Presentation on theme: "AICPA Practice Aid: Mergers and Acquisition Disputes"— Presentation transcript:
1 AICPA Practice Aid: Mergers and Acquisition Disputes G. William Kennedy, Ph.D., CPA/ABVManaging DirectorFTI Consulting, Inc.
2 When Do Shareholder Disputes Occur? Shareholder Class ActionMinorityShareholderBuyoutMinorityShareholderSqueeze outMinorityShareholderDissentFormerShareholderDisputeM&ATransactionBuyer Benefit of the Bargain/Breach/FraudMaterial Adverse ChangePurchase Price AdjustmentLetter Of Intent
3 AICPA Mergers and Acquisition Disputes Practice Aid The AICPA Practice Aid, Mergers and Acquisition Disputes was issued in early 2012The Practice Aid was authored by the AICPA Mergers and Acquisitions Dispute Resolution TaskforceTo supplement the Practice Aid, Taskforce activities included authoring articles for the AICPA Journal of Accountancy and providing presentations at AICPA National Forensic and Valuation Conference on M&A Disputes services provided by CPA’s
4 AICPA M&A Dispute Resolution Taskforce The Taskforce was comprised of 5 attorneys representing the ABA M&A Committee and 12 CPA’s representing the AICPA Forensic and Litigation Services CommitteeMembers of the Taskforce were selected for their expertise in practice area of M&A disputesTaskforce activities included reviewing and commenting on theABA’s Model Stock Purchase Agreement and theABA’s Model Asset Purchase Agreement
5 Introduction and Scope of Practice Aid The Practice Aid was prepared for the CPA practitioner who serves in the role of the neutral accountant, consultant, or expert witness in engagements involving M&A purchase price disputesFocus of the Practice Aid:TheoreticalLegalAccounting basis
6 Chapter 1: Overview of Merger and Acquisition Transactions and Disputes
8 The Purchase and Sale Agreement Legal document memorializing the agreement of the partiesPurchase price and post-close adjustment mechanisms (e.g. working capital/balance sheet true-ups)Provisions governing earnouts (if applicable)Representations and warranties of partiesIndemnification provisionsOffers protection but can also present hazards
9 Representations, Warranties, and Covenants To gain comfort in the valuation of the target, Buyers often require certain assurances from Seller.Financial statements provided by management during due diligence are prepared in accordance with GAAPMaterial information with respect to the business has been disclosed (e.g. litigation, environmental hazards, status of key customer relationships, significant contracts, etc.)No undisclosed Material Adverse Changes have occurredOperation of business in ordinary course
11 The Purchase PriceReflection of investment value specific to transacting partiesReflects “bargained for”:Anticipated stream of future earnings or cash flowsMeasure of capital necessary to support operation in the normal courseOften incorporates synergistic considerations
12 The Purchase Price Market Approach (Financial Element x Multiple) Financial element can be earnings measure (e.g. EBITDA) or balance sheet measure (e.g. assets) depending on businessMultiple – Based on multiples derived from companies determined to be guideline comparable companiesIncome ApproachDiscounted cash flow valuationRequired internal rate of return (IRR) based on earnings projectionCost ApproachNot applicable in most deals
13 Concluding a Purchase Price While relevant, valuations of the parties do not always result in the precise purchase price agreed upon.A number of factors may influence the ultimate purchase price determination.The ultimate purchase price is the result of the negotiation between the parties.
14 Chapter 2: Post Closing Purchase Price Adjustments
15 Post Closing Purchase Price Adjustments Introduction-Post Closing Purchase Price AdjustmentsBackground of a Purchase Price DisputeThe Role of a CPA in a Post- Acquisition DisputePost-Acquisition Dispute: An OverviewIllustration of a hypothetical Seller’s perspective and Buyer’s perspective
16 Background of a Purchase Price Dispute An acquisition price may reflect a negotiated or implicit valuation multiple of earnings/EBITDA between a Buyer and a SellerAs a consequence of the transaction, there is a negotiated mechanism in the purchase agreement to “true-up” the balance sheet acquired by the BuyerUsually, the parties are entitled to the following post-closing adjustments:GAAP adjustmentsOther “dollar for dollar” adjustments provided for in the agreementThe Buyer may additionally or alternatively be entitled to:“Benefit of the bargain” damages, if there is a material misrepresentation of the financial statements by the Seller
17 The Role of a CPA in a Post-Acquisition Dispute As an ExpertAs an ArbitratorAs a MediatorAs Advisor to the Attorney as Arbitrator
18 Post-Acquisition Dispute – An Overview Seller’s Representation“GAAP” vs. “ Consistency”Subsequent EventsComparison of the Seller’s perspective vs. Buyer’s perspective
19 Seller’s Representation “The financial statements present fairly, in all material respects, the financial position of the business, as of the respective dates thereof and covered by said statements in accordance with generally accepted accounting principles consistently applied throughout the period involved.”
20 “GAAP” vs. “Consistency” The most hotly contested issue in a post-acquisition disputeSeller’s position is that a consistent/past practice, which results in a GAAP presentation, is a winning strategy at trialBuyer’s position is that Seller’s past practice is not GAAP and seriously understates the reserve/accrual/presentationIf Seller’s past practice/methodology does not result in a GAAP presentation, then GAAP would probably trump consistency (depends on the facts and circumstances of the case)
21 Subsequent Events A hotly contested issue In general, the Arbitrator would consider what is known or knowable at the date of the closing balance sheet. In addition, the Arbitrator is often asked to consider:What is known or knowable at the date of the preparation of the closing balance sheet, or “report date”Whether later subsequent events indicate that the Seller’s position is unreasonable regarding what was known or knowable
22 Illustration of a Hypothetical Seller’s Perspective vs Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s PerspectiveSeller’sPast practice/consistency will result in a GAAP presentation/Seek a specific “carve out” of problem accountsExtensive access to Buyer’s books & records, ability to make copies, interview personnelSeek to negotiate a basket or threshold for post-closing adjustments and indemnity claims
23 Illustration of a Hypothetical Seller’s Perspective vs Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s PerspectiveSeller’s, ContinuedLimit escrowSeller’s accountants should prepare closing balance sheetConsistency is retroactive to the Target Balance Sheet (TBS) and offsetting to claims in the CBSDefine losses to be dollar for dollar, exclude lost profits and diminution of value and a multiple of EBITDADefine purchase price as a multiple of EBITDA
24 Illustration of a Hypothetical Seller’s Perspective vs Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s PerspectiveBuyersNegotiate a mechanism in the contract to increase or decrease the purchase price based upon EBITDA fluctuation before the closeLosses would include lost profits, diminution in value, and a multiple of EBITDA or other relevant measuresGAAP trumps consistencyAsserts a very conservative GAAP position/no “carve out” of any accounts
25 Illustration of a Hypothetical Seller’s Perspective vs Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s PerspectiveBuyers, ContinuedLimit the Seller’s access to Buyer’s books & records/copies/interviewsLimit basket/threshold issues of any kindSet up adequate escrowBuyer’s accountants should prepare closing balance sheetBuyer seeks a specified amount of net assets
27 What is an Earnout?A contingent element of the acquisition’s purchase price determined post-closing based on the target business performance against certain contractually defined criteria or benchmarks.
28 Illustration of Earnout as Component of What is an Earnout?Illustration of Earnout as Component ofTotal Purchase PriceClosing Consideration – 12/31/ $100+/- Net Working Capital Variance from Peg – 2/28/+ Earnout Amount – 12/31/Total Purchase Price $115Where 2010 EBITDA was $22 million, and the Earnout Amount is defined by the Earnout Agreement to equal 5x EBITDA during 2010 in excess of $20 million.
29 Why do Parties to Deals Utilize Earnouts? Effective negotiating tool when differing perspectives on value and/or outlook for the target business20%Growth10 %Growth
30 Why Do Earnouts Appeal to Sellers? Protect Seller from failing to realize value in their business.May allow Sellers to obtain greater consideration that they might receive otherwise.Can be advantageous in difficult economic climates (such as today).May allow Seller to control its own destiny when Seller management will continue to be involved in business post- closing.
31 Why Do Earnouts Appeal to Buyers? Protect Buyer from overpaying for the target business.Effectively Seller financing – reduces cash necessary at closing.Can distinguish Buyer’s bid when there are multiple suitors for target.Indicates confidence of Seller.Motivation of Seller management when Seller management will continue to be involved in business post-closing.
32 Why Don’t Parties Utilize Earnouts? Shared concerns of the Buyer and SellerAbility to “move on” post-closing.Difficulty of administration post-close.Challenge of negotiating for all contingencies.Fear of post-acquisition disputes.Buyer-Specific ConsiderationsMay restrict integration of target.May indicate uncertainty.Concern of compensating Seller for Buyer enhancements.Fear of manipulation of earnout by Seller management.Seller-Specific ConsiderationsLack of control of business.Lack of custody of records.Fear of manipulation of earnout.Concern that value in business will not be realized.
36 Measurement of Business Performance Post-closing AccountingPost-closing Conduct of Business
37 Areas of Dispute Regarding Operation of Target When business is operated by Buyer post-closing…Perceived management of business to minimize performance measures and in turn the earnout.Alleged deviation from consistent historical operating norms.Alleged failure to invest in the business / provide for adequate capital.Alleged failure to pursue opportunities.Alleged impairment of earnout due to discontinuation of business.Alleged shifting of sales or customer relationships from target to other Buyer entities.When business is operated by Seller management post-closing…Perceived management of business to maximize performance measures and in turn the earnout.
38 Disputes Regarding Accounting Areas Prone to Dispute in Earnout Costs of transactionPost-closing capital investmentsGoodwill amortizationIntercompany overhead allocationsDepreciationDiscontinued operationsExtraordinary itemsWhat should / should not be included when measuring the target’s performance against earnout benchmarks?
40 Valuation of EarnoutsOld Standard – any expected contingent consideration would be recorded when earnedRevised Standard (SFAS 141R) – any expected contingent consideration is measured at Fair ValueRecognized at the acquisition dateRe-measured annually until all contingent consideration is paid
41 Valuation of Earnouts, Continued Sample Facts:Deal price – $1.8 billionEBITDA – $100.0 millionContingent Consideration Earnout:50 percent of every dollar of EBITDA that exceeded $100.0 millionTerm of Earnout – 2 yearsEarnout Cap – $40.0 million
42 Valuation of Earnouts, Continued Scenario Approach:Example:Buyer’s Projected EBITDA:Year 1Year 2Scenario LikelihoodEBITDA (Best Case)$150.0$175.015.0%Earn-out bonus25.037.5EBITDA (Base Case)120.0125.050.0%10.012.5EBITDA (Worst Case)707535.0%Weighted average earn-out bonus8.811.9Discount ratePresent value factor [a]0.93250.8109Present value of earn-out payment$8.2$9.6Value of contingent consideration$17.8Year 1Year 2EBITDA$120.0$125.0Earn-out bonus10.012.5Discount rate15.0%Present value factor [a]0.93250.8109Present value of earn-out payment$9.3$10.1Value of contingent consideration$19.4[a] Calculated using the “mid-year convention,” which assumes that cash flows will be received evenly throughout the projection period rather than at the end of the period.
43 Chapters 4 & 5: Material Adverse Change Clauses and Representation and Warranty Disputes
44 Material Adverse Change, Measuring Damages, and Related Pitfalls
45 Standard Material Adverse Change Clause Purchase and Sale Agreements typically include a Material Adverse Change (“MAC”) clause containing language similar to the following:Material Adverse Change:Any event, development, circumstance, change or effect that is or would reasonably be expected to be materially adverse to the business, financial condition or results of the operations of the Acquired Company
46 Standard Material Adverse Change Clause, Continued Purchase and Sale Agreements typically include a Material Adverse Change (“MAC”) clause containing language similar to the following:Representation of SellerSince date XX, there has not been any Material Adverse Change in the business, operations, properties, prospects, assets, or condition of any Acquired Company, and no event has occurred or circumstance exits that may result in such Material Adverse Change.
47 What is a Material Adverse Change (MAC)? IBP, Inc. v. Tyson Foods, Inc.Based on VC Strine’s ruling in this case, a MAC may have been sustained if:Dramatic downturn in earnings from the date of the signing of the SPA and before the closing.There is a downturn in the business that is disproportionate to the industry.The downturn is durationally-significant (or over a commercially reasonable period), meaning years and not months (is the downturn a blip or a trend?), andThe change in the business in unknown to the Buyer.
48 Benefit of the Bargain Damages A measure that awards the plaintiff the difference between the gain had the misrepresentations been true and what the plaintiff actually received.11 Litigation Service Handbook, Fourth Edition, 18.7
49 Measuring Damages: Indemnity Claims Indemnity Claim: A dollar-for-dollar measure of the difference between what was “bargained for” versus what was received if affect earnings into the future.
50 Measuring Damages: Example #1 Assumptions:$10 MM of undisclosed and unrecorded one-time liability associated with environmental remediation costsPotential liability known to Seller during negotiations, but not disclosedNot probable/reasonably estimable at time of negotiations or at time of closePurchase price of $750 MMEBITDA of $150 MM5x Multiple
51 Measuring Damages: Example #1 Observations on Measuring Damages:Buyer did not contemplate these costs in its valuationBased on fact pattern, non-recurring impact on future earningsAppropriate measure of damages likely dollar-for-dollar to reflect gain Seller would have received “but for” misrepresentation/failure to discloseReduce purchase price by $10 million to $740 MM
52 Measuring Damages: Example #2 AssumptionsSignificant customer lost just prior to closingCustomer loss not disclosed to the Buyer
53 Measuring Damages: Example #2 CPA should consider:Value of the customers to the business (i.e. contribution margin, operating profit, or customer EBITDA)Target company’s customer turnover rateCan customer be replaced?Impact on long-term capital structureWill loss impact only a few periods or extend into perpetuity?
54 Measuring Damages: Example #2 Observations on Measuring Damages:If part of ordinary customer turnover, possible that no damages incurred.If unprofitable customer, possible that no damages incurred.If profitable customer with finite life with the Company, damages may be appropriate over customer life.If profitable customer into the future, damages measured by valuation excluding cash flow from customer may be appropriate (e.g. impact on earnings x deal multiple)
55 Pitfalls to Avoid in Assessing Damages Analyze PSA and contemporaneous documents carefully to understand Buyer/Seller motivations and key data to parties.Assess situations involving double recovery carefully.Indemnity claim v. working capital claimInterplay of contractual overlays v. GAAP working capital requirementsConsult with counsel in matters requiring contract interpretation.
56 Pitfalls to Avoid in Assessing Damages, Continued One time losses do not result in permanent earnings impairments and should not result in damages at a multiple.Only claims resulting in ongoing or permanent impairment to the target company’s earnings warrant consideration of “at the multiple” benefit of the bargain damages.A post-close analysis of the deal may establish that Buyer received benefit of its bargain irrespective of an alleged breach.
58 Facts of the CaseValassis and ADVO are in the direct mail advertising business. Each company had sales in excess of $1B. The combined entity will exceed $2.65B in sales.Late in 2005 Valassis commenced merger discussions with ADVO.On July 7, 2006, Valassis and ADVO signed the SPA, whereby, Valassis would pay $37/share in cash.
59 Facts of the Case, Continued PRIOR to the signing of the SPA, ADVO represented:Forecasted operating income for FY2006 of $68 million;The integration of their SDR computer system was progressing as planned;That the April & May 2006 financial statements were materially correct.The SPA is signed on July 5, 2006.
60 Facts of the Case, Continued AFTER the signing of the SPA:ADVO disclosed that April and May’s 2006 financial statements were misstated by $2.6M;August 10, 2006, ADVO adjusted its $68 million forecasted operating income to $54.8 million, nearly identical to an internal April forecast of $54.5 million;Actual FY results ending 9/30/06 were $37.9 million, some $30 million below expectations.Negotiations stalemated. On October 31, 2006 Valassis filed suit to rescind the merger.
61 Assignment Investigate the following allegations: Financially speaking, did ADVO’s business suffer a material adverse change? More specifically:Was ADVO’s EBITDA materially misstated?Did ADVO sustain an dramatic downturn?Was ADVO performing disproportionately below its peers in the industry?Was ADVO’s downturn known to the buyer prior to closing?Did Valassis obtain the benefit of its bargain?
63 ADVO’s Recent Operating Income is Below the Historical Mean Declined 70% From Q to Q4 2006($) in Millions25MMean = $19.5$22.4$22.1$21.6$21.6$20.7$20.0$19.8$21.320M$19.0$18.7$18.515M$12.6(1)$14.1$14.1$11.6(2)10M$7.0(3)5MQ1Q2Q3Q42003200420052006
65 ADVOS’s Fiscal Year 2006 Operating Income Forecasts ($) in Millions7/6/2006Merger Agreement$76.1(Original Budget)80M$68.6$68.070M$65.060M$54.5$54.850M$37.940M30M20M10M4/14/20065/4/20065/10/20066/23/20068/10/2006Actual (unaudited)
67 ADVO’s Performance is Disproportionate to the Industry (4.3)% Change($) in Millions$38.1$38.140M$37.3$37.4$37.4$37.2$36.3$36.6$35.8$37.135M$35.9$35.3$35.3$35.1$32.230MTime between Q1 & Q4$25.6$25.925M$21.6$21.3$23.1$23.2$20.6$21.620M$18.5$18.715M$14.1$14.110MIndustry Average*ADVO$10.3$9.2(69.5)% Change$6.3(2)5MQ2Q2Q3Q3Q4Q4Q1Q1Q2Q2Q3Q3Q4Q4Q1Q1Q2Q2Q3Q3Q4Q4Q1Q1Q2Q2Q3Q3Q4Q420032003200420042005200520062006
68 Valassis Did Not Receive the Benefit of its Bargain Purchase Price Overpayment CalculationIn Millions (except multiples)Pre-Signing Forecasted Fiscal '06 Op. Income - Misrepresentation$68.0Less: Pre-Signing Forecasted Fiscal '06 Op. Income – Realistic(54.5)Operating Income Misrepresentation$13.5% of Misrepresented Operating Income19.9%ADVO '06 EBITDA (Valassis/Bear Stearns Projection)$119.0Less: Misrepresentation(13.5)Corrected ADVO '06 EBITDA$105.8EV/EBITDA Purchase Price Multiple 9.0xAdjusted Enterprise Value$950Less: Actual Enterprise Value Purchase Price(1,291.3)Purchase Price Overpayment$(341.8)% of Actual Purchase Price26.5%9.0x Multiple
69 Valassis Did Not Receive the Benefit of its Bargain - ADVO Misled Valassis into Overpaying by $300 - $400 Million ($) in MillionsMultiple of EBITDA Based on Guideline CompaniesValue at July 5, 2006$1,291FY 2006 EBITDA$105.5Multiple9.0xValue at August 10, 2006950($342)Income Approach(Free Cash Flow)Value at July 5, 2006$1,080Value at August 10, 2006676($404)(1)(2)(3)(2)
71 Role of the Accounting Neutral Overview: The Role of the Accounting Neutral in M&AThe Purchase Price Agreement: The Accounting Neutral’s Role is Created and DefinedThe Engagement Process: Accounting Neutral and Buyer/Seller ConsiderationsKey Considerations During the Arbitration ProcessCommon Working Capital Dispute Items Adjudicated by the Accounting NeutralThe Accounting Neutral’s Final Opinion and Overall Engagement Performance
72 The Role of a CPA in a Post-Acquisition Dispute CPA RolesExpert ConsultantArbitratorMediatorAdvisor to the Attorney as Arbitrator
73 OverviewCertified Public Accountants are often asked to serve in the role of neutral in resolving disputes between parties arising from merger and acquisition transactions.The most common scenarios are those in which the accountant will resolve purchase price disputes and earn-out disputes.Applicable sale/purchase agreements contract clauses include:Purchase PriceWorking Capital or other adjustmentsEarn-out provisionsFinancial representations and warranties
74 What is the Accounting Neutral’s Role? A variety of terms are applied in purchase/sale agreements:Expert DeterminationArbitratorArbitrating AccountantIndependent AccountantNeutral AccountantBottom line: It is the neutral accountant’s role to render a decision on the disputed items. But where does one start?
75 Typical Arbitration Process Common elements of the arbitration process:Generally, there are no set guidelines for how to conduct the processShould consider that some contracts may refer to third-party guidelines such as AAA or CPR Institute of Dispute Resolution rulesThe actual process may take various forms depending on what the parties agree to (i.e. baseball arbitration)Preliminary ConferenceDiscoveryWritten StatementsInterrogatoriesHearings/ConferencesDecision/Award
76 The Purchase Price Agreement: The Accounting Neutral’s Role is Created and Defined
77 Drafting Acquisition Documents Anticipate Potential Areas Of DisputeKnow Client’s InterestsPredict Potential Liabilities/ClaimsDispute Notification
78 The Dispute Resolution Provision Forum/JurisdictionDiscoveryTimeframeSegregation of IssuesCost Shifting/Fee Shifting
79 The Engagement Process: Accounting Neutral and Buyer/Seller Considerations
80 Accounting Neutral’s Engagement Process Parties/counsel to obtain Accounting Neutral candidate resumesConduct interviews of Accounting Neutral candidatesContact Accounting Neutral candidate referencesInquire about Accounting Neutral candidate fee structureConfer with opposing party/counsel to determine top candidate choices
81 Neutral’s Considerations: Accounting Neutral’s Engagement Letter Common elements of neutral engagement letters include:Identification of the contract from which the dispute aroseIdentification of the specific disputed issues within the neutral's scopeConfirmation of absence of known conflicts of interest and disclosure of existing or prior relationshipsRight to resign if conflicts arise that would impair independence or impartialityDisclaimer that the services are not an audit
82 Neutral’s Considerations: Accounting Neutral’s Engagement Letter, Cont. Common elements of neutral engagement letters include (cont.):Hold-harmless clause giving the accounting neutral’s quasi-judicial immunitiesIdentification of the neutral individual and team membersDescription of agreed upon format/process for the proceedingDescription of the form of award/report the neutral will issue (baseball arbitration vs. ability to dictate a different number)Description of fee and billing arrangements – also state that fees will be collected before issuing the decision
83 Parties/Counsel’s Considerations: Accounting Neutral’s Engagement Letter Accounting Neutral’s ScopeIssues To Be ResolvedScheduleDescription of the form of award/report to be issuedCosts – Controlling the Accounting NeutralConflicts
84 Preliminary Conference Gain an understanding of the disputed issuesDiscuss expected proceduresSet schedule for the proceedings with specific dates and locations, if necessary
85 Hearings/Conferences Does there need to be a hearing?Mixed in practice as to whether or not there will be a hearing.Adds a significant cost componentOften has a significant impact on the timing of the decisionWhat is the perceived value?The parties can agree to a hearing up front or can agree to address the need for a hearing later in the process.A common approach is to allow for a hearing if either of the parties or the neutral requests one.
86 Common Adjustment Dispute Items Adjudicated by the Accounting Neutral
87 Post-Acquisition Disputes – An Overview “GAAP” vs. “ Consistency”Subsequent EventsEarn-outsCommon Financial Statement Account Disputed ItemsComparison of the Seller’s perspective vs. Buyer’s perspective
89 The Accounting Neutral’s Final Opinion and Overall Engagement Performance
90 ReportingForm of decision letter should be as agreed upon by the parties per the engagement letter.The form of the final report can take many forms:One final numberFinal numbers for each disputed itemNumeric finding for each disputed item including the basis or reasons for the neutral’s decision- “reasoned report”Arbitrator should consider ruling that the final decision not be released until all fees have been collected.Fee Allocation- final decision should provide a final fee allocation.Subsequent to the final decision, Arbitrator can allow for the consideration of any clerical, mathematical, or other errors of factual nature brought to attention by any interested parties.
91 The Role of the Accounting Neutral: Concluding Remarks
92 The Role of the Accounting Neutral - Concluding Remarks Carefully consider the language drafted in the purchase price agreement regarding the role of the Accounting Neutral.Review and consider the qualifications of the Accounting Neutral before engagement.Accounting Neutral must consider the following before accepting the engagement: 1) Conflicts, 2) Appropriate level of expertise, and 3) Engagement letter language
93 The Role of the Accounting Neutral - Concluding Remarks, Continued The actual process and timeline for arbitration will vary.Accounting Neutral may opt to perform his or her own analysis and procedures, exclusive of the parties written submissions.Most disputes pertain to GAAP vs. “Consistency”, Subsequent Events, and Revenue Recognition.Accounting Neutral will typically render a “reasoned report” at the request of the parties.Accounting Neutral needs to be aware of the professional standards and laws that govern this type of work.