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After due diligence, negotiating and signing of the purchase contract and closing, one could think that the M&A transaction is completed. However, more and more often this hope proves to be vain because the number of disputes that follow M&A transactions is increasing. What might trigger disputes are in particular matters involving interpretation of laws relating to the calculation of earn outs or purchase price adjustment mechanisms, information on the company to be acquired received within due diligence and accounting errors detected after the transaction. What conclusions can be drawn from such disputes for the next transactions and how can the damage be recognized and valuated?
There are many reasons for disagreement: If the earn out is used to bridge different price expectations of the buyer and the seller during purchase price negotiations, later on the parties often have different views on the contractually agreed basic points. Even if both parties act in good faith, the post deal integration of the target company under the influence of the buyer, imprecise definitions of the earn out valuation parameters, or unexpected trends of the market environment, frequently cause disagreement between the buyer and the seller on the amount of the earn out.
Another reason why parties disagree is often due to balance sheet errors detected after the transaction. Thus, errors appearing minor at first glance may lead to hefty claims for damages. If the value of EBIT reported by one of the fully consolidated subsidiaries in the last financial year ended prior to the transaction was too high, e.g. due to the failure to set up a provision, it can lead to a claim of refund of 200,000 Euro in a single transaction. However, if in such a case the purchase price was determined based on EBIT and a fixed multiplier of, say, 7.5 with the EBIT amount being guaranteed in the purchase contract, claims made against the seller can amount to 1.5 million Euro.
The list of particularly disputable issues related to M&A transactions can be extended by any of the following: realization of profit from long-term construction contracts, double recognition of accounting items ("double dip") in the DCF valuation and purchase price adjustment mechanisms or interpretation issues arising during preparation of closing accounts. Such disputes are rarely fought out in public, because no parties involved wish to hit the headlines on this account. Therefore, it is reasonable to agree already in the purchase contract that any issues involving business operations will be consulted with an independent expert and that any differences will be heard before an arbitration court instead of a court of general jurisdiction.
In order to minimize the risk of disputes over a transaction, the parties should include the results of due diligence and business valuation in the purchase contract. It is, in fact, a matter of course, but it is often neglected in practice. Therefore, the due diligence process should include from the very start a real-time and systematic information exchange between the parties and persons involved in the transaction so as to dovetail the findings of the operational, tax, financial and legal due diligence and the business valuation. Only through such an interdisciplinary exchange can potential risks be detected and taken into account wherever they may prove relevant.
In addition, the contract should include precise definitions of concepts relevant to the transaction. This especially applies to all parameters to be incorporated into the purchase price calculation, purchase price adjustment mechanisms or an earn out. Besides defining the concepts, the parties must also agree on the accounting standards to be used for calculating ratios. If an earn out is a component of the purchase price mechanism, a shortest possible measurement period must be selected and the earn out should be calculated based on a figure, such as revenue, which can be manipulated for accounting strategy purposes to a limited extent only. If the earn out is based on such earnings-related figures as e.g. EBIT, one should bear in mind that not only accounting options but also real business transactions can have a significant impact on those figures. Thus, for example, business transactions made between the buyer and the target company after the transaction are not always governed by the same terms and conditions as those applicable to transactions between unrelated third parties (arm’s length). Furthermore, the result can be manipulated via intra-group allocations or allocation of results to a period not covered by the measurement period.
If, despite all precautions taken to avoid damage, the damage does nevertheless occur and a dispute arises after the transaction, it is necessary not only to examine the legal basis for the claim but also to estimate the monetary value of damages. The damage amount can be estimated by an expert arbitrator appointed by joint agreement of the parties. However, it often happens that one of the parties calls in a valuer to prepare an opinion before filing a claim, in order to determine the scope of damage beforehand. Although such a valuer acts as an expert for one of the parties, he should remain neutral in this role and determine the value in an objective manner. This is the only way to ensure that the values determined by the expert are upheld by the arbitration court and the expert is not seen as the "hired gun" whose arguments cannot be duly respected because of that.
Depending on the damage, the structuring of the purchase price and the seller's warranties, the amount of damage can be calculated euro for euro, based on either the multiplier underlying the transaction or the future cash flows. This is particularly the case when the damage also affects the enterprise's future cash flows. The damages are calculated as the difference between the actual condition and a hypothetical damage-free condition. To find out this difference, a valuation must be made with respect to both scenarios. Here the challenge for the valuer usually is to realistically illustrate the fictitious damage-free condition. In this regard, it is particularly important to choose a valuer experienced in handling disputes related to M&A.
No less important during the calculation of the above values are the close liaison with a lawyer that is proficient in transaction-related disputes and the documentation prepared thoroughly and in a manner allowing the arbitration court to easily understand its details – of all assumptions and premises made for the purpose of determining the damage amount. This is the only way to optimally prepare yourself to arbitration proceedings and win the dispute. Since such proceedings are often resolved by a compromise, it is recommended to strive to achieve an amicable solution with the counterparty already in advance. This is because – to quote a saying – “it's better to suffer small injustice than waste time trying to contest it.”
Peter Längle
Partner
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