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Transaction disputes: Extract more value

Don’t be tempted to assume that less explanation of the financial and accounting facts and arguments is acceptable when presenting information to a neutral accountant instead of a judge.
Over $1.1 trillion in U.S. and $2.4 trillion in global M&A deals have been signed this year through August — the highest year-to-date volume since 2007.1 With the growing M&A market, business owners are finding opportunities for investment. But not all transactions realize anticipated value, which can lead to post-acquisition disputes. Some disputes relate to provisions for future payouts based on performance. Other disputes relate to the accounting for certain elements in the closing balance sheet. Companies may even dispute over the determination of seemingly simple calculations, such as the change in working capital between a preliminary closing and final balance sheet.

Disputes are typically argued before a judge with legal training and experience. However, many transaction agreements provide for disputes to be resolved by an accounting expert; a benefit being that a neutral accountant will likely have more financial experience than a judge. When the parties are preparing information to present to a neutral accountant, they must remember that it is still critical to present the facts and analysis in a clear and compelling manner. Don’t be tempted to assume that less explanation of the financial and accounting facts and arguments is acceptable when presenting information to a neutral accountant instead of a judge. Parties should have a thoroughly prepared analysis and clearly articulated arguments to achieve the best results.

6 actions to tip the scales in your favor
Avoid leaving the neutral accountant unarmed to make the best decision. Here are six actions to help avoid such situations.

1. Outline the dispute process in the transaction agreement
The best way to minimize risk in disputes is to avoid them to start with. A clearly written transaction agreement can help avoid disputes. For example, state whether adjustments to working capital are based on the change in working capital between two points in time or if corrections to the final account balances are allowed to adjust for prior accounting errors.

Pre-defined provisions related to the neutral accountant will streamline the dispute process. Ideally, the transaction agreement will outline the process in detail. If it does not, the parties should define the process as soon as possible when a dispute arises. The format may range from very simple to somewhat complex. A simple process may include an initial submission from each party, a rebuttal from each party, the neutral accountant’s questions and requests for documentation, and the neutral accountant’s decision. In some circumstances, parties may include a surrebuttal round of submissions, a hearing with oral arguments and witness testimony, and a final round of written submissions containing concluding arguments from each party.

It is important to balance the benefits of a more timely resolution (including lower costs and quicker access to cash) against the risks of accelerating the process (including the presentation of fewer facts, a less robust analysis and less persuasive arguments to the neutral accountant). When agreeing upon a timeline, opposing parties must factor in time for the neutral accountant to make the final determination. Since it is impossible to predict the number and complexity of issues that may be disputed, be prepared to adjust the schedule in the transaction agreement, based on discussions between the parties and the neutral accountant.

2. Agree to disagree (i.e., agree on what is disputed)
Clearly define disputed items. The parties should prepare an easy-to-understand list of the issues and associated amounts (including the total amount) in dispute. The amounts should link directly to the ultimate determination, which in turn should link directly to the transaction price and dispute resolution language in the transaction agreement. While that concept is simple, its execution can fall by the wayside. Failing to distinctly outline the items and amounts in dispute can lead to additional disputes during the course of the proceeding, causing delays in the decision and incurring more time and cost by the neutral accountant, advisors and disputing parties. Before starting work, the neutral accountant should be engaged by a letter that lists the issues and amounts in dispute as agreed upon by all parties. Another simple but valuable tip is to agree on a consistent numbering of issues and amounts in dispute. This approach can save time and reduce confusion throughout the process.

3. Choose between consistency and GAAP
Disputes sometimes arise regarding whether to apply consistency of accounting method or GAAP when calculating post-closing adjustments. This is especially relevant when calculating working capital adjustments that may be intended only to measure the change in working capital from one period to another, typically from the preliminary closing balance sheet date to the final balance sheet date. The transaction agreement may specify whether the post-closing adjustment contemplates adjustments to the preliminary closing balance sheet only, the final balance sheet only, or both. If the intent is truly to measure the change in working capital, a proposed adjustment to one balance sheet as a result of correctly applying GAAP would generally apply to the other balance sheet as well. If the intent is to adjust the final balance sheet to GAAP, as opposed to measuring a change in working capital, the determination of how to correctly apply GAAP is especially critical. In the transaction agreement, parties should clarify their intent with respect to accounting methods. If the transaction agreement is unclear, its language will have to be assessed by the neutral accountant. A neutral accountant may request email correspondence and prior drafts of transaction agreements from each party in an attempt to discern the intent of the parties.

Regardless of that intent, GAAP should be applied consistently. For example, multiple methodologies exist for calculating reserves for inventory or accounts receivable that are in accordance with GAAP. However, consistent application of GAAP would mean using the same method of calculating a reserve in the final balance sheet as was used in the preliminary closing balance sheet.

4. Address common accounting issues
Common disagreements arise around inventory and accounts receivable:

Parties often disagree about the value of inventory as recorded on the balance sheet. The nature of inventory accounting presents challenges for parties seeking to demonstrate whether inventory is obsolete or will be used in the continuing operations of the business. Disagreements sometimes arise when the buyer asserts that inventory is not valuable to the new entity. Upfront discussions between the parties during due diligence can minimize arguments during the dispute resolution process. The neutral accountant will likely seek compelling information that demonstrates whether inventory on the books during the due diligence process has value to the buyer. Be wary of attempting to argue that the inventory is not valuable to the buyer because the buyer has different plans for the business. A neutral accountant may not hold the seller responsible for inventory write-offs resulting from the buyer subsequently making unanticipated changes to the business plan.

Determining the expected dollar value and collection percentage of accounts receivable can also present challenges for a new owner. Some deals exclude some or all accounts receivable for that very reason. If accounts receivable are included in the transaction, carefully consider the factors affecting the amounts at which those accounts are recorded on the balance sheet. As a seller, do not overlook or dismiss the fact that certain accounts receivable have aged. Failure to acknowledge aging accounts or any collection difficulties may shed a negative light on your position and raise doubt in the mind of the neutral accountant. Address any collection issues directly while also providing objective support for the accounts receivable balance net of reserves. Buyers and sellers should consider specific historical experience related to accounts receivable and review any correspondence related to significant individual accounts; this correspondence may help the neutral accountant make a decision.

Case study:
In my experience as a neutral accountant, I have seen submissions that varied in degrees of professionalism and persuasiveness; this example highlights how those differences have an impact.

One party presented submissions in a format similar to typical court pleadings. The party clearly supported its position with specific and logical statements that linked and referenced the financial documents.

The other party provided a series of bullet points in an email. In addition to this detracting format, the structure of the presentation did not clearly demonstrate how all assertions and calculations related to the underlying documentation. I was required to figure that out on my own. This resulted in additional time spent by our team, asking clarifying questions of that party. Also, a curious aspect of the party’s supporting narrative was the failure to address, or even acknowledge, facts that clearly supported the opposing viewpoint. Not addressing such obvious information caused me to question whether all of the relevant information had been presented — or even if the party may be simply ignoring facts in hopes that I would overlook the information. Neither of these is a good result.

In this case, the party that presented the clearest and most organized narrative and supporting materials was awarded approximately 90% of the aggregate amount it sought. While the determination was ultimately based on the relative strengths and weaknesses of the facts underlying each position, the manner in which the materials were presented certainly affected the decision-making process and associated time and costs.
When assessing these issues, consider what information was known — or should have been known — when the balance sheet was prepared. Differences can occur when the parties base their arguments on information known at different times. Unless these issues have been agreed upon, the neutral accountant will likely base the decision on what would have been known to the parties as of the date the balance sheet was prepared, consistent with GAAP. However, the neutral accountant may consider the behavior of the parties in their collection efforts undertaken both before and after the transaction date. For example, documentation that the buyer did not attempt to collect receivables will make it more difficult for the buyer to obtain a favorable decision in this area.

5. Document analyses thoroughly
If the neutral accountant cannot easily follow the supporting documentation, he or she is less likely to adopt your position. For complex analyses, consider a reference system to facilitate the understanding of complicated schedules. Clear referencing of values and the flow of calculations increases the efficiency of the neutral accountant’s decision-making and increases your persuasiveness.
 
The absence of documentation creates difficulties for the neutral accountant. Inconsistencies within the historical accounting records can reflect poorly on the seller. If disputed issues were not discussed during due diligence, the neutral accountant may wonder why. Lacking other detailed and persuasive analysis, the neutral accountant may decide to give audited financial statements the highest possible weight when assessing each position’s relative strengths. Don’t leave the neutral accountant guessing about why accounting records may be missing.

Prepare a clearly stated and supported analysis that provides reasons and documentation. Even if you believe your point is obvious, emphasize relevant facts and strong logic.

6. Review your report and exhibits adequately
Consider additional assessments of your material for a different perspective:
  • Enlist someone unfamiliar with the situation to review the materials; this can highlight areas that are not clear to someone who is new to the facts and analysis.
  • Have a nonfinancial person read the financial analysis as a sanity check. Lawyers involved in such disputes are very familiar with accounting analysis and quite effective in presenting arguments. They are well-suited to provide an objective review of the analysis and presentation.
  • A few extra hours of time by an outside attorney or another person in management can pay valuable dividends in the end. Have someone else listen to a description of the other party’s position compared to your position and tell you what resonates with them and what does not. It may help you focus your analysis more effectively.

Conclusion
Don’t make the neutral accountant “work for it.” Be helpful to the neutral accountant, who you should expect wants to arrive at the best answer. If the neutral accountant must make multiple requests to obtain information that could have been easily provided at the outset, he or she may begin to question the position or even the veracity of the responses more broadly. Be proactive before coming to the neutral accountant. Discuss the parties’ respective understanding of facts and assumptions before you bring issues to the neutral accountant to avoid wasting time and money.

With the anticipated increase in transaction activity, the potential for post-acquisition disputes also increases. By following these suggestions, parties can save themselves some aggravation during the dispute resolution process and maximize the likelihood of a favorable result. These steps can:
  • Help you minimize the number of issues that must be presented to a neutral accountant (when you apply these principles early in the dispute process)
  • Increase the probability that you can persuade the neutral accountant to agree with your point of view
  • Reduce the costs incurred in terms of hours spent by employees of each party, lawyers, outside accountants or other financial professionals and the neutral accountant
  • Result in each party feeling more satisfied about the dispute resolution process and, ultimately, about the underlying transaction

Planning your approach actively and in advance can result in a more cost-effective dispute resolution process and a higher probability of realizing more value from a transaction.

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1 Amaïzo, Quincy. “US Targeted Advised M&A Activity at Highest YTD Level Since 2008,” Dealogic M&A Statshot, Aug. 19, 2014. See www.dealogic.com/media/market-insights/ma-statshot/ for more information.