What to Do When a “good” acquisition goes bad
Not all business acquisitions are successful. And when post-transaction disputes arise over such issues as purchase price adjustments and alleged seller misrepresentations, financial expertise is essential. As this article argues, financial experts with experience calculating damages, assessing business value and finding fraud can help parties make a convincing case.
Even with the best due diligence efforts, a buyer may find that the company it has acquired isn’t the company that management thought it was. When post-transaction disputes arise over such issues as purchase price adjustments (PPAs) and alleged seller misrepresentations, financial expertise is essential.
Protective PPA provisions
Typically, acquisitions are negotiated before closing-date financial statements are available. So the parties must rely on previously issued “reference” financials provided by the seller during negotiations. To avoid unpleasant surprises after the transaction closes and the closing-date financials become available, purchase agreements usually provide for PPAs to reconcile any disparities.
For example, if the seller’s working capital has increased or decreased between the time of the reference financials and the closing date, the purchase price would be adjusted upward or downward on a dollar-for-dollar basis. In some cases, post-closing revelations can affect the selling company’s valuation.
To help avoid disputes, a financial expert can develop specific provisions for PPAs — for example, establish a dollar threshold for determining “materiality” and define the accounting standards and practices to be applied to both the reference and closing-date financials. Other provisions designed to avoid litigation might include the following:
- Specify the party responsible for preparing reference and closing-date financials. Typically, the seller prepares the former and the buyer prepares the latter. Some agreements call for the seller to prepare both, but this can be problematic because the buyer controls the post closing books.
- Spell out the formula for calculating PPAs. Typically, it’s based on working capital, but some agreements use earnings, cash flow, tangible or total net worth, or some other measure.
Experts avoid including valuation reserves, which are susceptible to manipulation, in their working capital calculations. Working capital should be based on gross amounts for accounts receivable and inventory. And reserve levels should be locked to preclude any exercise of discretion or judgment.
Responding to misrepresentations
Sometimes a buyer discovers facts that its seller failed to disclose, and the buyer brings a “benefit of the bargain” claim against the seller. Essentially, the buyer argues that the business isn’t as valuable as the seller represented it to be when the parties negotiated the purchase price.
For example, the seller might lose a major government contract shortly before the acquisition and not disclose this fact to the buyer.
In such a case, the buyer might seek damages based on a revaluation of the target. This is where valuation skills are critical. The buyer’s expert might testify that the loss of the contract had a material negative impact on the seller’s value and calculate damages based on the alleged diminution in value.
The seller’s expert might counter that, based on the target’s forecasts and other evidence, loss of the contract isn’t expected to hurt its future financial performance or market value. Perhaps this type of customer turnover is an ordinary part of the seller’s business. Or perhaps the seller was in the process of negotiating new contracts that would replace the lost revenue.
Question of materiality
Another important consideration is the materiality of an alleged misrepresentation. The buyer may argue that it would have paid less for the business had it known about the lost contract. But from the seller’s perspective, the loss may have had no impact on the price it was willing to accept.
In some cases, the seller’s actual performance may be relevant. If subsequent events demonstrate that the seller’s post-closing performance was consistent with the buyer’s expectations at the time the transaction was negotiated, the seller might argue that the buyer received the benefit of its bargain after all.
If your client’s acquisition turns to litigation, don’t head to court alone. A financial expert with experience calculating damages, assessing business value and finding fraud can help you make the most convincing case.