M&A: Avoiding Buyer-Seller Disputes That Plague Almost Half of Mergers and Acquisitions
It was late Friday afternoon when Roger received a call from his lawyer. Roger had sold his business almost two months earlier for $7.54 million. His lawyer told him that the buyer wanted a purchase price adjustment. The buyer alleged that Roger breached his warranty and representations regarding the accuracy of the company’s accounts receivable. This breach affected the amount of working capital of his former company. Rogers’s breach occurred between the final due diligence review and the closing date of the transaction. Roger was shocked. He could not believe what he was hearing.
Working capital “true-ups,” earnout provisions and valuations of COVID-19-affected companies are the three most frequent areas that cause major disputes after the deal has closed. It happens more than you think.
Deals in Dispute
Grant Thornton, the sixth largest U.S. accounting and advisory firm, surveyed almost 200 U.S.-based M&A professionals, who had completed more than 1,300 deals last year. The firm found that almost half of all deals wound up with some form of accounting dispute. The survey revealed that the deal size had little to do with the dispute. It did not matter whether the company was $10 million or $1 billion in size, complexity of the balance sheets was the root cause of dispute.
Working capital is a balance sheet item. It is defined as current assets minus current liabilities. It is simpler to think of it as the capital required to run the day-to-day business operations. A quick calculation to determine the company’s short-term liquidity position is to divide current assets by current liabilities. If the result is 1 or higher then the company can pay its current liabilities. The higher the number the better the company’s liquidity is.
Since the seller usually retains all cash in excess of the working capital needs, it is vital that the target amount of cash be established.
The target working capital amount is important because the last thing the buyer wants is to have to inject money into the business shortly after the purchase date — to make payroll or buy inventory. The seller also doesn’t want to leave more money than is absolutely necessary to meet the company’s day-to-day needs. Practically every private company transaction involves some specific mechanism for establishing a working capital requirement. In theory, working capital disputes should never kill deals. Reasonable people should be able to arrive at a reasonable formula for calculating the target amount of cash needed to meet its monthly short-term obligations.
Besides disputes over working capital requirements, conflicts over earnout calculations, vague language in purchase-and-sale agreements and, these days, the valuations of COVID-19-affected companies all contribute to buyer/seller disputes.
In the recent Grant Thornton survey, a transaction attorney said, “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 money through the purchase price adjustment provision, or by making claims for breaches of the agreement.”
This is exactly what Roger’s buyer claimed.
Avoiding Common Buyer-Seller Disputes: Five Recommendations
What can sellers do to avoid these common disputes?
First, avoid vague language in the purchase and sale agreement. I recommend that precise definitions or formula calculations are imperative to avoid buyer misinterpretations. The specificity of the language should be followed by a mathematical example illustrating the written definition or formula.
Second, show the buyer your company’s potential for future growth. Buyers like compelling stories. Provide sound pro-formas with valid assumption sets that do not overshoot reality. I once saw a set of projections that suggested that the company could out-perform the industry average by four times. When I asked for the “assumption sets” to back up the projections, there were none. The seller admitted they just estimated what they could do by funding a major business development effort.
Third, have a valuation analysis prepared by an independent valuation firm. Overestimating a company’s enterprise value is a common deal killer — particularly in an earnout deal structure. According to Lutz M&A, in a recent survey of business owners, “56% thought they knew the value of their business, yet only 18% had a valuation analysis prepared by an independent valuation firm.”
Fourth, be consistent. According to Forbes, inconsistency in what you tell the potential buyer can be a source of disputes.
Fifth, prepare for the buyer’s due diligence. It is one of the most crucial phases of the transaction process. Ensure that your documents are accurate.
Roger and the buyer resolved their dispute two months later. Roger returned $156,000 to the buyer. They avoided a protracted court battle by settling the dispute amicably.
In short, selling your business is one of the most important events of your life. Addressing the areas for potential disputes, as described above, are critical to a successful outcome.
Author Gary Miller is CEO at GEM Strategy Management. Read more from GEM Strategy Management here.
Well done Gary. Your outline of Working Capital was refreshingly accurate, simple and spot on. Your Five Recommendations are also on point. Appreciate your perspective.