The CPA's role in quantifying post-acquisition dispute damages.

Author:Litvak, Jeff
Position:Certified public accountants
 
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EXECUTIVE SUMMARY

* Legal actions involving claims for post-acquisition purchase price adjustments are a growing area where a CPA's expertise in GAAP, financial forensics and business valuation is in high demand. A CPA may become involved in a post-M&A transaction to quantify the benefit-of-the-bargain damages in a dispute.

* The most common M&A disputes involve post-closing adjustments for working capital or net assets, indemnity or fraud claims, material adverse change (MAC) claims, and earnout disputes, among others.

* In a dispute involving both working capital and indemnity claims, working capital claims are typically measured on a dollar for-dollar basis, while indemnity claims can be measured dollar for dollar, over a finite period or into perpetuity. It is not uncommon for both issues to be raised.

* The measurement of damages into future periods is predicated on assessing whether the misstatement will affect future periods; the buyer's expectations were based on future performance; the business was significantly devalued after the acquisition; and the misstatement would have been "material" to a "willing buyer."

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Given today's environment of bankruptcies, bank failures and recessionary pressure, consummating merger and acquisition transactions is more challenging than ever. The potential disputes arising from the challenges of an M&A transaction are numerous. The following two types of disputes are the focus of this article: working capital disputes regarding whether the financial statements were in accordance with GAAP; and indemnity claims involving whether the buyer in the transaction obtained the benefit of the bargain.

Most post-acquisition disputes involve some form of financial forensics, and therefore lend themselves to general CPA skills. More often than not, however, these disputes involve specialized business valuation skills (see sidebar "Breaking Into Business Valuation") and are well suited for experienced valuation professionals with a deep skill set in the interpretation of GAAP who are also damage experts and can be credible witnesses in this area (see sidebar "How to Get Experience in M&A-Related Disputes"). This article describes the types of issues that arise in these disputes.

Consider the following example of an M&A dispute in which a CPA may become involved:

Company A acquires Company B for $400 million, or eight times the annual EBITDA (earnings before interest, taxes, depreciation and amortization) of $50 million. Company A alleges Company B overstated EBITDA by $10 million as a result of material misrepresentations involving GAAP violations. Company A alleges it bargained for a business worth $400 million and received a business worth $320 million, or EBITDA of $40 million x 8 (the EBITDA multiple).

POST-ACQUISITION DISPUTES

Post-acquisition disputes between an acquirer and a target company (selling shareholders or management) can arise in various ways, each with unique facts and circumstances producing a combination of accounting, valuation and legal issues. While parties to mergers and acquisitions attempt to create a purchase and sale agreement that clarifies the responsibilities and duties of each party, contracts are often imperfect and open to interpretation, resulting in disputes after the purchase and sale agreement is executed or the transaction is consummated. The most common M&A disputes involve post-closing adjustments for working capital or net assets, indemnity or fraud claims, material adverse change (MAC) claims, and earnout disputes (when both buyer and seller share the risk), among others.

MEASURING DAMAGES IN M&A DISPUTES

In a typical acquisition transaction, the target company's purchase price will be evaluated as a multiple of trailing 12 months reported EBITDA with an adjustment for any working capital excess or deficiency above or below a contractually agreed-upon level. The target company's required level of working capital at closing will typically be negotiated, agreed upon and specified in the purchase and sale agreement. The target company's actual levels of working capital will be established by its closing balance sheet presented in accordance with GAAP (Note: The requirement for GAAP presentation of the target company's closing balance sheet is a common provision of purchase and sale agreements, however, other, non-GAAP agreed-upon accounting principles or amounts may be specified.)

Here we examine the issue of measuring damages in a dispute involving both working capital and indemnity claims. Working capital claims are typically measured on a dollar-for-dollar basis while indemnity claims can be measured dollar for dollar, over a finite period or into perpetuity For indemnity claims that imply a permanent impairment to the value of the business, the damages may be measured "at the multiple" (the purchase price divided by the EBITDA of the subject company). The measurement of damages into future periods is predicated on assessing whether:

* The misstatement will affect future periods;

* The buyer's pricing expectations were based on future performance;

* The business was significantly devalued after the acquisition; and

* The misstatement would be "material" to a "willing buyer."

For example, the buyer may allege that $10 million of invoices was not recorded as accounts payable on the balance sheet and assert a working capital claim for a purchase price adjustment. In addition, the buyer may also assert a fraud claim alleging the seller deliberately withheld the information and that it was material to the buyer. As a result of not recording the invoices, the target company's expenses were understated, and EBITDA was overstated. The buyer may claim the purchase price was based on eight times the target's trailing 12 months EBITDA and, therefore, demand a purchase price adjustment of $80...

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