ARTICLE | August 07, 2024

Authored by RSM US LLP

For more information, please contact Thomas J. Emmerling at tjemmerling@dopkins.com.

The transactional landscape during the past few years has been one of extremes. After record-breaking deal volumes in 2021, the M&A market has encountered consecutive down years in the midst of economic and geopolitical uncertainty. Now, with unprecedented levels of dry powder available combined with the anticipated decline in interest rates, deal activity is primed for a rebound headed into the second half of 2024.

With deal volumes projected to increase, buyers and sellers must contend with the risk of post-closing disputes, and the high-stakes dispute resolution process that goes with it. Here are three post-acquisition dispute trends we are seeing and expect going forward:

1. Continued prevalence of working capital disputes

Regardless of the deal environment, buyers and sellers rarely agree on the value of the current assets and current liabilities being acquired at closing. Accounts that are judgmental in nature, such as reserves or contingent liabilities, are often an area of disagreement. High dollar accounts subject to reserves, such as inventory, where there are a variety of reserve methodologies, often give rise to disagreements. In the absence of clear definitions and illustrative exhibits, deal parties can expect to be tied up with dispute notices and arbitration well after the deal has closed. The Financial Times highlighted a recent acquisition of a supermarket chain in which the seller’s failure to include certain subsidiary debt into the definition of “indebtedness” within the purchase agreement resulted in the buyer receiving a windfall in the form of an over $100 million discount to the purchase price. The best time to mitigate a dispute is before the deal closes, and having a dispute specialist involved before the purchase agreement is signed can play a big part in optimizing deal value.

2. Increased utilization of earnout provisions

The past few years have seen a significant increase in earnout clauses. Earnouts are a useful mechanism in bridging the valuation gap between deal parties, making a portion of the purchase price contingent on the acquired company achieving certain agreed-upon metrics. Earnouts not only protect buyers from overpaying for a business that fails to perform post-closing, but also eases the buyer’s up-front cash layout during challenging financing conditions. According to a Jan. 26, 2024, article in the Wall Street Journal, it is estimated that during the first three quarters of 2023, approximately one third of deals contained earnout provisions, up from just 21% the year before. Earnouts are often highly contested areas, due to the subjectivity that is often inherent in the calculation, particularly when the metric is based on multifaceted and vague definitions such as adjusted EBITDA. Common areas of dispute include:

• Subjective addbacks such as unusual or nonrecurring expenses
• Accusations by sellers that buyers intentionally thwart the ability of sellers to achieve the earnout payment based on buyers’ post-closing intervention in the operation of the business
• Revenue recognition and bad debt expense

Earnout provisions should include clear definitions and illustrative exhibits where applicable to eliminate ambiguity and ensure parties are aligned.

3. Evolving representation and warranty dispute landscape

The American Bar Association (The Continued Rise of Representations and Warranties Insurance: 2024 Forecast) estimates that approximately 33% of post-closing disputes in North America are caused by an alleged breach of a seller’s representation and warranty. The utilization of representation and warranty insurance has become the norm, particularly in deals involving middle market targets and private equity acquirers to alleviate risks on both sides. According to the Lowenstein Sandler LLP R&W Insurance Claims Report 2023, though breaches related to the accuracy and/or GAAP compliance of financial statements remain the most frequent breaches reported, breaches related to cyber and environment, social and governance issues are becoming increasingly common. Given the frequency with which buyers are relying on seller representations of historical financials to determine purchase price (typically on a multiple of EBITDA), potential breaches by sellers will only continue to be magnified given the dollars at stake.

Parties should ensure that the scope of due diligence and quality of earnings for an ascribed financial reporting period also considers the potential impact on financial reporting periods to which seller is representing are accurate and GAAP-compliant.

Takeaway

A true team approach consisting of M&A attorneys, due diligence services and dispute specialists can shore up and clarify areas subject to interpretation and ripe for potential disputes.

Source: RSM US LLP.
Reprinted with permission from RSM US LLP.
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For more information, contact

Thomas J. Emmerling PhD, CFA®, CVA®

Tom counsels clients in exit planning and mergers and acquisitions, helping them navigate the complex and often lengthy process as businesses are transitioned to new ownership.