a neutral decisionmaker to reconcile the terms in the sales and purchase agreement. This party’s decision is usually final and binding. At this point, legal practitioners play the critical role of keeping their clients calm, organized, and focused.
Legal practitioners, particularly those who practice M&A law, are well-positioned to prevent post-acquisition disputes. But even if they can’t prevent arbitration, they still can make a significant impact for their buyer or seller clients at various stages of the acquisition.
Written by Jeffrey Katz. Copyright © 2023 BDO USA, LLP. All rights reserved. www.bdo.com