Originally published in PE Hub

By Joanne Baginski

Whether you’re buying or selling a company, post-transaction should be a time for celebration about getting the deal done and excitement about the future.

But many deals quickly devolve into disputes over the finer points, from purchase-price adjustments and working-capital disputes to whether negotiated earnout metrics are attained.

Post-merger disputes have become an endemic problem. According to SRS Acquiom research, in 2016, 39 percent of deals included a separate escrow specifically for post-closing purchase-price adjustments. The average agreement holds back 10% of the deal value in a general escrow account and some can hold back 15% or more.

Deals valued at $50 million or less tend to withhold larger escrow percentages, making it particularly important for middle-market companies to follow best practices during negotiations in order to minimize disputes.

With M&A activity expected to gather even more steam in 2018, buyers and sellers should pay particular attention to five areas that can generate the most trouble after the deal is done.

Use consistent accounting standards: GAAP (generally accepted accounting principles) provides the overall hierarchy for financial reporting, but only a quarter of sellers use GAAP standards.

This provides a disconnect for buyers and sellers as nearly two-thirds of deals employ the terminology GAAP “consistent with past practices” in documents. The phrase sounds innocuous — but it causes headaches when those practices are not explicitly explained or illustrated.

For example, if the seller presents financials that are “mostly” GAAP but exclude certain accruals, a buyer should investigate whether those exclusions could have a material impact. Buyers should look for discrepancies related to vacation time, warranty reserves, retirement obligations and accrued property taxes. On the asset side of the balance sheet, inadequate accounts receivable and inventory reserves can cause a shortfall in net working capital.

New standards on revenue recognition and leasing may affect what GAAP financial statements look like post-close. This will have an impact on most companies and create inconsistency and comparability issues from historical periods. When post-close metrics are set, considerations should be made to ensure each party is aware of any effects these changes could have on the financial statements post-close.

Take care calculating net working capital: Differences of opinion over net working capital are the No. 1 cause of post-deal disputes. Defining net working capital should be simple — current assets less current liabilities — but often leads to disagreements between buyers and sellers, which can escalate to arbitration and even litigation.

Calculations often fail to account for such factors as seasonality and recent changes in operations. They can also fail to include normalizing, or year-end-only, adjustments and excluded items, or they might omit off-balance-sheet liabilities.

Being clear and consistent in how working capital is calculated for the target and the post-close reconciliation is critical, and noting any unusual factors in writing can help avoid problems during the final true-up.

Negotiate sensible earnouts: Earnouts can help bridge the gap between the price the seller wants and how much the buyer is willing to pay. And they can help give management an incentive to grow the company post-close. In the current deal market, earnouts are providing an insurance policy for both buyers and sellers that helps buyers not overpay for projections, and both benefit from growth.

Earnouts are a feature in 15% of deals, averaging 9% of transaction value. But setting smart targets is crucial. In as many as 70% of deals with earnouts, management is paid out, typically within two years, if the company can reach certain revenue targets. That metric can be counterproductive if revenues rise but overall profits don’t follow the same trend.

Linking carveouts to rising revenues while maintaining gross-profit margins, for example, is more likely to produce a mutually agreeable outcome. Basing earnouts on net income or EBITDA can be problematic as well if the buyer adds costs that were previously not a part of the company.

Beware of representations and warranties: Seller representations and warranties that financials are in order are a major cause of post-deal disputes.

Noncompliance with state and local taxes is one of the top risks in most deals. While certain deal structures can protect buyers from federal tax liabilities, buyers can still be responsible for paying large liabilities from previous years of sales and use taxes, wage withholding, and other non-income-based taxes.

It’s a huge problem: 80 percent of deals in 2016 had escrow accounts withholding 10 percent to 30 percent of the deal amount to cover potential tax liabilities, according to SRS Acquiom.

Whereas general escrow accounts often last for 12 to 18 months, tax escrows can persist for as long as seven years. For large transactions, buying representations-and-warranties insurance — which costs about 0.5 percent of the transaction price — can make sense. For deals of $50 million or less, forensic due diligence is a more affordable option.

Include anti-sandbagging clauses: Anti-sandbagging clauses are now a feature in nearly 60% of deals. Such clauses protect both buyer and seller from the other party using information that was known before the deal to adjust the price after the deal.

With so many deals ending in dispute post-close, it makes sense to add anti-sandbagging clauses to protect against buyer’s remorse.

To avert disagreements after a deal closes, we tell sellers to negotiate a price they would be happy with, even if they don’t get one penny back from escrow holdbacks.

The reality is that even with the best procedures in place, sellers may find it difficult to recover a great deal of the funds held back. But following the right processes mitigates deal risks and increases the chances that escrow accounts are released and earnouts are achieved.

Joanne Baginski leads the transaction-advisory-services area at EKS&H. She has been involved in more than 200 transactions, on both the buy and sell sides, and her expertise also includes business finance, financial planning and analysis, and capital financing. Reach her at jbaginski@eksh.com or at +1 303-846-3309.