CHICAGO — Approximately half of all merger and acquisition (M&A) deals wind up in some form of accounting dispute, according to a recent survey from Grant Thornton LLP.
The survey — which included nearly 200 U.S.-based M&A professionals — also found that 66% of the survey respondents felt the COVID-19 pandemic has increased the likelihood of disputes. Moreover, the survey revealed that respondents identified two common reasons that deals unraveled after they closed: 51% cited earn-out disputes and 46% blamed working capital issues.
“The sudden drop-off in the economy has created a perfect storm, where buyers may dispute historical judgments and estimates used by sellers,” said Charles Blank, Forensic Advisory Services managing director at Grant Thornton. “Further, earn-outs and working capital will also become more prone to disputes if the performance of past acquisitions significantly declines.”
Survey respondents highlighted several key factors that not only increase the risk of an initial dispute, but increase the time required to reach a resolution.
- Vague language — Dealmakers tend to use vague language when describing the guiding accounting principles used to calculate purchase price adjustments. To combat this, there has been a move toward including more prescriptive language in the last few years. For example, 50% of respondents noted increased use of “accounting hierarchy” language, while 44% use “specific accounting policies” language more frequently. Related to this increase, 23% said they rely less on “Generally Accepted Accounting Principles (GAAP) consistently applied” language. While using imprecise language can help avoid disagreements at the time a purchase agreement is finalized, it often results in disputes later.
- Purchase price adjustments — Survey results indicated that working capital and earn-outs 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. The methodology used to calculate working capital is often at the center of the dispute and now requires more attention when a deal is negotiated.
- Working capital calculations — Grant Thornton’s survey found 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. Most post-acquisition working capital disputes can be resolved by proactively considering things like accounts receivable and inventory reserves when drafting the purchase agreement language.
- 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 — although revenue is not without issues, but can be more tightly defined. Despite this, survey results showed earnings before interest, taxes, depreciation, and amortization (EBITDA) as the most common earn-out metric.
“Both buying and selling parties often have the sense that ‘it won’t happen to me’ when it comes to deal disputes,” said Max Mitchell, head of Purchase Agreement Advisory Services at Grant Thornton. “Nobody thinks they’re going to be the one facing a working capital or earn-out dispute until soon after closing, when suddenly there’s a shift in mindset and a difference in approach. Things that were nonissues can suddenly become big problems.”
Managing disputes for better deal-making
With the current economic conditions and unprecedented business climate, it is more important than ever to proactively mitigate these risks and plan for the future. Grant Thornton developed some best practices that can help dealmakers guard against disputes.
- Clarify your methodology and language. Survey respondents indicated they would have had fewer disputes had there been an accounting hierarchy or specific accounting policies. Vague language that is left open to interpretation can be understood differently after the closing date. It is a best practice for parties to agree on the specific accounting treatment of certain items to be adopted 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 frustrated 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 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. Failing to outline dispute resolution clauses in the purchase agreement can add further topics to negotiate when the parties find themselves facing a dispute.
- Manage earn-out timing, scheduling and metrics. Survey respondents reported that earn-out clauses were one of the most disputed areas of purchase agreements post-deal. 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, attention or are poorly drafted, they can damage the business and create significant, contentious post-deal disputes.
- Use a locked box mechanism. Thirty percent 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. In fact, using an LBM ranked as the top response for how to reduce post-closing disputes.
“Effective deal due diligence is beneficial to understand the risks at stake, especially during turbulent times,” summed up Kate Lattner, Strategy & Transactions director at Grant Thornton. “The more detailed and process-driven you are, and the less judgment is present in your policies and procedures, the better your 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, visit: www.grantthornton.com/disputesurvey
About Grant Thornton LLP
Founded in Chicago in 1924, Grant Thornton LLP (Grant Thornton) is the U.S. member firm of Grant Thornton International Ltd, one of the world’s leading organizations of independent audit, tax and advisory firms. Grant Thornton, which has revenues of $1.92 billion and operates more than 50 offices, works with a broad range of dynamic publicly and privately held companies, government agencies, financial institutions, and civic and religious organizations.
“Grant Thornton” refers to Grant Thornton LLP, the U.S. member firm of Grant Thornton International Ltd (GTIL). GTIL and the member firms are not a worldwide partnership. Services are delivered by the member firms. GTIL and its member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or omissions.
+1 312 602 8332