Post-closing disputes in private mergers and acquisitions (M&A) transactions can quickly turn what was thought to be a value creating decision into a source of frustration and value destruction. Thankfully, many post-closing disputes are due to a lack of appropriate planning and insufficient forethought prior to executing the definitive acquisition agreement, meaning they can be avoided with proper diligence and experienced legal counsel. This article summarizes the most common post-closing disputes and ways to avoid them or at least mitigate their severity.1
Earnouts
An “earnout” is a potential payment that a buyer may make to a seller after the closing, based on the performance of the target company’s business (or some segment of the business) during an agreed period of time after closing. Generally, earnouts are used when the parties cannot agree on the value of the company due to uncertainty surrounding its future performance.
If the parties agree that an earnout is necessary to get the deal done, it is critical that each of them understands precisely what performance metric(s) of the target company will be measured to determine the earnout (e.g., revenues, EBITDA, net income, performance of a specified portion of the business and, if so, based on what metric(s)). Disputes usually arise around the measurement of performance of the business and/or the manner in which buyer operated the business during the earnout period (i.e., a claim by seller that buyer operated the business in a way that caused the earnout not to be achieved or to be artificially low, whether intentionally or otherwise).
To limit the potential for dispute over an earnout, the parties and the acquisition agreement should be clear on the following key points:
• The specific portion of the business to be measured, unless the parties agree to base the earnout on the performance of the target company as a whole. If practicable, the portion of the business to be measured for the earnout should be limited to those areas that are the subject of the valuation disagreement. For example, if seller wants full value for a specific high-growth subsidiary or division of the business, but buyer is not convinced that future growth projections are likely to be met, then only the performance of that subsidiary or division should be measured for calculation of the earnout. This narrows the scope of the earnout, but could add some complexity, for example, in allocating overhead or other shared costs and expenses to the business segment in calculating performance for the earnout calculation.
• The metric(s) to be measured and the accounting method and principles to be used in measuring performance. These should be clearly defined and fully understood by both sides, including how to handle any necessary internal expense allocations. As with the working capital adjustment discussed below, it is critical here that the parties, together with their business and financial advisors, fully understand the relevant business operations and how the selected performance metrics to be used for the earnout will be measured. The parties’ understanding should then be clearly reflected in the acquisition agreement. Ambiguity or shortcuts in drafting here are ripe areas for future disputes. In this regard, the use of an illustrative calculation statement may help avoid disputes when the earnout is ultimately determined (which will, in some cases, be several years after the closing).
• Limitations on Buyer’s operation of the business during the earnout period. The parties should agree with specificity on how much freedom buyer will have to operate the purchased business after closing. This can be a very difficult negotiation, but a balance needs to be struck between limiting buyer’s ability to change the way the business is run (thereby limiting the ability to manipulate the financial performance of the business during the earnout period to seller’s detriment) and buyer’s need to freely operate the business it now owns in order to pursue its long-term business objectives. There is no one-size-fits-all approach here, so open and frank discussion and clear drafting are critical to avoiding a messy dispute down the road.
Breaches of Post-Closing Covenants
Sellers of a business will often agree, for some period of time after closing, to refrain from taking certain actions that could harm the business. These may include agreements not to compete with the business, not to solicit or hire employees of the business, not to interfere with customer or supplier relationships, and not to disclose or use any confidential information or trade secrets of the business.
Some of these agreements may require negotiation, depending on the particular circumstances. Key terms may include the scope of a non-compete, including the definition of the types of “competing business” to be avoided, the geographical coverage of the non-compete and how long it will apply, and the universe of current and/or former employees or consultants of the business that are subject to a non-solicitation agreement and how long this restriction will apply.
Buyer should make a careful evaluation of the risks posed by seller’s principals potentially competing, or otherwise harming the business, in their future business dealings. If a meaningful risk is perceived, then buyer would be well served to include in the acquisition agreement (or in separate agreements with the selling principals) carefully thought out and well drafted post-closing covenants of the type described above. From the perspective of the seller’s principals, they too should carefully consider their post-sale plans and objectives in determining whether, and how stridently, to resist or limit these types of covenants.
Indemnification Claims for Breaches of Representations and Warranties
Almost every acquisition agreement contains detailed representations and warranties (R&Ws) made by seller that set forth a variety of facts about the target company and its business2, including financial condition (and financial statements), legal, tax, and environmental compliance, adequacy and suitability of the company’s assets to operate the business, and many others. R&Ws are used to allocate various risks between the parties and are relied upon by buyers in supporting the agreed upon purchase price for the business. Naturally, buyers want R&Ws to be as comprehensive as possible and free from qualifications and limitations, while sellers want the opposite. As a result, R&Ws are often heavily negotiated with regard to scope, limitations, exceptions and the like.3 Most commonly, certain R&Ws will be limited to matters of which seller or management of the target company had knowledge or may be limited to matters that are “material” to seller’s business, thereby allocating the risk of unknown or smaller (immaterial) problems to the buyer.4
Acquisition agreements also typically provide that seller will indemnify buyer for “losses” suffered because of a breach of seller’s R&Ws (i.e., a claim that certain aspects of the business were not accurately represented by seller in the acquisition agreement resulting in some harm to buyer). Acquisition agreement indemnification provisions are also heavily negotiated by the parties, particularly with regard to the limitations and exceptions that will apply, including a limitation on the “survival” of R&Ws (i.e., the amount of time after closing during which buyer can make a claim), and limitations on the amount of seller’s exposure to indemnity claims such as de minimis limitations, deductibles or “baskets”, and caps.
Sellers will often want to define indemnifiable “losses” in the acquisition agreement as being limited to “actual compensatory” losses, specifically excluding punitive or consequential damages such as lost profits or diminution in value of the purchased business. This definition limits buyer’s ability to claim that a breached R&W resulted in the buyer over-valuing the business and to seek return of a portion of the purchase price. Buyers should be careful in agreeing to this type of limitation as it could under some circumstances block them from seeking redress for loss of the basic benefit of their bargain.
A buyer’s best defense against significant post-closing disputes over R&W breaches is to conduct thorough and extensive due diligence on the target and its business. This will help ensure that buyer is aware of all the target company’s key risk areas going into the deal and will drive the drafting and negotiation of the R&Ws to protect buyer from undisclosed problems in these key areas. Sellers on the other hand are best served by being forthcoming early in the due diligence process with regard to all risk areas and any particular problems facing the business. Then these matters can be fully vetted with buyer and the risk clearly allocated among the parties through the acquisition agreement negotiation, avoiding post-closing disputes and litigation.
Other Indemnification Claims
Another subject of potential disputes is the allocation of post-closing responsibility for particular liabilities or exposures which the parties knew about but did not carefully apportion among themselves in the acquisition agreement. (In an asset purchase transaction this could also include the inclusion or exclusion of specified assets in the deal.) Examples might include responsibility for an ongoing legal case or the cost of a known environmental cleanup obligation of the target company. Once again, where the parties have identified specific risks or future liabilities prior to closing, those items should be described clearly in the acquisition agreement and the parties’ respective responsibilities for them should be clearly delineated. For example, in the case of a known environmental cleanup obligation of the target company, the parties should be clear to allocate cleanup expenses incurred before and after closing, any fines or penalties incurred before or after closing, and even any third-party claims (such as an individual tort claim for personal injury related to the contamination) that may arise in relation to the underlying contamination. A detailed understanding of the nature of the known liability and careful drafting are crucial in avoiding a future disagreement.
Working Capital (or similar) Purchase Price Adjustments
Parties will often agree in the acquisition agreement to adjust the amount of the purchase price paid at closing based on the actual amount of the target company’s working capital (or another financial metric such as net worth) at closing versus seller’s pre-closing estimate of its closing date working capital. Prior to closing, seller will deliver an estimate of its working capital as of the closing date and this estimate will be used to adjust the purchase price that is paid at closing. After closing, buyer (typically) will determine the actual amount of working capital of the target company at the closing date, and the amount of the actual closing date working capital that is above or below the pre-closing estimate will be paid by buyer or seller as an adjustment to the purchase price.
Since working capital, generally defined as a company’s current assets less its current liabilities, can include (and exclude) a variety of financial assets and liabilities and can be calculated using a variety of accounting methodologies, the acquisition agreement should make very clear those items that will be included in or excluded from the definition of working capital, and the accounting methodology to be used for purposes of this purchase price adjustment. For example, parties often choose to exclude cash and debt from working capital and, depending on the business, there may be reasons to include or exclude other items as well. These issues should be thoroughly vetted with the parties’ respective accounting and financial advisors to ensure everyone agrees on how working capital will be calculated, and this understanding should be clearly laid out in the acquisition agreement. The acquisition agreement should also make clear that the accounting methodology used to determine actual post-closing working capital will mirror that used by seller in preparing its pre-closing estimate. Ideally, the parties will use generally accepted accounting principles (GAAP) applied consistently with seller’s past practices, with any deviations from or exceptions to GAAP or past practices clearly described and understood by both parties.
Mechanisms for Resolving Disputes
Despite appropriate planning, both parties should address and agree upon (in the acquisition agreement) the process for handling post-closing disputes. Most disputes, such as alleged breaches of acquisition agreement covenants, will be adjudicated either in court or in an arbitration proceeding, depending on what forum is agreed to by the parties. The acquisition agreement may also require that the parties escalate negotiation of the dispute internally, and possibly engage in non-binding mediation, before starting formal legal action. Each party should consult with its counsel before committing to alternative dispute resolution in order to ensure that they fully understand the potential advantages and risks in light of the nature of the company’s business, its location and other relevant factors. Working capital adjustment disputes are typically governed by a separate dispute resolution process detailed in the acquisition agreement, which includes an ultimate resolution by an independent accountant that is jointly selected by both parties.
Disputes arising from claimed breaches of R&Ws are often limited in the acquisition agreement as well. The acquisition agreement will typically specify that indemnification is a buyer’s sole and exclusive remedy for matters arising under the acquisition agreement or related to the transaction, and the R&Ws in the acquisition agreement constitute the only representations that seller is making about the company. In that case, any post-closing concerns buyer has about the state of the business it just bought that are not covered by the R&Ws are not actionable. A common exception to this limitation is a claim by buyer based on seller’s fraud. Fraud can have a variety of meanings under different states’ common law, so parties should consider defining this term with specificity in the acquisition agreement to ensure that they have a clear understanding of what circumstances might give rise to this non-contractual remedy. Proving fraud can be very difficult and typically requires, among other things, establishing (with the higher burden of clear and convincing proof) that seller knowingly misrepresented a material fact, that buyer relied on seller’s fraudulent misrepresentation, and that seller’s fraudulent misrepresentation resulted in damages to buyer (which must then be quantified). Given the difficulty in pursuing a fraud claim, the importance to buyer of providing for adequate contractual protection and relief in the acquisition agreement cannot be understated.
Conclusion
Resolving disputes after the closing of an M&A transaction can be a time-consuming, costly, and emotionally draining experience. Closings are typically a time for celebration by both buyer and seller as each has hopefully achieved its objectives in completing the sale. Most post-closing disputes can be avoided through a combination of careful and thorough due diligence by buyer, full disclosure of all known issues and risks by seller, and well thought out resolutions to contested issues that are carefully reflected in the acquisition agreement.
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Notes:
1 This article does not address common disputes arising in public company M&A transactions, such as claims for breach of fiduciary duties, nor valuation disputes raised by dissenting shareholders in state appraisal rights proceedings or disputes over events or circumstances that may have caused a party not to close a transaction, such as claims that the target company suffered a material adverse change prior to closing.
2 In all-cash deals, buyer typically makes limited R&Ws in the acquisition agreement regarding matters such as the valid existence of the buyer entity, that all necessary approvals have been obtained, that buyer has access to funds sufficient to close the transaction, and that the acquisition agreement has been validly executed by buyer such that it will be enforceable against buyer. These buyer R&Ws are rarely the subject of a post-closing dispute.
3 In recent years, insurance companies have begun writing R&W insurance for buyers and sellers in M&A transactions. A premium is paid to the insurer to shift some of the risk that a R&W will be breached. The impact of R&W insurance on risk sharing and post-closing indemnification disputes is beyond the scope of this article.
4 “Materiality” is often left undefined in acquisition agreements, which can be a source of a future dispute. Where the parties can adequately define materiality, some disputes can be avoided, though many find an adequate definition of materiality to be elusive.
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This Client Alert is for the benefit of our clients and friends and provides only a high-level summary of the subject matter. It is not intended to be comprehensive or address any particular transaction or set of facts, and should not be relied upon as legal advice or a legal opinion.
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