Use upfront diligence to head off M&A disputes

A response to recent pressures

High interest rates have exerted pressures on buyers. Grant Thornton Transaction Advisory Services Managing Director Max Mitchell articulated the buyer’s mindset: “If it's going to cost me money to raise the money for a payout, maybe I can find a way to push down what I need to pay.” 

The increase in disputes is, in many ways, a natural byproduct of the recent history of M&A activity. As Mitchell explained, “In 2021, coming out of the pandemic, there was easy access to capital which spiked deal volume and drove up valuations. That was followed by a slowdown and a gap in expected valuations between buyers and sellers.”

“Financing became more expensive, which had two consequences: first, deal teams which weren’t executing new deals had more time to focus on post-closing working capital true-ups and earnouts.  Secondly, they had a strong incentive to claw back some of the value that had been paid when valuations were high.”    

In addition, the 2024 survey found that 40% of respondents were holding back on deals until after the election, further contributing to diminished activity and increased scrutiny of existing deals.

The persistence of enduring challenges

This desire to recapture value is exacerbated by the very nature of deals, where there are strong initial pressures to get the deal done. Processes are often contingent on successfully achieving an earnout and an assumed ongoing agreement on working capital matters.

After closing, there can be strong pressure on the buy side team to extract as much value as possible. Mitchell noted that “I’ve never seen as many buyers suggesting that sellers have potentially misrepresented prior accounting as I have in the past year. And it’s not necessarily intentional misrepresentation. It’s just that, in the run up to the deal, accounting nuances can be overlooked.”  

When the buyer eventually takes control of the company, they have much better access to detailed information — and the time to process that information — so they can see new issues that they previously didn’t recognize or have access to see. 

Stakeholder incentives

The nature of the parties can increase the propensity for disputes. On the seller side, a founder who has turned over their life’s work often has the time to carefully scrutinize the execution of the deal. Blank observed that it’s not simply a matter of having time on their hands: “A lot of emotion gets into it because they are often selling businesses they’ve held for a long time, they’ve looked forward to capturing the earnout, and now if it’s not happening, there’s cause for concern.”  

Similarly, buyer-side deal teams looking at relatively fewer deals may have more time to look for ways to challenge earnouts or working capital calculations. 

Complicating factors

Certain factors are more likely to generate disputes. For example, the Grant Thornton team has seen an increase in carveouts. Carveouts naturally create complexity — there’s more judgment involved as assets, liabilities, revenues and expenses are allocated. Complexity, in turn, creates issues.

There’s also been an increase in earnouts. Blank explained that “earnouts often represent more significant value than a working capital dispute because the agreement is structured in a way that it’s a bigger adjustment to the overall purchase price.” Because more money is at stake, earnouts are more likely to be disputed. Earnouts based on Adjusted EBITDA rather than revenue are particularly likely to give rise to contentiousness because the relative complexity of EBITDA, and adjustments to it, create opportunities for manipulation. 

Obviously, many things can spur disputes. For example, the Grant Thornton team has also recently noticed disputes precipitated by customer bankruptcies and post-closing inventory reviews.

That’s why Mitchell counsels an emphasis on the fundamentals — specifically, upfront due diligence and careful negotiations.