Journal of
Corporate
Renewal
July/Aug
2017
any proposed adjustment. In some
cases, the purchase agreement includes
sample calculations for any expected
or foreseen adjustments. However,
vague terminology, undefined terms, or
the absence of these terms altogether
can open the door for disagreements
between buyers and sellers (Figure 1).
Earn-outs. Earn-outs are consideration
paid to the seller based on post-closing performance of the business
and are most commonly related
to meeting or exceeding defined
financial and operational goals.
Earn-out arrangements can provide a
mechanism for buyers and sellers to
compromise on the acquisition price and
are commonly employed to incentivize
the acquired company’s management
to remain with the purchasing entity
after the acquisition. Additional
compensation is not guaranteed and is
often tied to a designated performance
metric, such as EBITDA, net income,
or cash flow from operations. In
addition, a variety of other key
performance indicators (KPIs), typically
focused on operational efficiency and
profitability, are often considered when
calculating earn-out payments.
Similar to issues with other
post-closing disputes, earn-out
calculations can be susceptible to
highly contested disagreements
between buyers and sellers (Figure 2).
Sellers often expect earn-out goals
and amounts to be relatively easy
to achieve and earn, while buyers
frequently hold a counter opinion.
Representations and Warranties.
Almost every purchase agreement
contains representations and warranties,
which are factual statements about the
past, present, or future status of a target’s
operations, financials (such as assets and
liabilities), business, or other conditions.
Representations and warranties are
vital for several reasons. They provide
one party (usually the buyer) with
disclosures of information that would
otherwise only be known by the
counterparty (usually the seller). This
reduces asymmetries in knowledge
that may be material to the transaction
and can shift certain risks associated
with the transaction to the seller. This
disclosure of information also allows
the buyer to price the transaction more
accurately and may even reassure the
seller that the buyer has the necessary
funding and capital to pursue the deal.
FIGURE 2: EARN-OUTS: KEY AREAS OF DISAGREEMENT
FIGURE 1: WORKING CAPITAL: KEY AREAS OF DISAGREEMENT
Common issues in post-closing working capital disputes include:
· Recent changes to accounting methodologies and applications
· Accelerated revenue recognition and related accounts receivable
· Accounts payable and other short-term liability measurements
· Reserves and provisions that can be highly subjective
· Inventory valuation methodology and inventory that may be obsolete or excessive
· Aging and collectability of accounts receivable
· Proper measurement and categorization of current assets (as assets or
expenses) and current liabilities (as liabilities or deferred revenue)
· Discretionary bonus accruals
· Accounting for employee benefit liabilities and other actuarially determined amounts
Common causes of disputes include:
· Ambiguity of terms or contract language, most commonly related to the earn-out measurement
and calculation methodology.
· Problems assessing profitability measures, disagreements over classifications, or the timing
and recognition of transactions, which can greatly influence financial reporting.
· Control of accounting information often rests with the buyer post-close, and financial reporting
policies (e.g., revenue recognition) and business unit structures (e.g., combination of similar
business units), etc., may make it difficult or impossible to evaluate earn-out performance
as contemplated by the purchase agreement.
· Buyers and sellers may disagree over the proper data sources required to evaluate
earn-out performance.
· Profitability may be influenced by factors other than the isolated transaction between the buyer
and seller. For example, the purchased company’s profitability may be affected by the buyer’s
access to additional capital for expansion of operations or to make additional acquisitions.
· Macroeconomic factors (e.g., interest rates or unexpected regulation), changes to the
industry (e.g., heightened competition, increased costs for raw materials), and other
factors may affect profitability in a way that was unanticipated by buyers and sellers.
• There is disagreement about
estimates and assumptions used
to prepare the balance sheet
Further, in many situations, adjustments
are made in accordance with specific
language or definitions established in
purchase and sale agreements. Well-
written purchase agreements often
define specific terms and principles
included in the contract and provide a
detailed methodology for calculating
by the seller in past practices
is inconsistent with GAAP
• The parties interpret components
of GAAP differently
• An error in the beginning
balance sheet is discovered after
the agreement is executed
