Disputes post-deal closure can happen more often than you may think, with assumed non-issues suddenly becoming problematic.
This is particularly prevalent when the economic environment deteriorates, as has been the case due to Covid-19. When it looks like the buyer may have overpaid for a target company, they could look to claw back value through the purchase price adjustment process or claim for breaches of the agreement.
There can be many reasons for deals unravelling post-close. Earn outs and working capital are two commonly disputed types of purchase price adjustment. Working capital calculations may be disputed, particularly concerning debtor recoverability and excess or obsolete stock. Earn out disputes, on the other hand, often arise where the measurement basis includes expenses of the acquired business, where the buyer has increased discretion to determine which expenses to allocate to it, rather than a solely revenue based earn out.
Spending time reviewing the details before closing a deal and involving a professional advisor can help to avoid some of these pitfalls. It can also allow the owners to focus on other key areas. You should ensure there is clarification on methodology and language, e.g. what specific accounting policies are required; vague language can be interpreted differently after the closing date and can lead to issues down the line. It is also recommended that you include an illustrative example of purchase price adjustments within the legal documentation, which will help each party to understand the intentions and implications of the mechanism.
Engaging with a due diligence provider can give both buyers and sellers a better insight into the accounting policies of the target company, and guide the drafting of specific accounting policies to manage the risks particularly for items requiring judgment. This should reduce working capital or earn out disputes.
Ensure that post-closing dispute resolution clauses are included in the agreement. Failure to do so will add further complications should the parties face a dispute.
Manage the timing and metrics of earn outs. Used correctly, they allow another opportunity to validate the headline price. Poorly drafted wording can create contentious post-deal disputes, which may also be damaging for the business.
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Consider a locked box mechanism. With this mechanism, purchase price adjustments for cash, debt, and working capital are derived from a historic balance sheet, which is typically subject to a diligence review by both parties, reducing post-closing disputes.
Effective due diligence is important to understand the risks of a deal. The clearer the mechanism is drafted, and the less judgment required for policies and procedures, then the better the chances of the deal running smoothly.