It happens more often than you think. The strong relationships, thorough research and careful diligence woven into a merger or acquisition suddenly unravel post-closing, as nonissues suddenly become problems. A Grant Thornton survey of almost 200 US-based M&A professionals who completed over 1,300 deals last year, found that approximately half of their deals wound up in some form of accounting dispute.
Two-thirds of survey respondents indicated that the COVID-19 pandemic has increased the likelihood of disputes. “When the economic environment deteriorates, and it looks like the buyer may have overpaid for a target company, the buyer will sometimes look to claw back value through the purchase price adjustment process, or by making claims for breaches of the agreement,” said one law firm partner. Added deal risk in the COVID environment is something board members should track.
Grant Thornton found two common reasons that deals unraveled after they closed: 51% cited earn-out disputes and 46% blamed working capital issues. Other areas of weakness identified were:
6 key points for boards to discuss with management
- Vague language — Dealmakers use vague language when describing the guiding accounting principles used to calculate purchase price adjustments.
- Purchase price adjustments — Earn-outs and working capital top the list for the most commonly disputed types of purchase price adjustments. Purchase price adjustment disputes have become increasingly common in recent years and are more common than breaches of representations and warranties.
- Working capital calculations — There are several common areas that become the source of most working capital disputes. The top two include reserves associated with accounts receivable and excess and obsolete inventory.
- Earn-outs — Earn-out disputes often arise because the measurement basis for the earn-out includes expenses of the acquired business, where the buyer has more discretion to determine which expenses to allocate to it versus basing an earn-out on revenue alone.
Board members should make sure they have a good understanding of the M&A process to be able to ask management key questions during the overview and presentation of the deal before it has been approved by the board. Spending a little time on the discussion points below could have avoid pitfalls and also set an expectation that the board understands the process. As management teams become more experienced in M&A, the board can shift to other areas of focus around a deal.”
- Clarify your methodology and language
Survey respondents showed they would have had fewer disputes had there been an accounting hierarchy or specific accounting policies. Vague language can be interpreted differently after the closing date. It is a best practice for parties to agree on the specific accounting treatment of certain items in a closing balance sheet or earn-out statement.
- Provide an example but understand the limitations
Preparing illustrative purchase price adjustments can help parties avoid frustrating transactions by understanding intentions from a dollar perspective, rather than relying on each side’s unspoken views on the words of the agreement.
- Use a diligence provider
On average, dealmakers are only using diligence providers on 59% of deals. Using a diligence provider gives buyers and sellers deeper insight into the accounting of the target company. Diligence providers can also help craft detailed accounting hierarchies or specific accounting policies to manage the risks associated with the specific accounts requiring judgment that may lead to working capital or earn-out disputes.
- Be careful and comprehensive with resolution clauses
Eighty-five percent of respondents said they included a detailed post-closing dispute resolution process in their deals, and with good reason. Failing to outline dispute resolution clauses in the purchase agreement can add further topics to negotiate when the parties face a dispute.
- Manage earn-out timing, scheduling and metrics
When earn-outs are used correctly, they can provide both parties with another opportunity post-deal to true-up and validate the headline price. When earn-outs do not receive enough focus or are poorly drafted, they can damage the business and create significant, contentious post-deal disputes.
- Use a locked box mechanism
Only 30% of those surveyed used the locked box mechanism (LBM). With an LBM, the purchase price adjustments for cash, debt and working capital are derived from a historic balance sheet. This “locked box balance sheet” is typically subject to diligence and detailed review by both parties, and acts as a proxy for the closing balance sheet. Using an LBM ranked as the top response to reduce post-closing disputes.
Effective deal due diligence is beneficial to understand the risks at stake, especially during turbulent times. The more detailed and process-driven management is, and the less judgment is present in policies and procedures, the better the chances of deal success.
For additional findings from Grant Thornton’s M&A disputes survey or to learn more about dispute prevention guidelines and best practices in arbitration, contact us or download the survey repor
For more pragmatic board insights, please visit our boards and audit committees insights page
Charles K. Blank
Forensic Advisory Services
+1 212 542 9725
Purchase Agreement Advisory Services
+1 312 602 8387