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Reading Transaction Sale and Purchase Agreements and Transaction Structuring Considerations

The Sale and Purchase Agreement (“SPA”) represents the agreed-upon legal, accounting, and financial terms of an M&A transaction. In the event of a dispute, the underlying signed SPA is what an arbitrator or court will use in deciding which party’s arguments will prevail. As such, it is important for Buyers and Sellers to proactively negotiate such agreements and ensure that the terms of the SPA adequately represent the agreed-upon transaction terms, in order to avoid a costly dispute later on.

Items of dispute can include:

  1. Purchase price computation
  2. Earn-out methodology
  3. Computation and release of escrowed monies and holdbacks
  4. Working capital targets and computation

Deal teams may wish to hire a consulting firm to read draft documents and provide guidance to clients regarding comments. Although lawyers are the ones who will draft the SPA and make changes to these documents, law firms typically do not have an accounting background and are not familiar with the intricacies of financial and accounting definitions within an agreement.

Included below are key considerations to keep in mind when structuring and writing the SPA from an accounting perspective:

  1. Many times, a purchase agreement will contain provisions for an earn-out, which is a method in which Buyers and Sellers can align interests by offering additional purchase consideration to a Seller based on the post-closing performance of an acquired business. To the extent that an earn-out is based on post-closing EBITDA, Buyers and Sellers should clearly define EBITDA and consider how purchase accounting adjustments and other non-recurring items will affect the earn-out (note: the definition of non-recurring items should be clearly defined within the SPA so as to create no ambiguity regarding which expenses and items fit the definition of non-recurring items). Additionally, earnouts are occasionally based on revenue growth, especially growth the Seller has driven. In these cases, it is necessary to clearly define how sales will be tracked and in what situation the Seller gets credit for growth vs the buyer.
  2. Vague terms within the SPA can lead to purchase price disputes, especially in the case of an aggressive Buyer or Seller. For example, if a SPA simply states working capital is to be computed based on the most recent “GAAP financial statements”, the terms of the agreement could ultimately result in a dispute. Each party may have different views regarding which items should be included in the delivered working capital computation, and if such amounts are comparable to the agreed upon working capital target. Net working capital is not formally defined under GAAP and there is no standard definition across all parties, which has led to an increasing number of disputes in recent deals.
  3. Note that simply referring to GAAP is often not enough to prevent a working capital dispute and can actually give rise to disputes. This is especially the case for middle-market deals involving companies that do not comply with GAAP on a monthly basis, adding complexity with regards to comparability against the working capital target at closing. Further, there are various methods of computing reserves, judgmental accounting estimates, accounting changes, etc. As such, consideration should be given to ensure that consistency occurs between the historical financial statements and the delivered working capital amounts, and that an aggressive Buyer/Seller cannot change the terms of computations for purposes of “gaming” the delivered working capital computation. For example, if a company has historically computed an allowance for bad debt in a certain way, a Buyer should not be able to apply a new allowance methodology in order to gain more favorable working capital treatment at closing, even if the new method proposed by the Buyer is acceptable under GAAP. Further, to the extent that certain balances on the Company’s historical financial statements are not recorded based on GAAP (especially with regards to liabilities), or that GAAP principles change, the SPA should clearly state whether a) consistency with past practices or b) GAAP should prevail.
  4. As it relates to the above, the SPA should clearly outline the methodologies, principles, and practices which should be used when determining the delivered level of working capital. This is often accomplished via reference to a formal illustrative working capital computation schedule, definition of accounting principles, or both. Definitions of accounting principles should state more than simply what components are included or excluded within working capital, but rather how such amounts are recorded. For example, “Net Accounts Receivable is defined as trade accounts receivable accounts only, net of an allowance for doubtful accounts computed based on past practices of the Company, to include amounts aged over 90 days or otherwise determined to be uncollectible based on evidence of significant collection risk. Interest on overdue balances is not to be included if not fully reserved for.”
  5. A SPA should also clearly outline the methodologies for disputing working capital or other balance sheet items, as well as provide Sellers with adequate time to review the closing accounts and working capital after preparation by Buyers. Typically, a period of 30 days subsequent to the delivery of a closing working capital statement is adequate; time frames less than this may not allow the Seller with suitable time to review the final working capital computation.
  6. Consideration may be given to ensuring that costs of arbitration are borne by the losing party in a purchase price dispute. For example, an aggressive party may choose to dispute numerous immaterial and/or frivolous items in an attempt to win certain concessions with a rationale that something is better than nothing. However, a clause which states that the losing party in a dispute will bear the other side’s legal and accounting fees in proportion to the amounts of items disputed could discourage this practice. For example, suppose there are 8 items of equivalent magnitude disputed in a purchase price dispute, with the Buyer winning 3 of the items and the Seller winning 5 of the items; in this case, the Buyer would ultimately pay 5/8th of the total dispute legal costs.
  7. To the extent that a closing date is not at month end, consideration should be given to ensure that the target company’s accounting systems are able to close financial records at mid-month. Frequently, a company’s accounting methods and systems are not sophisticated enough to close at a period other than month-end. In addition, to the extent that a company’s month-end closing procedures are not the same as year-end procedures, consideration should be given to ensure that all appropriate year-end adjustments are factored in. While reading a SPA, consideration should be given to ensure that debt and debt-like items are not included in the working capital target and are instead included within the definition of Indebtedness. For example, if a restructuring accrual is included as a dollar for dollar adjustment to purchase price through inclusion within the definition of Indebtedness, as well as is included in the working capital methodology, this will result in some level of double counting.
  8. Regardless of the level of diligence performed and levels of representation obtained from each side, any M&A transaction will contain risk to the Buyer from intentional or unintentional breaches of representations and warranties. As such, Buyers should consider purchasing representation and warranty insurance (“R&W Insurance”). R&W Insurance can be a way for Buyers to protect themselves from breaches of representations, and, also may allow the Buyer to pursue an insurance company for claims, rather than Management of a Seller which may now be employed by a Buyer.

Proactively designing the SPA alongside financial consultants is prudent for both sides of an M&A transaction and can reduce the risk of value-leak and post-closing disputes. An experienced transaction advisor should assist with clarification and resolution of all items listed above. Considering the future potential costs of an ambiguous or poorly negotiated SPA, the cost of hiring an experienced financial consultant can pay for itself.