Post-closing Post closing Disputes: What to know know, how to avoid them June 3, 2014 © 2014 McGladrey LLP. All Rights Reserved. © 2014 McGladrey LLP. All Rights Reserved. Requirements for CLE credit From the start of the program, you must be connected 50 or 60 minutes, minutes depending on your state’s requirements—our system will monitor it Answer the polling questions Complete the post-event evaluation, which can be downloaded from the handouts section Certificates of attendance will only be sent to those completing the above requirements CLE credit has been approved for CA, MO, MN, and TX and is pending for NY and IL 2 © 2014 McGladrey LLP. All Rights Reserved. Our presenters today Patrick Chylinski Director McGladrey LLP Director, Los Angeles, CA 213.330.4605 [email protected] Todd T dd Sigler Si l Manager, McGladrey LLP Los Angeles, CA 213.330.4634 t dd i l @ [email protected] l d John J h Ti Tira Manager, McGladrey LLP San Francisco, CA 415.848.5313 j h ti @ [email protected] l d 3 © 2014 McGladrey LLP. All Rights Reserved. Webinar agenda Mergers & Acquisitions Activity and Deal Structure Post-closing P t l i Di Disputes t - Common Causes of Post-closing Disputes Common Post-closing g Adjustments j Post-closing Dispute Case Studies - Working Capital Disputes Mi Misrepresentation t ti off Financial Fi i l Statements St t t Di Disputes t Earn-out Disputes Contingent Liability Disputes Q&A 4 © 2014 McGladrey LLP. All Rights Reserved. Mergers & acquisitions activity 1,200 $300 1,000 $250 800 $200 600 $150 400 $100 200 $50 - $- Deal Volume Aggre egate Deal Va alue ($ billion ns) Deal V Volume The US Mergers & Acquisitions Market Index Aggregate Deal Value Source: Factset 5 © 2014 McGladrey LLP. All Rights Reserved. Mergers & acquisitions structures Acquisitions q - Asset Purchases Stock Purchases Mergers M - Forward Merger Reverse Merger Subsidiary Merger Reverse Subsidiary Merger Types of Buyers - Financial Strategic 6 © 2014 McGladrey LLP. All Rights Reserved. Sequence of events Negotiation of agreement terms based upon benchmark financial information and other items of importance p to the p parties A delay of weeks or months then ensues between the execution of the agreement and closing, caused by: • • • • Regulatory notice or clearance Transfers of ownership rights/licenses etc. Execution of employee p y contracts Finalization of buyer financing or other closing conditions During this delay period, changes in the acquired operation’s balance sheet, h t iincome statement t t t and/or d/ cash h flows fl may require i an adjustment The changes giving rise to an adjustment are identified in the agreementt 7 © 2014 McGladrey LLP. All Rights Reserved. Disputes arising from mergers & acquisitions Pre-acquisition q Disputes p - Disputes arising prior to the close of a transaction Typically occur when one party withdraws from a transaction (against the other party’s party s wishes) Post-acquisition Disputes - Disputes arising subsequent to the close of the transaction Typically occur based on differing interpretations of purchase price adjustment language and application Also are based on earn-out provisions allowed pursuant to the agreement 8 © 2014 McGladrey LLP. All Rights Reserved. Post-closing disputes Working g Capital p Disputes p - Adjustments to working capital Basis of accounting Subsequent events and materiality thresholds Earn-out Disputes - Basis of accounting Recordkeeping and oversight Differences in pre vs. post-management strategy Material and Fraudulent Misrepresentations International Considerations 9 © 2014 McGladrey LLP. All Rights Reserved. Common causes of post-closing disputes Ambiguity in the agreement’s definitions or purchase price adjustment dj provisions i i Disconnect between GAAP and historical accounting applications Disagreement Di t over the th proper application li ti off GAAP b between t the buyer and seller Disagreement over the estimates used under GAAP Knowledge K l d off subsequent b t events t Changes in the economic landscape/recession Discovery by the buyer during due diligence of material issues pertaining t i i tto th the fi financial i l statements t t t Competing interests of buyer and seller in a transaction Former employee(s) of seller 10 © 2014 McGladrey LLP. All Rights Reserved. Common post-closing adjustments Adjustments may be calculated on book values of: • Workingg capital p • Net worth • Specific financial statement line items Adjustments j may y be based upon p EBITDA Adjustments represent the difference between the business bargained for and the subsequent business actually acquired Adjustments allocate the economic risks of continued operations during th iinterim the t i period i db between t th the b buyer and d seller ll Adjustments may help protect against potential seller abuses such as liquidating inventory , accelerating receivables, or extending payables Adjustments may help protect against potential seller manipulations of the financial statements causing an overstatement of the value of the business Adjustments often become the basis for disputes 11 © 2014 McGladrey LLP. All Rights Reserved. Working capital disputes Working Capital is a measure of a company’s short-term financial health Working Capital = (current assets – current liabilities) “C “Current” t” means th the amounts t will ill b be converted t d tto cash h or paid id off within one year The majority j y of agreements g have a working g capital p adjustment j provision built into the contract Many of the adjustment provisions name and define the elements of working capital 12 © 2014 McGladrey LLP. All Rights Reserved. Working capital disputes – Common accounting issues Reserves and provisions • May be highly subjective Inventory • • • Obsolete or excess inventory Inventory value applying the lower of cost or market rule The specific elements of costs included in inventory and the related method of absorption of overhead costs Accounts receivable • Aging and collectability Prepaid assets • Whether prepaid assets are properly categorized as assets or operating expenses Discretionary bonus accruals The accounting for employee benefit liabilities and other actuarially determined amount 13 © 2014 McGladrey LLP. All Rights Reserved. Working capital disputes – Basis of accounting g Typical language in an purchase agreement: “ The Balance Sheet shall be prepared in accordance with United States generally accepted accounting principles, consistently applied” or “...consistently applied with past practice” or “...on a basis consistent with the preparation of the most recent balance sheet” Issues with GAAP versus consistent treatment • • • • • G GAAP iss followed, o o ed, but not ot consistently co s ste t y Differing interpretations of a component of GAAP A consistent practice is followed, but it is not GAAP An error is discovered in the beginning balance sheet that is unknown until after the agreement is executed The seller employs defective accounting estimates/judgments When GAAP and consistency are mutually exclusive, arbitrators will often interpret according to GAAP 14 © 2014 McGladrey LLP. All Rights Reserved. Working capital disputes – Basis of accounting g ((continued)) Parties often mistakenly believe GAAP clearly defines one correct method • • GAAP is subject to interpretation • “GAAP consistently applied” does not mean you should change an accepted accounting method that had been applied by the seller in the past There can be inconsistencies between interim and fiscal year-end financial reporting • GAAP recognizes no generally accepted accounting method as better than another generally accepted accounting method Applying consistency with interim financial statements may cause conflicts with later fiscal year-end reporting Subsequent events may color the buyers perception of previous estimates, whether they were GAAP or not 15 © 2014 McGladrey LLP. All Rights Reserved. Working capital disputes – Other items of importance p Subsequent q Events - Type I Event Type II Event Materiality M t i lit - Materiality thresholds Based on GAAP, historical accounting treatment or other? In aggregate or individually Carve-outs - Treatment according to GAAP Agreed-upon exceptions to GAAP 16 © 2014 McGladrey LLP. All Rights Reserved. Case study #1 – Working capital dispute Seller entered into a purchase agreement with Purchaser to acquire a 100% ownership interest in a subsidiary The purchase agreement contained the following language: - “Seller must prepare the unaudited balance sheet and the lists of working capital assets and working g capital liabilities in accordance with Generally y Accepted Accounting Principles (“GAAP”). In addition, Seller must prepare this information on the same basis as the audited financial statements for the years 2011 through 2013, and the unaudited financial statements as of June 30, 2014. ” If the actual working capital amount was greater than the “Minimum Working Capital Amount”, the purchaser would be obligated to settle with the Seller for an amount equal to the difference The parties were unable to reach agreement regarding the working capital assets and liabilities liabilities, and agreed to submit the disputed items to an arbitrator A Big-Four CPA firm was chosen as arbitrator, and the seller retained y to analyze y these disputes p and p provide information to assist McGladrey the arbitrator 17 © 2014 McGladrey LLP. All Rights Reserved. Case study #1 – Working capital dispute ( (continued) ) The parties disputed three items: 1. Accrual of management bonuses – seller did not accrue a liability for bonus payments that might be paid under the 2014Annual Bonus Incentive Plan. Purchaser believed a liability prior to closing g should have been recorded the dayy p 2. Workers Compensation Reserve – the seller estimated that a workers compensation reserve of approximately $100,000 is appropriate. The purchaser contended the reserve should be $471 000 $471,000 3. Inventory Reserve – the seller represented they made proper allowances for obsolete and defective inventory and that the inventory reserve should have been be $142,000. The purchaser h contended t d d it should h ld b be $204 $204,000. 000 Th The purchaser h claimed spare parts and labels were included in inventory even though the inventory could no longer be used. Purchaser claimed fuel in inventory was contaminated 18 © 2014 McGladrey LLP. All Rights Reserved. Overstatement of represented value The value attributable to a merger or acquisition may often be determined through applying a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), operating earnings, or other measure of profitability or cash flow Changes to the measure of cash flow may significantly impact th purchase the h price i Changes can be caused by: - Errors Disagreements over the proper accounting treatment of certain items Deliberate manipulations of the income, expenses or cash flow It is important to understand how the buyer priced the deal to understand the key value drivers Make sure it is well documented that the acquirer used a multiple of earnings or cash flow as opposed to asset valuations, discounted cash flow, or a hybrid approach 19 © 2014 McGladrey LLP. All Rights Reserved. Misrepresentation of financial statements Failure to disclose: Material contingencies/liabilities Material adverse effect/change Loss of keyy customer or contract Financial statements may have been knowingly manipulated - Entries run to manipulate earnings: • • - Premature revenue recognition Deferral/capitalization of expenses Entries run to manipulate working capital balances: • • • Not properly writing down inventory value Stockpiling inventory Inadequate allowances and reserves 20 © 2014 McGladrey LLP. All Rights Reserved. Case #2 – Overstatement of represented value Seller did not properly disclose related party transactions Seller understated cost of goods sold due to below-market pricing on key cost of goods sold items from an affiliated company owned by the owner of the seller Seller’s profitability was overstated due to below-market pricing on key cost of goods sold items Buyer missed this in conducting due diligence Calculated the impact of the reported cost of goods sold expense due to below-market below market pricing Calculated the value of the seller based on adjustment to market-pricing of cost of goods sold 21 © 2014 McGladrey LLP. All Rights Reserved. Earn-out disputes Earn-outs are a contingent consideration owed to the seller based on the post-closing performance of the business They are often a method to bridge disagreement between the seller and buyer as to price The seller may believe the earnings capacity of the business is greater than reflected in current earnings Earn-out disputes often give rise to the largest claims in purchase price disputes Often calculated as a multiple of EBIT EBIT, EBITDA EBITDA, operating earnings or other measure of profitability or cash flow 22 © 2014 McGladrey LLP. All Rights Reserved. Earn-out disputes (continued) Disputes frequently involve problems with financial performance measures such as: - Accounting classification of transactions Timing g of the recognition g of transactions At issue is who has control of the business post-closing? - The accounting is overseen by the buyer, who has incentive to reduce the earn-out - The buyer may perceive it is operating the business in a sound manner to maximize future earnings - The accounting g may y reflect changed g circumstances Often the seller alleges the business was not operated as represented 23 © 2014 McGladrey LLP. All Rights Reserved. Case Study #3 – Earn-out disputes Publicly traded buyer acquired a small, privately-held company Buyer failed to pay earn-out to seller based on achieving certain EBITDA in Year 1 and Year 2 Buyer grew the sales revenue but profitability declined significantly - Buyer allocated a significant amount of corporate expenses to this division - Asset Purchase Agreement g required q that the buyer y operate p the business in a manner comparable to the seller 24 © 2014 McGladrey LLP. All Rights Reserved. Case Study #3 – Earn-out disputes Sample Company Historical EBITDA US$ in hundreds FY11 % Net Rev FY12 % Net Rev FY13 % Net Rev Sales $ 500 500,000 000 Less: Returns/Allowances 50,000 Net Sales 450,000 Less: Cost of Goods Sold 240,000 Gross Margin 210,000 Less: Operating Expenses 120,000 n/a n/a 100.0% 53.3% 46.7% 26.7% $ 600 600,000 000 60,000 540,000 275,000 265,000 150,000 n/a n/a 100.0% 50.9% 49.1% 27.8% $ 750 750,000 000 75,000 675,000 325,000 350,000 200,000 n/a n/a 100.0% 48.1% 51.9% 29.6% EBITDA 20.0% $ 115,000 21.3% $ 150,000 22.2% $ 90,000 25 © 2014 McGladrey LLP. All Rights Reserved. Case Study #3 – Earn-out disputes Sample Company Earn-Out EBITDA US$ in hundreds FY11 % Net Rev FY12 % Net Rev FY13 % Net Rev FY14 % Net Rev Sales S l $ 500 500,000 000 Less: Returns/Allowances 50,000 Net Sales 450,000 Less: Cost of Goods Sold 240,000 Gross Margin 210,000 L Less: O Operating ti E Expenses 120,000 120 000 n/a / n/a 100.0% 53.3% 46.7% 26 7% 26.7% $ 600 600,000 000 60,000 540,000 275,000 265,000 150 000 150,000 n/a / n/a 100.0% 50.9% 49.1% 27 8% 27.8% $ 750 750,000 000 75,000 675,000 325,000 350,000 200 000 200,000 n/a / n/a 100.0% 48.1% 51.9% 29 6% 29.6% $1 1,200,000 200 000 120,000 1,080,000 550,000 530,000 450 000 450,000 n/a / n/a 100.0% 50.9% 49.1% 41 7% 41.7% EBITDA 20.0% $ 115,000 21.3% $ 150,000 22.2% $ $ 90,000 80,000 7.4% 26 © 2014 McGladrey LLP. All Rights Reserved. Case Study #3 – Earn-out disputes Sample Company Operating Expenses US$ in hundreds FY11 FY12 FY13 FY14 General & Administrative Advertising Rent Office Research & Development Miscellaneous/Other $ 20,000 15,000 30,000 25,000 10 000 10,000 20,000 $ 30,000 20,000 35,000 30,000 10 000 10,000 25,000 $ 40,000 $ 40,000 40,000 35,000 10 000 10,000 35,000 50,000 50,000 150,000 45,000 115 000 115,000 40,000 Operating Expenses $ 120,000 $ 150,000 $ 200,000 450,000 $ 27 © 2014 McGladrey LLP. All Rights Reserved. Case Study #3 – Earn-out disputes Sample Company Earnout Scenario Analysis US$ in hundreds Rentt U R Unadjusted, dj t d R t Adj Rent Adjusted, t d Rentt U R Unadjusted, dj t d R Rentt Adj Adjusted, t d R&D Unadjusted R&D Unadjusted R&D Adjusted R&D Adjusted EBITDA $ Rent - Research & Development EBITDA, Adjusted $ Agreed Upon EBITDA Multiple E Earnout t 80,000 $ 80,000 $ 2.5x $ 200 200,000 000 $ 80,000 $ 105,000 185,000 $ 2.5x 462 462,500 500 $ 80,000 $ - 80,000 105,000 105,000 105,000 185,000 $ 290,000 2.5x 462 462,500 500 $ 2.5x 725 725,000 000 28 © 2014 McGladrey LLP. All Rights Reserved. Contingent liabilities and financial statement implications p An event that has occurred that creates a liability but whose impact (or non-impact) is contingent upon subsequent events Examples of contingent liabilities • • • • • Lawsuits I Income tax t disputes di t Bonus payments Product warranty Guarantee of another party’s loan Under GAAP a contingent liability is recorded with a journal entry only if the contingency is both probable and the amount can be estimated 29 © 2014 McGladrey LLP. All Rights Reserved. Contingent liabilities and financial statement implications p ((continued)) If a contingent liability is only possible (not probable), or if the amount cannot be estimated, a journal entry is not required. However, a financial statement disclosure is required Contingent liabilities often include a large degree of subjectivity as to whether and how much to accrue When accruing for a contingent liability: Debit- Expense Credit- Liability Contingent liabilities are often current liabilities Therefore a contingent liability will usually affect both EBITDA g capital p and working 30 © 2014 McGladrey LLP. All Rights Reserved. Case Study #4 – Contingent liabilities A private equity firm acquired 100% of the stock of a closelyh ld reall estate company. held - The target’s core operations were located in the western United States, but the company had recently discontinued operating many l locations ti iin Fl Florida id d during i llate t 2008 2008. - The acquirer was aware of the Florida operations, but understood that only 2 of 15 locations remained in operation as of the purchase date and that all other locations had been shut down in an orderly fashion. After the sale had closed, the buyer learned that the target had guaranteed leases and other contractual responsibilities of the 13 nonoperational entities. The buyer claimed that the liabilities were inappropriately undisclosed, di l d while hil the h seller ll claimed l i d the h opposite. i 31 © 2014 McGladrey LLP. All Rights Reserved. Case Study #4 – Contingent liabilities Excerpt p from the Purchase Agreement: g - Seller has delivered to Buyer the financial statements of the Company set forth in Schedule 3.2 as included within ((the “Financial Statements”). ) The Financial Statements fairly present the financial condition of the Company as of the Closing Date. Excerpt from an email from the Seller’s Seller s CEO 16 days prior to the sale: - “Jack, please note that our California bases operations have guaranteed certain contractual obligations of our Florida operations. At this time, we are unable to measure the amount of the liabilities, but to the best of our understanding we believe the amounts to be immaterial understanding, immaterial.” 32 © 2014 McGladrey LLP. All Rights Reserved. Case Study #4 – Contingent liabilities Sample Company Balance Sheet $ in thousands US$ Cash Accounts receivable Inventory Prepaid expenses Other (Audited) 12/31/11 (Audited) 12/31/12 (Audited) 12/31/13 $ $ $ 100 80 200 20 15 80 65 210 22 18 90 75 190 18 17 Total current assets 415 395 390 Fixed assets, net 500 480 460 Total assets $ 915 $ 875 $ 850 Line of credit Note payable Accounts payable Accrued expenses Payroll taxes payable Current portion of long-term debt $ 60 300 55 40 8 6 $ 45 300 50 42 7 6 $ 30 300 60 45 9 6 Total current liabilities 469 450 450 Long-term debt Deferred compensation Commitments and contingent liability 436 10 - 415 10 - 390 10 - T t l liabilities Total li biliti 915 875 850 - - - Stockholders' equity Total liabilities and equity $ 915 $ 875 $ 850 33 © 2014 McGladrey LLP. All Rights Reserved. Case Study #4 – Contingent liabilities Sample Company Contingent Liabilities US$ in thousands FY14 FY15 FY16 FY17 FY18 Lease 1 Lease 2 Lease 3 Lease 4 Lease 5 Lease 6 Lease 7 Lease 8 Lease 9 Lease 10 Lease 11 Lease 12 Lease 13 $ 12 21 4 3 3 7 8 210 3 12 $ 6 2 210 5 $ 210 - $ 210 - $ 105 - Total Contingent Liabilities $ 283 $ 223 $ 210 $ 210 $ 105 34 © 2014 McGladrey LLP. All Rights Reserved. Suggestions to prevent potential disputes In some situations, preventing a dispute among the parties to a transaction can prove to be very difficult difficult. In general general, it is often best for buyers and sellers to attempt to work together to avoid costly litigation. Below are a few suggestions that can help prevent such disputes: - Ensure terminology is well-defined Avoid vague terminology Incorporate illustrative examples Eliminate incomplete, inconsistent or bad data 35 © 2014 McGladrey LLP. All Rights Reserved. Addressing your questions Patrick Chylinski Director McGladrey LLP Director, Los Angeles, CA 213.330.4605 [email protected] Todd T dd Sigler Si l Manager, McGladrey LLP Los Angeles, CA 213.330.4634 t dd i l @ [email protected] l d John J h Ti Tira Manager, McGladrey LLP San Francisco, CA 415.848.5313 j h ti @ [email protected] l d 36 © 2014 McGladrey LLP. All Rights Reserved. Thank you for attending! Reminder to obtain CLE credit Attend the webcast for a minimum of 50 or 60 minutes to receive credit depending on your state requirement Answer the poll questions Complete post-event post event evaluation 1.0 CLE credit hours will be issued to eligible participants within 60 days via email Follow-up materials The presentation slides and a link to the call recording will be sent to all participants within a few days of the webinar 37 © 2014 McGladrey LLP. All Rights Reserved.
© Copyright 2024