Companies seek to sell, acquire, or merge with other companies for various reasons. The expectation of increased profits, expansion into new markets, and the creation of synergies, among other things, fuels the business transaction market. A well-constructed purchase and sale agreement, while key to a successful transaction, does not guarantee the satisfaction of the parties involved. When a transaction fails to meet expectations, one or both parties will often conclude that the failure of the company’s performance post-transaction is due to their counterpart. When this occurs, attorneys and other professionals are retained as the disputes can easily escalate, frequently resulting in litigation. Generally, there are three ways that parties to business transactions can claim remuneration:
Breach of Representations and Warranties included in the agreement
In evaluating damage claims related to a merger and acquisition dispute, information is needed to uncover the facts and circumstances of the allegations. In many cases, information is available in documents not generally considered “basic” financial information, such as annual financial statements and tax returns. This is especially true in breaches of representations and warranties disputes, which are typically much larger in scope than post-closing adjustments or earnout disputes. Following is a brief description of some documents that may be useful in each of the three dispute types mentioned above.
Representations and warranties are assurances made by the parties in an acquisition transaction to assure that the buyer is “getting what they paid for” and that any interests in the company maintained by the seller are protected after the acquisition is complete. They are a frequent source for disputes when a party to the acquisition is dissatisfied with the ultimate outcome of the transaction.
In a breach of representations and warranties claim, the financial expert is involved in both establishing that a breach occurred and calculating the amount of damages suffered as a result of the breach. Once evidence of a breach is uncovered, related damages can be assessed. The nature of the documents requested can differ greatly from case to case, depending on the specific representations allegedly breached.
Common documents that are typically requested in a breach of representations and warranties dispute in most cases include, but are not limited to:
Due diligence workpapers prepared by external accountants and other professionals, as well as the due diligence files of the buyer
Internal financial reports, such as monthly financial statements, profit and loss statements by product line, division or segment
Internal emails, memorandums and other correspondence pre-transaction, during due diligence and post-transaction
Correspondence, analyses, valuations, and other documents related to previously considered merger, acquisition, or joint venture transactions
Schedules of annual sales to key customers, annual purchases from key suppliers, and vendors and related correspondence
Accounts receivable, inventory-related documents, support for major capital asset acquisitions, and depreciation schedules
Additional documents, while they may not intuitively seem relevant to the financial damages associated with a breach, can contain information that can lead to, or provide direct or corroborative evidence to, either support or dispute a breach claim. Examples of certain documents are detailed below:
Documents submitted in conjunction with obtaining and maintaining loans from financial institutions, including submissions relating to compliance with loan covenants
In addition to the loan/financing agreements themselves, when applying for debt facilities, companies are generally required to submit substantial amounts of financial data to demonstrate financial solvency and creditworthiness to the lending institution, as well as supporting documents related to collateral. The information required by the bank will depend on many factors, such as the financial health of the company and size of the loan being sought. Generally banks require the financial statements (both internal and external), business plans, projections, information about the company and its key individuals, and budgets (see below for a discussion of business plans, projections, and budgets). Most financial institutions also require periodic submission of this information during the period the financing is outstanding. On occasion, the information submitted to the lending institution is different from the records the company maintains in its normal course of business.
These submissions also can provide information relative to ongoing concerns, breaches of covenants, negotiated extensions, financing denials, and other relevant items. In addition, loan applications may include financial information about individuals associated with the company in the event personal guarantees are required as collateral, and can provide additional insight on related companies and related-party transactions.
These types of documents may provide corroborative evidence that supports seller’s or buyer’s representations and warranties or may contradict them.
Business plans, projections, and budgets
Business plans, projections, and budgets prepared before the acquisition negotiation began can provide valuable information about the company’s financial and operational outlook before any potential biases from a possible acquisition enter into the equation. They can be compared to the company’s actual results to gauge management’s proficiency at making projections.
In addition, historical projections can provide a barometer with which to compare recent projections which were provided to the seller when negotiations were taking place. This comparison may identify several areas for additional investigation, including but not limited to, sales, customer relationships, cost of sales, supplier relationships, payroll costs, and impairment of long-lived assets.
The narrative portion of business plans can often provide as much valuable information as the financial data they contain. Narratives may include descriptions of management’s “vision” of what the company will look like, expansion areas, concerns and threats, and how the company will achieve optimal results. For example, the seller may be using the financial projections associated with a business plan in demonstrating the value and upside of the company during negotiations. However, it may be found that these projections were prepared in part or whole on a different basis, i.e., the narrative descriptions in the business plan that underlie the financial projections fundamentally differ as to how the company was going to achieve these results.
Minutes of Meetings of the Board of Directors
The minutes of board of directors’ meetings should document all significant transactions, agreements, and strategic initiatives of the company. They are a source to identifying key events or transactions that may be at issue during a post-acquisition dispute. Information found in the minutes may include events such as:
Potential merger and acquisition transactions considered
Extinguishing or entering into loan and lease agreements
Major asset acquisitions
Significant sales and/or supply agreements entered into
Employment agreements entered into with key personnel
Stock purchases or sales
Strategic decisions of the corporation such as entering or exiting product lines or geographical areas
Off-balance sheet and contingent liabilities such as potential liabilities from litigation or guarantees of the liabilities of related parties
In addition, many companies are organized into segments or divisions or have various committees, such as the audit committee. The meeting minutes from these groups may also be relevant.
Electronic downloads of detailed general ledger files
While providing the detailed general ledger files of a company is often objected to as “overly burdensome,” for small to mid-sized companies it can be as simple as printing a pre-programmed report to an electronic file. For larger companies, detailed general ledger data can often be obtained for the specific relevant segments or divisions. This data can be imported into software tools specifically designed to quickly and easily analyze large amounts of data. The detailed general ledger file can then be used to identify various types of transactions that may be relevant to a breach investigation. Examples of such transactions are:
Unusually large or non-recurring transactions, especially in close proximity to key dates in the acquisition agreement and negotiations
Manual journal entries, especially in close proximity to key dates in the acquisition agreement and negotiations
Transactions with related parties or intercompany transactions that may affect the financial position or results of operations of the purchased company
The detailed general ledger information can be used to perform high-level analytical analyses to identify possible areas for more specific investigation and/or to perform very specific analyses for minute pieces of data.
Narratives of accounting policies and procedures and job descriptions
In the event a post-acquisition dispute occurs, reviewing narratives of the subject company’s accounting policies and job descriptions can provide valuable information about weaknesses in internal controls that may make certain business processes more susceptible to misstatements in financial reporting and/or more vulnerable to fraud. Internal control weaknesses identified can provide starting points for further investigation and/or corroborative information about specific claims in a post-acquisition dispute.
It should be noted that the documents discussed in this section may also be applicable to Post-Closing Adjustment and Earnout disputes, depending on the facts and circumstances of the individual case.
The transaction price is typically formed based on interim financial statements, and post-closing adjustments are made to derive the actual value of the transaction as of the closing date. During this interim period, the seller is required to operate the company in the “normal” course of business. Typically, this is based on the valuation of certain balance sheet accounts and, often, issues relate to the consistent application of Generally Accepted Accounting Principles (“GAAP”). Money is typically held in escrow to resolve these disputes.
Documents required for post-closing disputes depend on the nature of the item being disputed. Many of the issues are typically balance sheet-driven such as the final value of accounts receivable, inventory, and certain payables. To determine if a post-closing adjustment is warranted, both the interim and closing financial statements are needed. Beyond that, the documents required are typically specific to the item being in dispute. For instance, if the value of accounts receivable is in question, one would want to obtain the general ledger for the accounts receivable accounts for the interim period, the sales journal, the cash receipts journal, accounts receivable aging documents, documents pertaining to collection efforts, any adjustments to bad debts or accounts written off and related support and explanations, and possibly source documents supporting order-to-cash transactions. If the issue is GAAP-related, the company policies surrounding the adoption and use of GAAP (or its departure from GAAP) are needed and related accounting guidance is utilized.
If the issue is that the company did not operate in the normal course of business during the interim period, a more robust set of documents would likely be required, similar to a breach of representations and warranties, in that one is evaluating company operations and their financial impacts.
Transactions are sometimes accomplished with earnout agreements. These agreements allow the seller to realize a portion of the sales price post-transaction should the company realize certain targets. These targets vary by agreement, but are often measured by sales, gross profit, EBITDA1, or net income, typically over a 1-3 year period. The seller also may have a consulting agreement to continue to work with the company post-transaction, allowing them to have some control over whether the earnout will be achieved. The agreement usually calls for the company to operate and financially report on a comparable historical basis for purposes of determining the earnout.
Earnout disputes are typically broader than post-closing adjustment disputes, as questions often arise as to whether the company was run in the same fashion as it was historically. Commonly disputed issues are mismanagement, decreases in sales, inconsistent application of GAAP, ineffective cost management, absorption of expenses from the combined company, intercompany transactions, employee turnover, and the post-acquisition efforts of the seller if still working for the company under a consulting agreement.
For instance, assume that post-transaction, a company experienced a 25% drop in sales to its largest customer resulting in missed earnout targets. The seller may indicate it is still entitled to the earnout as the buyer didn’t follow historical practices in its effort with its customer. In this situation, a number of documents related to the customer would need to be analyzed to determine the claims in this situation, such as sales of product, sales attempts of the company, terms or proposed terms of transactions, sales policies, sales personnel, commission structures, cost of goods sold, and perhaps other items. One may look beyond just the customer at issue as well to see if similar or different financial results were experienced by other customers, for certain products, for certain product lines, etc. Sales may have declined for a number of reasons that may or may not impact an earnout calculation.
Again, earnout disputes, once analyzed, are likely to be specific to one or more defined areas, and the documents required to analyze the situation will differ based on the allegations.
In Post-Acquisition Disputes, uncovering the facts and circum-stances behind transactions and events is essential before alleged damages can be calculated. It is often the qualitative factors that, once uncovered, provide the basis for financial analysis and quantification of damages. A financial expert will use a company’s financial data as well as non-financial data to tell the history of past events and transactions. Once the history has been unfolded and details are organized, damage calculations become a factual representation of amounts at issue.
EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.