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M&A Hot Topic: Avoiding Pitfalls in Working Capital Adjustments and Earnout Provisions


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AMY: It is now my pleasure to turn this briefing over to Zach Snickles.

ZACHARY SNICKLES: Thank you so much, Amy, and thank you everyone for joining. We really appreciate the opportunity. We pulled together this content because we see a lot of deal activity that we actually play a part in, and we think that this course will be very helpful for both the deal attorneys who are writing up the agreements, companies who deal a lot in M&A, as well as some of the dispute attorneys on the back end for when sometimes these things end up not where maybe the parties actually envision they'd be.

So moving on to the next slide, we see pretty frequently working capital adjustments and earnout provisions that are in agreements related to the sale of a company from one party to another. These clauses are typically used to incentivize the seller to maximize the value of the company, either as of closing or at a subsequent date. And this prevents the Sellers from coasting through that closing date or from overpaying for a lemon.

Typically, we see these adjustments in one of two forms, either working capital adjustments or earnout provisions. There is a distinction. There is some times where we get involved with reps and warranties situations. We'll talk about that separately. But this first part of the course is really related to those working capital adjustments and earnout provision clauses, and we'll talk separately about the reps and warranties issues that we do come across.

The working capital adjustments are typically going to be for an asset purchase agreement. So this is really when one company is purchasing the assets of another. This captures value at a point in time-- as of that closing date. It's going to be based on the company's balance sheet and typically calculated as a derivative of current assets less current liabilities and agreed upon by a target amount. So this is really going to be related to asset purchase agreements, and again, we see both kinds.

On the earnout provisions, this is actually going to capture value of a period over time. Typically, we see this in a stock purchase agreement. In a stock purchase agreement, you're actually buying the business as opposed to just buying the assets. This is going to be based on the company's income statement and some derivative of income versus an agreed upon threshold over a period of time.

Typically, an earnout period lasts between one to two years in length. This really extends the relationship of the parties, as well as the transaction, beyond just the closing date. So in the event that it does get contentious, these earnout periods and earnout provisions can get a little bit complicated.

Selection can be based off a variety of variables as well. The economy-- when times are bad, you'll see a lot more asset purchase agreements. Whereas when times are a little bit better, you might see more of an earnout provision related to that. Also, the stage of the target company or the company that's in question for being sold, a startup might be more in line to do an earnout provision just because there's not that steady track record of performance. So the buyers want a little bit more assurance that they're getting a quality company.

Whereas if a company has had a very stellar track record for a long period of time, a working capital adjustment might be a better fit for that. Also, the motivation of the stakeholders, understanding what it is that they want to get out of the deal, can really result in whether it's a stock purchase agreement or asset purchase agreement as well as whether it's a working capital adjustment or earnout provision.

We see on our end more working capital adjustments than we do earnout provisions, at least recently that has been our experience. Earnout disputes can become more complicated typically with time, but either way, we see a very steady diet of disputes for both of these arrangements in what we do. In many instances, we're asked to consult with the disputing parties who help them craft opinions to be put forth in front of a neutral arbitrator, whether that be someone at another accounting firm or in some other capacity.

And then also, as a global accounting firm, we do act in a neutral role on a pretty regular basis. So we feel that we have a decent amount of experience in this realm to provide some insights today that we'll talk about. So with that, I'll hand it off to Charles to cover the next slide.

CHARLES BLANK: OK, thanks, Zach. This is Charles Blank here. So we're going to set the table here before we get into some of the areas of deceit that we commonly see by first talking about as it relates to the common contractual terms that exist in purchase agreements around working capital adjustments as well as earnout provisions. And generally speaking, these broad categories that we have on this slide are covered within your typical purchase agreement and they're typically located in a purchase price adjustment section to the contract.

As it relates to the first one, targets, oftentimes you'll see a contract that establishes a target clause for the measure against for which either working capital levels or a measure of the earnout, such as EBITDA, are measured against for purposes of determining whether there is going to be an adjustment to the purchase price. These amounts are either set based on a historic level of, let's say, working capital of the business and to the extent that the seller is delivering more than that average amount, there may be a positive adjustment.

And less, there may be a negative adjustment to the purchase price, whereas with earnouts, you may see that the parties have looked and agreed upon what a targeted level of performance is for which they believe that if the acquired company exceeds that target, such as gross sales or earnings, there will be an adjustment to the purchase price contractually specified.

In addition, the purchase agreement will oftentimes set aside or establish, rather, the methodologies for the measurement of either the working capital item or the earnout. For example, what you'll often see with working capital is that it will often include the current assets and liabilities of the company that has been acquired calculated in accordance with GAAP consistent with the seller's historical policies and practices. And that's usually language when the seller has had financial statements, often audited. They've applied GAAP.

Sometimes you may see deviations from the methodology where maybe if it's a smaller acquisition, the company did not have prior financial statements in accordance with GAAP and maybe the agreement will just say, current assets and current liabilities measured in accordance with GAAP, omitting the consistently applied piece.

In addition, after that the methodology is set, it may reference an example calculation. And that you'll see many times included is an exhibit to the purchase agreement, which may be for a pre-close period that includes the components of the items to be included in the working capital or EBITDA calculation. And oftentimes, you'll see that it will have for working capital, for instance, the specific line items, accounts receivable inventory, prepaid, other items that the parties have agreed to, including current assets.

And then on the liability side, they may have accounts payable, accrued expenses, contingent liabilities in other areas or items, rather, that they've agreed to include. In addition, you're going to see oftentimes either in the exhibit or called out within the agreement itself where there may be definition's particular to specific items that will be included within working capital or the earnout calculation.

For example, some areas, such as let's say an allowance for doubtful accounts on accounts receivable, where there's oftentimes judgment applied to how to measure that. The parties may agree and carve out from the traditional GAAP consistently applied definition to say, specifically agree how the accounts receivable reserve will be calculated. They may agree that items over a certain age may be reserved x percentage to be able to take out some of the judgment that different parties may apply.

In addition, the contractual terms typically call for specific timetables. And the timetable or areas of focus are going to usually include from the closing date to the date that the closing statement needs to be submitted, oftentimes you see from 30 to 60 days for that.

And then, an additional period of time from the closing statement to when the buyer would submit a-- the seller would submit a dispute notice. Oftentimes, that's a 30 day period as well. And then you'll have an additional period of time between the dispute notice where the parties are engaging in good faith negotiations and to the extent that they are unable to reach an agreement on the disputed items, you would then have an additional-- you'd then have a period where they would then engage an arbitrator and then a period of time for the arbitrator to conduct its proceedings and reach a determination, which is oftentimes, again, specified in the contract. And we often see that as an additional 30 days as well.

Moving on to other areas that are in the contract is materiality and collars. Sometimes the parties may put in a materiality cushion as it relates to if there's a disagreement between the parties that they can only dispute it to the extent that the difference is above a certain threshold. And that may mitigate the smaller disputes. In addition, shall there be a dispute that's unresolved, the agreement will typically call for an arbitration process and specifically specify that the parties are to engage an arbitrator, which is oftentimes either specifically identified as an accounting firm such as Grant Thorton or more broadly as a nationally recognized accounting firm.

The arbitrator itself may be referred to in different ways. Common terms are neutral accountant, arbitrator, or accountant firm. And in addition, as I mentioned previously, the agreement itself will then call for specific steps to be taken, protocol for the dispute resolution process itself. After this election of the arbitrator, it may call for a submission of position papers by the parties, potentially a rebuttal submission as well as the opportunity for the arbitrator to ask questions, obtain additional information, and then finally laying out a timeline for the arbitrator to provide its determination as it relates to those items in dispute.

Finally, as it relates to discovery parameters, the agreement will also oftentimes layout that during the period of time prior to the dispute notice, the buyer, who oftentimes now has the books and records of the business, is to provide reasonable access to books and records to the seller as well to the buyer's folks that prepared the closing statement. This usually continues after a dispute notice and prior to engaging an arbitrator as well.

So with that, let's move on to the next slide, and I'm going to pass it off to Erik to talk about some commonly disputed contractual language term.

ERIK LIOY: Thank you very much, Charles, and good afternoon, everybody. I'm going to cover a handful of areas where we commonly see disputes arising from in contract language. And these are the themes that we see over and over again.

So starting with the accounting standards, and whether you have a working capital mechanism, adjustment mechanism, or an earnout, there will be some definition of how the calculation is to be calculated. Very typically, you see something along the lines of the working capital being calculated in accordance with generally accepted accounting principles or GAAP as consistently applied by the target. But there are 1,000 flavors of that we see in practice, including one recently where a derivative I saw where it really just referenced historical practices and said, the working capital will be prepared in accordance with historical financial statements without making reference to GAAP.

So this is one of those key areas where the accountants and the attorneys need to get together in drafting the agreement on the front end and make sure that everybody understands what is being written, what is applicable, and what makes the most sense for your given deal. There is no perfect language that we can bottle and say, this is exactly how you want to do it every time.

As Charles touched on earlier, different deal sizes might drive it. So in instances where you don't have audited financial statements historically, maybe it's a smaller company that's privately held. You might want to make reference more to historical practices or carve things out. More sophisticated companies, you might go broader with just GAAP historically applied.

So some of the things to consider here. First is the precedence. So if somebody were to determine that the calculation, the past practice, was not in accordance with GAAP-- so the target company calculated reserves for inventories this way and that way is not GAAP for whatever reason, what takes precedence? So is it GAAP or is it the past practice?

I often recommend when I'm on the front in a due diligence setting and drafting agreements that you might want to carve out certain items, and Charles touched upon this. But for example, some of the subjective areas like valuing inventory reserves, valuing accounts receivable reserves, you might just want to define that the inventory will be cost less everything that is over so many years old or supply in excess of a certain amount or so forth to take all of the vagueness and judgment out of it.

Another thing to think about is disputes that come about what the past practice really was. And I'll give you an example. A number of years ago, I was involved in a dispute where the target company had government contracts which were long term and commercial contracts which were short term.

For the long term government contracts, they used percentage of completion accounting. Recognizing there's lawyers here, I'm not going to go into details of it. But they used a different method for the short term contracts called completed contract.

Well, in the months leading up to the closing of the sale, they ended up in a commercial long term contract. So you could see the parties took very diverging views of what was the historical practice. One argued the historical practice was its long term contracts going to percentage of completion. The other side argued, no, this is a commercial contract and the historical practice for commercial contracts is completed contract method.

Especially in middle market companies where things might not be documented or if you have a client or target company that is very dynamic and things are changing, you can get into those kinds of arguments.

Next up in the common disputed areas, definitions. One of my favorite examples is working capital itself. You quite often will see working capital calculated in accordance with GAAP, and what you'll find if you talk to an accountant is working capital is not actually defined by GAAP. I think we generally understand that probably means certain current assets minus current liabilities that are individually in accordance with GAAP, but it's one of those common languages you see in agreement after agreement that really isn't defined.

Same thing holds true in earnouts with EBITDA. And EBITDA it even more vague. There are lots of flavors of how EBITDA is calculated, what the starting earnings is before you back out interest taxes and depreciation and amortization. A lot of that is industry based. So I think it's very important to make sure that you understand what the definition is and you get that documented in your agreement, which brings me to the third item, which is one of the best ways to do that is to have illustrated exhibits that show calculations.

I think they're a great tool. They set out what the parties mean. If people are working diligently on the front end, they flesh out a lot of the issues. Where you do get into disputes around exhibits is sometimes they're almost always marked illustrative and so therefore they're not authoritative. So when you do get into a dispute, it's not uncommon for us to hear people say, well, you can't just rely on that exhibit.

So I do recommend them, but I think that's a caution note. The dispute process itself is often disputed. So it is not uncommon where one party will want to submit a working capital dispute to an arbitrator or accounting arbitrator or referee and the other party will dispute their authority to do it. They might argue that it's not really a working capital issue, it's a rep and warranty issue or what have you.

So I see two flavors in how these provisions are drafted in contracts. Some are very vague and they'll just say if there's a dispute between the parties, it will be given to a national accounting firm for resolution. On the other extreme, we will see some that are very detailed, and the disputing party will submit a notice 30 days, the other side will respond, and then rebuttals back and forth, et cetera.

There, again, is no magical answer of whether you want to be on the vague side or the detailed side. There are pros and cons. Being vague allows you flexibility to scale the process when there is a dispute based on the dispute. So if it's a relatively small dollar number and relatively small number of issues, you might want to do a very quick process. Conversely, we've done some that are 50 or 100 different dispute items. So leaving that flexibility can be helpful, but it can also cause disputes.

Another area that we see a lot of disputes going back to the contract language is the discovery process in an arbitration or access to the records. So I think it's always important to be mindful of who is going to have custody of the historical accounting records post-deal? They stay behind with the buyer or does the seller take them with them? And who's responsible for preparing the closing working capital or the earnout?

It sounds silly, but I have seen examples where it was very clear that the buyer would maintain the accounting system and all the accounting records and the seller was responsible for preparing the closing balance sheet after the deal was done. And they then got into fights over how much access they should get and who should prepare. So looking for those contradictions.

Finally, I'll summarize the last two bullets on the slide-- substance versus form and intent versus fair and equitable. Always there are arguments-- when it comes to us, it comes to me as a dispute and I'm sitting as a neutral. One side or the other will argue the other party knew about this. This was the intent of the deal, and this is the fair thing to do. And the other party will argue a more technical this is GAAP, this is the language of the contract.

So I think if there are things that you are drafting that is the intent of the parties or things that are understood by both parties about how things are done historically, you've got to get those documented. You don't want to make those arguments. Everybody make them, arbitrators hear them, they will consider them. But they're obviously hard to rule on. So I caution you on that area. If there are those things in there, get them documented in your agreement. And with that, I will hand the baton back to Zach.

ZACHARY SNICKLES: Thank you, Erik. So continuing beyond just the contracts and the execution of the working capital adjustments and actually getting to the brass tax of looking at the accounts themselves can result in some issues. So even if the language in the agreement is what both sides wanted, just in the execution of that language, even if it is very clear, can be problematic.

And that starts with purely the calculation of working capital. Cash is normally excluded in these transactions, but it's treatment often gets disputed because cash is left behind. So the seller was supposed to essentially drain the accounts before leaving, didn't do that, and then ownership rights as well as how that should be accounted for gets a little bit muddy when dealing with it in these working capital disputes.

The actual accounts that should be included in the calculation also can create an issue. As Eric pointed out, working capital is not defined in GAAP. And so there are very different variations of that. So understanding what accounts should be there and what accounts should actually be part of that calculation typically gets problematic.

Additionally, the contract itself can be contradictory between the language on the contract as well as any exhibits. So we've seen multiple examples where the contract itself lays out a very specific process to be followed and then an exhibit seems to contradict that. So inevitably, you have two ways of doing it that have both parties up in arms about which way should be done.

And then moving on to the next item, buyer's GAAP versus seller's GAAP and this could be IFRS as well. So GAAP being generally accepted accounting principles and then IFRS being the international version of that. This is a regularly disputed item. The buyer typically gets their hands on the documentation and applies methodologies that are their GAAP or their IFRS, but these are very different than the seller's practices.

So this is a common theme that applies to a lot of different accounts, and we'll talk about some of those items here. Estimates are typically something that gets a little bit troublesome when dealing with these things. Accruals is one of those. Accruals for our accounts payable and prepaid assets typically, again, creates issues for stakeholders normal practice. And this is really prevalent when perhaps the target company is either a startup or not sophisticated.

They manage their books a lot of times operationally and less in line with accrual accounting or within US GAAP, and so they've been doing things for a very long time in a very certain way and then the buyer comes in having not realized that and the due diligence and they, of course, get into a dispute over how those things should be handled.

Moving on to allowances, bad debt allowances are typically disputed based off alternative methodologies. Hindsight is typically used as an argument when we sit in the neutral seats. It's based off of what was actually collected for this accounts receivable. However, that itself is not a standalone argument. Any arguments for bad debts should be based in generally accepted accounting principles or IFRS and consistently applied based on the information available at the time of close.

So we typically get our hands on these disputes six months to a year after the close for working capital adjustments, and at that point, a lot of accounts receivable are known to have either been collected or uncollectible. And a lot of times, we will see hindsight arguments made. However, that can't necessarily come into play or cannot be a primary argument. It should really be based off of the information that could have been known at the time of closing.

Moving onto reserves. Inventory is typically a hotly contested account as impairment arguments are made pretty frequently. Essentially, an argument that the buyer has come out and said, some of this is no longer saleable. Or the seller comes in and says, we've been selling that for years. There's no issue with that.

So there's also various ways within GAAP to account for inventory reserves. So those are things that typically get a little bit disputed in these situations. And one of our examples that we'll discuss later actually will talk about inventory as well.

Loss contingencies, these can result in disputes, especially when there is an unexpected potential loss contingency that shows up in the period prior to closing or one that is identified with a buyer shortly after. A recent example I came across that resulted in a dispute was a vendor contract issue that the buyer didn't know was in existence until post-close and the seller stated that they were not aware of the issue pre-close.

This puts the neutral accountant in a very tough position as the seller has typically represented, as Eric spoke about earlier, that all material claims against the company have been disclosed. So the buyer argued that the lost contingency should have been on the books, whereas the seller stated they didn't know about it and that they also believed that the potential claim was defendable and not necessarily payable. So these lost contingencies can really create some difficulty for the neutral and somewhat tie their hands a little bit because on a lot of instances, it ends up being a reps and warranties situation.

Cut off issues. Liability cut off results in a lot of disputes. We have consulted in situations where the seller historically didn't actually capture any liabilities, and we were consulting for the buyer in this transaction. And so essentially, the seller would just only accrue for any liabilities that came in prior to the closing date. The buyer obviously disagreed with that because some of those liabilities, while they weren't known prior to closing, could have been estimated and understood.

So the buyer disagreed with this approach. So as consultants for the buyers, we had to go through thousands of invoices to perform an appropriate cutoff for purposes of their position.

Lastly, closing procedures on working capital can affect the amount in question. The closing procedures themselves have proven to be problematic. An example here is a soft close for an accounting group may have happened for purposes of developing the target, and this is typically prepared by the seller. But then a hard close is performed as of the actual closing dates.

There's different protocols related to those and so you end up in a situation where just the process itself of closing the books creates some difference in those amounts. So with working capital typically contested issues discussed, I'll pass it off to Charles for the next slide.

CHARLES BLANK: OK, thanks, Zach. So now we're going to turn our attention to commonly disputed items as it relates to earnout provisions. And as Zach introduced the topic of earnouts, I think there's a few factors if you compare them to working capital that make them more prone to dispute. Typically we don't see as many in the work that we do, either as a party consultant or expert.

However, I think if you talk to folks, a lot of times you'll understand that these are highly contested provisions. Sometimes they don't get to deceit, but oftentimes, there is a process or a dispute amongst the party that goes through a resolution process, which may be the parties agreeing ultimately to settle it out.

But what I would say too is that what also differentiates these and makes them more contestable than working capital provisions is really two things. One is the dollars are sometimes larger because the provision itself will be subject to a multiple. In other words, as we mentioned before, the parties may agree to a certain multiple of an amount in excess of a target and that will be applied to the purchase price.

And so any difference or dispute amongst the parties is magnified in that respect. And two, you have a situation where the buyer has now taken over the books and records of the company and as well we'll get into here in a moment, they now are, one, control on how they account for things and, two, are able to manage the business, which may be different from how the seller had done.

So first things first as it relates to disputed items is just starting with the calculation of the earnout amount itself. And as we mentioned, sometimes the parties agree to a measure, which may be something like gross sales, earnings, EBITDA. And to the extent that they are less detailed than how they define the earnout amount-- for instance, a term like earnings-- raises questions as to does that go down to net income, net of tax? Is that an item that represents an amount prior to tax?

When you think about an entity that's been rolled into a much larger entity, there can be questions as to how are taxes from the overall corporate entity allocated down to this individual entity that's now been acquired? So typically, where there becomes issues with these calculations and definitions of the earnout is really for the most part focused on is there a lack of detail within how they've actually defined the term?

And that rolls into the next issue, which is GAAP versus GAAP. So now, like we said, the buyer has taken over the business. They are keeping the books and records. They may be required by contract to maintain the GAAP, the book's consistent with what the seller did. And so here's where issues can arise, especially if you think of new types of transactions that may arise and maybe they weren't contemplated in the seller's books and records, so the buyer is applying GAAP. But there's nothing to consistently apply against.

The other concept here is Zach had mentioned all the issues that can arise as it relates to estimates and cut off issues as it relates to GAAP. One of the issues that-- or as it relates to an earnout, where this becomes problematic or challenging is that in a working capital adjustment, you're just looking at a point in time balance. So if the parties disagree to an amount of inventory, then they'll take the arbitrator or the parties will decide between the difference between the-- will ultimately agree to what the difference is between the two amounts, buyer and seller.

Here, again, we're now dealing with what is oftentimes the impact that's running through the income statement and being used and then a multiple is being applied to it. So even small adjustments that are running through the income statement-- so in the example of inventory, if you now have a difference in what the cost of sales, that may be applied a much bigger number that's now being considered over a multiple year period with the multiple applied. So it does have a magnifying impact, GAAP issues, when it relates to an earnout.

We touched upon the change in management strategy or management and/or strategy. And this is the one I think we see most common as it relates to earnouts. So where the buyer will take over a business and they may decide to manage it differently, they may decide to a common thing that you may see is that the buyer may decide to discontinue a line of business that the seller had entered into. Maybe they continue with the core line of business. They exit a smaller line of business or they change the way that they're marketing the product.

And the buyer may say, no, this wasn't contemplated. We approved this business. It's a new product. We don't think it's contemplated in the earnout. The seller would say otherwise. And you end up in a situation where there's a significant amount of judgment that would be left to an arbitrator to really understand or rule in such a case.

We talked about the application of the multiple, and I'll only highlight there that the other piece of this is ultimately you may see disputes arise where there was an unanticipated item. And so EBITDA may have contemplated revenue, cost of sales, and operating expenses. But what if there's a restructuring and there's a termination and there's significant termination benefits that are paid out?

The seller may argue, you need to exclude that one-time charge because we really were looking at the core profitability of the business, where the buyer may say, no, it's clearly within the definition. And that could have a significant impact on the earnout amount because, again, keep in mind small amounts in dispute can have an impact as to whether you apply the multiple. In this case, one party would say the multiple applies and the other party would say it would not.

The definition or calculation of EBiTDA-- again, this is always challenging if the parties use a measure such as EBITDA for an earnout-- earnings before interest tax, depreciation, and amortization-- because it is not a term that's defined within GAAP or IFRS. And sometimes agreements will say EBITDA as defined in GAAP. And the challenge there is if the parties don't agree to the specific add backs that are going to be added back to that income for the entity, they're going to end up in a situation where the arbitrator, again, is going to have to apply judgment as to what specifically the parties were agreeing to.

Then, as it relates to the earnout period, again, Zach talked about cut off issues. Here with earnouts, the cutoff issues are usually a little different. And it could create a problem where let's say a company has entered into a new contract-- a significant new contract-- at the end of an earnout period. And the question then becomes would you look to the revenue or one party may argue, look, if you look at the revenue, you recognize under their contract.

Where the other party may say, no, look, you've got the significant new contract, which is going to have this stream of revenue in the future and you should include it in the earnout. And finally, as Zach talked to as well, all those issues that are within a working capital dispute, be it estimates around accruals, allowances, reserves, all those will play into the earnout and are oftentimes considered as well.

So with that, let me pass back off to Erik, and he's going to talk about some other issues that end up in dispute as well.

ERIK LIOY: Thank you, Charles. The last two speakers covered the common disputes from an accounting standpoint-- subjective areas, earnout areas, and so forth. I want to talk about a number of areas that also come across to us to resolve in disputes that are somewhat ancillary.

So first is that a lot of times when we get involved in a dispute, especially when we're in a neutral perspective or neutral position, is that the parties don't even agree on what they are disputing anymore. One side might tell me they've got 20 issues and it's $10 million and the other side says it's five issues and $2 million in dispute. There's been a disconnect in the conversation and communication between them. They're categorizing things differently and so forth.

So if you're in this and when you're in that early stage in advising your clients, if you can keep the parties agreeing on what they disagree about, it makes the dispute resolution process much more efficient and saves both parties money in fees. That is one area that we get involved with sometimes is just trying to reconcile the disputed items.

The second and probably more serious is the argument regarding whether the adjustment or the dispute is a working capital adjustment or a rep and warranty claim. Charles touched on this. It's very important for two primary reasons.

One is there is quite often different dispute resolution mechanisms in a purchase agreement regarding which-- depending on whether it's a rep and warranty claim versus whether it's a working capital adjustment. So if the parties can't agree what kind of a dispute it is, you can't just decide how to resolve it. And we can see that where one side will submit it to an arbitrator, the other side will go to the court house rep and warranty claim.

The other main reason this is important is the way the damages are calculated. So a working capital adjustment is almost always, if not always, a dollar for dollar adjustment. So if they calculate it and if the calculation is off by $5, I correct it. I get or pay $5 more. A rep and warranty claim is more of a commercial damages concept so that the other side-- one side-- might argue, well you're so far off in historically how you accounted for this that we paid too much for the-- we overpaid for the deal by $5 million.

And even though it's a million dollar adjustment to inventory, the way it worked into our pricing model, we overpaid by $5 million, so our damages are $5 million. So that's another area that is important to focus on as you're advising clients.

Next up is adjustments that affect the target amount. So whether it's a working capital adjustment or earnout, there's a target set. And if working capital is greater than or less than x the target or EBITDA reaches-- earnout, EBITDA, or revenue or whatever reaches x, then there's a payout.

Very often, you will hear arguments that while the target was based on historical accounting practice, and if you say that's not GAAP now, you now need to go back and adjust that target so that it's an apples to apples comparison. Occasionally, you see language in a contract sales agreement that has that mechanism in there. Quite often, it doesn't. It might say how they build up, again, through maybe an exhibit. How they build up to target sometimes, they might just say that if working capital is greater than $10 million.

And then parties will get into arguments going back and forth how the $10 million was decided. Going back and producing e-mails and other documents produced during due diligence. So that is a common area of disagreement.

Materiality, Charles touched on that. So I'm going to move this along and say, that's important, understanding it, getting involved. Comes across our desk. Subsequent events-- I've got an example we'll talk about later on this, but are there one time adjustments and events that happened that might affect the earnout calculation going forward. Or something that happened between the time that a working capital peg or target was set and then the closing of the deal that affect it.

Less so, but there are times that there's a dispute over the authority of the neutral. So we talked about it's very common about whether it's a rep and warranty claim that goes to the courthouse versus a dispute that goes to an arbitrator, but once a neutral is involved, there quite often are arguments over what they can do. So it's not uncommon in purchase agreements to define the authority of the arbitrator to make a ruling no greater than the highest position submitted or no lower than the lowest position submitted by the party is a goalpost approach. Sometimes there are arguments about whether the arbitrator has to rule on one argument or the other or whether they have the latitude to come up with their own calculation. And if they do, is it in between those goal posts?

The allocation of fees sometimes comes into dispute. That gets very complicated. So even when the parties think they have papered it well by explaining in the purchase agreement how the fees are going to be allocated inversely proportional based on the award, the starting point for measuring that comes into dispute quite often.

So if the parties have been negotiating and there's a dispute notice and then they go back and forth, they add some items, they take some items off, they resolve some things, they hire an arbitrator during the arbitration, they might agree before the arbitrator rules to settle on certain disputed items. That complication can get complicated. So that is something that we see a lot of, you need to be aware of in thinking through as you draft the agreement.

And then if and when you are in a dispute, knowing how that's going to work and being prepared to provide your sample calculation and your position on how it should be calculated.

With that, I will go ahead and hand the baton back to Zach.

ZACHARY SNICKLES: Perfect. Thank you, Erik. Inevitably, these things do get into dispute, frequently enough that these agreements actually have clauses for the dispute process. So I don't think there's any rule or language that's going to prevent a dispute from happening. Again, that's why the language is baked into these things.

However, we do feel based off of our experience that there are some tips to avoid some of these common pitfalls to help your clients or your companies truly understand what they are trying to accomplish in these agreements.

So one of those items is remember that accounting standards are not black and white. Introductory accounting courses give the impression that accounting is very straightforward. For every debit, there is a credit. And that is true. There is a credit for every debit, but the amounts of those and the account that they affect is very much up to judgment. So in practice, that is what we see-- that judgment very frequently comes into play for our accounting of certain things.

And again, most disputes result from different interpretations of the same accounting principles. So we're not seeing folks necessarily citing different areas of GAAP or IFRS. It's the same principle that they feel should be accounted for differently. So keep this in mind when defining terms, when drafting the working capital or earnout process, and adding additional explanatory language. We'll go through some examples where sometimes adding that explanatory language can actually muddy the water a little bit more than actually make it clear.

Performing a dry run, I think in many instances the process and the protocols are written up but not necessarily given any real test prior to the closing, meaning that they are written up in theory and everything should work but they haven't actually been conducted to understand if there's going to be any problems. We understand that a lot of times these deals happen very frequently and there might not be time to do it, but it is very effective when there is time to do it.

So obviously, these would be done before the agreement is finalized and can also assist in the determination of the target amounts. Also, example calculations in the accounts to be included or excluded as necessary, and we really feel like this dry run should be at least involving both parties. Sometimes the dry run is done solely by the seller to develop a target or anything else and then the buyer after the fact. Makes the claim that they weren't in the know on certain things that are done as part of that development.

So it should really be a situation where both parties are in the know. Alternatively, firms like our own have been contracted to come in and provide objective dry run for both parties to then evaluate so that both parties really have a chance to say, this is what we expected or, no, this is not what we expected in the calculation of some of these amounts. As an extension of that, including some of these example calculations that include account numbers and actual dollars and cents associated with them, it really helps to identify problematic language or to prevent including problematic language or ambiguities because there's actually a calculation that is explanatory in that sense.

Double check the defined terms. We've already spoken about a few of them that we've seen almost taken for granted that they have a rhyme or reason to specifically calculate. Both working capital itself as well as EBITDA, neither of which is truly a defined term that lays out how these things should be calculated. So double checking those to make sure that it's not EBITDA as defined by US GAAP or working capital as defined by US GAAP. Those definitions become problematic.

This one is probably inevitable of don't assume that the contract language has the same meaning to both parties. Again, these things are going to continue to end up in disputes. But performing some of these steps along the way I think will help to identify some of these inconsistencies and an understanding of what the intent was of the agreements.

Identifying and defining materiality thresholds can be helpful. This comes into play both with a multiple that's involved or just to prevent a lot of small items from adding up and becoming a material effect on one side or the other. So identifying materiality thresholds can decrease the likelihood of a dispute.

Reference the agreement when closing the books. Make sure your clients and customers-- or clients and companies-- actually do refer to that agreement. We have seen instances where neither disputing party actually followed the requirements of the agreement. By the time they realized it, certain procedures could no longer be performed because it wasn't necessarily timely enough to do so or the records weren't there to reposition that.

And that puts the neutral on difficult situation because now neither party has followed the procedures outlined in the agreements. And so the neutral has to attempt to recreate it themselves or just work through and find what the best answer is. And so you'd rather have your clients or companies understand what that is and come up with their own position based off of the process as opposed to forgetting about that process and then ending up with a number that doesn't have a basis that's been defined by the agreement.

Clearly defining a realistic dispute resolution process is helpful. Timing-- typically the timing and deadlines that are included in the dispute process clause within these agreements is extremely accelerated and not achievable. This then requires the disputing parties, as well as a neutral to come up with an alternative process because the timing or the structure of it is just not feasible.

So to the extent that you want to ensure the integrity of the process is kept from the get go, coming up with a realistic timeframe and submissions and those sorts of things is going to be helpful in doing that. The number of submissions have increased with time. Multiple submissions has become the norm. We recommend that at least having an initial position as well as one in that initial position to be able to make an affirmative opinion. And at least one secondary or second position to really allow both sides to have a rebuttal.

I think that's helpful. And then beyond that, we've seen additional submissions. We've seen hearings. We've seen Q&As. And this can really be customized and sometimes it's contemplated in the agreements and other times it's not. But to the extent that the process is going to be important, making sure that that's a feasible process on the front end in the agreement will ensure that that's the process that's actually carried out.

The simple rule of keeping it simple is something that we would recommend. We've seen some of the accounting adjustments in these agreements get over-engineered and create a lot more likelihood for dispute because of it. We'll go through some of those examples that we've seen in different things. Less can be more in certain instances. So following the keep it simple mantra should help in reducing the likelihood of a dispute for one of these accounting adjustments.

So with that said, with some of the commonly disputed items discussed and then with some tips to avoid some of these common pitfalls, I think we'll go into some hypothetical examples that are based off of issues we've seen previously. And so I'll hand it over to Charles to go over the first example.

CHARLES BLANK: Thanks, Zach. So we're going to go through example one here. And this one is an example of a working capital provision, what I would call a carve out from the typical "in accordance with GAAP" terminology. In this case, it relates to an inventory obsolescence provision. And so in other words, how much inventory should be valued at in the closing balance sheet.

And so in this example, the parties decided that they would specifically carve out what they called obsolete and discontinued items. And as it related to obsolete items, which they defined as those that cannot be sold due to damage or expiration, they determined that 100% reserve should be applied against all those items. As it relates to the discontinued items, those that they said are no longer to be ordered based on management's best judgment or sell through rates, they would apply at 30% reserve.

So in this case, they agreed to those terms and as we flip to the next slide here, that was the contractual term. Here's what happened. And in this case, in this example, we have historical sell through rates. And based on those, they found that they had four years worth of supply of a specific inventory item. However, The product only had a two year expiration. So in other words, they had an excess of an additional two years of product on hand at the closing date.

The parties agreed that for the product that expired within the two years-- so two out of those four years. So that amount of product, they both agreed that the 30% reserve would apply. Where they had a difference in opinion related to the additional two years of supply. So supplies that lasted into years three and four based on their average sell through rates.

And in that case, the seller took the position that a 30% reserve should be applied to that amount because given the excess supply, they would no longer be ordering of that item based on the sell through rates.

The buyer, on the other end, said that, no, a full reserve should be applied to this. Because by the time those items are ever going to be used, they will have expired. And so from what you can see here, both parties have now interpreted the contractual provisions differently.

What we've observed here is when crafting this provision, what may have prevented a dispute would have been to the extent that they could have put a qualifier term in the definition of the inventory in this case. In other words, if the parties would have incorporated into this provision or definition, a qualifier such as the inventory reserve, that will be calculated as of the closing date. That may well have prevented the parties later disputing it because the items that were going to be later to expire in subsequent periods, that would have been a determination that would have been made only at the time later on when they became subject to expiration.

So again, Zach pointed out that a walk through of these provisions is sometimes helpful. Because if you can walk through and consider how others may interpret it in taking a fresh look at it, it may help later on to prevent a dispute. So with that, let me move on to Erik for example number two.

ERIK LIOY: Thank you, Charles. The example us up there. This is an unusual one, but this is true. So I think it almost seems absurd, but we had an example where a client, a deal was struck where the price was 100% contingent based on a calculation post-closing of EBITDA. And it was going to be an eight times multiple of 12 months trailing EBITDA.

So obviously, the parties understood probably what nine months or 10 months was going into it. But it left the deal open to post-close. So on the eve of the transaction and the weeks leading up to it, there was an unexpected non-recurring expense of $9 million. The seller said, well, this is a one time. That's nine million dollars. We'll make you whole on that transaction. That's not a real measure of the business, and you should exclude it from EBITDA.

The buyer said, no, this is an expense. It's negative EBITDA. We want to reduce the purchase price by $72 million because we're buying it an eight times multiple. So it then got into the definition of EBITDA. And as we've noted earlier, it bears repeating, EBITDA is not purely defined in any one place. And when you talk about non-recurring items, while it is common in certain industries to adjust certain things, there's no book out there that tells you what is a non-recurring adjustment and what should just be included.

I had a partner several years ago that would say, bad luck counts. And it's bad luck, but it still gets counted in EBITDA. And we established the argument here. So again, it's another warning about the magnification effect that you have with EBITDA and when you're arguing about values of deals and how the multiples can apply and turn dollar for dollar adjustments into five or 10 times that amount.

With that, I'll go ahead and hand it back to Zach.

ZACHARY SNICKLES: Thanks, Erik. Moving on to example three, and since we are coming up on the top of the hour, we will do a high level of each of these last two examples. On this one, again, EBITDA is involved. It can get tricky based off of what we've talked about here today. But the earnout adjustment was to be five times the amount exceeding adjusted EBITDA.

The parties did their best to actually specifically define adjusted EBITDA and identifying items that are a one time costs not to be included. However, what they did was they actually developed a cap of $18 million for total compensation to be paid in the earnout period to all employees. So they were attempting to actually carve that out.

And in the avoidance of doubt, they actually included wages and bonuses. And why this was probably put in place is so that the buyers would not come in and essentially give large compensation or wage bonuses to essentially not hit or to reduce that adjusted EBITDA amount. So they wouldn't have to pay out to the sellers.

The company ended up performing much better than expected, so they hired additional personnel and had significant commission bonuses. The company's total compensation in that earnout period was $28 million, which was $10 million more than the cap.

So then the parties ended up in dispute on whether or not that $10 million expense was subject to the five times multiple. So here is a good example of these items. Again, both the multiplier creating some difficult situations as well as EBITDA creating some difficult situations. A recommendation here would have been instead of coming up with a static compensation number of actually making it a percentage of another metric.

So that way, if the company ended up doing better, the percentage would have been in line with the compensation. But having put a static number on it, the parties really have created a situation where it could be a windfall or a huge loss depending on what side you were on.

So moving on to example four, I'll hand it back to Charles very quickly.

CHARLES BLANK: OK, thanks, Zach. A final example here relates to an earnout provision. And in this case, it had a provision that said the purchase price would be based on five times EBITDA and it said that EBITDA would be as defined in IFRS. As we spoke previously in prior sections here, IFRS nor GAAP really define EBITDA.

And in this case, the calculation included an item where the buyer had paid out certain bonuses to its employees. But in the European country they were operating in had been considered akin to a tax. And they argued that EBITDA should be reduced for that amount.

The dispute was obviously does this item, given that it's termed a tax but really a bonus to employees, should it be included as a deduction to EBITDA or should it be more akin to a compensation item. So clearly here, this is an example of an item where the parties, if they took a look at this significant item realizing the challenge in how it was being termed under IFRS or rather within this individual country, they could have put a specific provision within their EBITDA calculation to call out the treatment for this item.

And again, I think that's the theme with a lot of this that some of these items where there is maybe-- they are vague and unclear. It's always hard to anticipate them, but in this case, it was a very significant number. And obviously, the spirit of the parties may well have been to treat it as compensation.

So with that, let me turn it back over to Zach to wrap up our presentation.

ZACHARY SNICKLES: Thanks, Charles. Moving on to the next slide, if any questions have come in along the way, while we won't have time to go over them today as time did not permit, we will make sure to follow up with each of you individually. But I did want to just thank you for your time. Hopefully you found the deck insightful. And then we have included our contact information at the conclusion of the deck in the event that you have any follow up questions or any additional needs related to this.

So thank you very much.

AMY: Thank you so much. We are now out of time. Your final slide is posted for anybody who'd like to reach out to any of you directly. But for now, I would like to thank our listeners and today's excellent speakers, Charles Blank, Erik Lioy, and Zach Snickles, for a really informative presentation. We thank you so much for your remarks. Bye bye.

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