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.