Low interest rates, an improving U.S. economy, the continued availability of cash reserves and the rush in 2014 mega-deal activity all continue to strengthen the mid-market M&A space (defined as U.S.-based companies acquired for between $25 million and $1 billion). Nearly 83 percent of private equity deal activity in the first half of 2014 involved mid-market M&A deals - a high-point dating back to at least 2005.
With a reported median valuation-to-Ebitda multiple during the first half of 2014 of 10.7x, previously reticent sellers are reconsidering. But as we regularly see, post-closing consequences in the form of disputed working capital calculations and contested escrow distributions await those sellers who don't "mind-the-GAAP" (generally accepted accounting principles). However, with adequate planning, creativity and full transparency, sellers and buyers can minimize those items that are often the subject of post-closing disputes.
While not an attempt to cover the entirety of the body of guidance that comprises GAAP, as professionals whose practice focuses on providing accounting advice to parties and adjudicating disputes as neutral accounting arbitrators will acknowledge, most U.S.-based M&A activity utilizes GAAP as the aspired basis of financial statement preparation. Accordingly, most post-closing disputes do not derive from complex accounting interpretation but rather, are attributable to more mundane factors including transaction timelines and a lack of accounting infrastructure, among others. Combine these factors with the differing perspectives of the seller and buyer as to what constitutes GAAP pre-closing versus post-closing, add the wisdom that comes with the benefit of hindsight gained many months after the transaction closing, and the stage is set for a potential multi-million dollar dispute. This begs the question: Why can't the parties consistently comply with the requirements of GAAP?
The spectrum of facts and circumstances leading up to an M&A closing are wide-ranging but one constant persists - timing. It is generally unpredictable and gives rise to practical concessions in an effort to get the deal done. These practical concessions give rise to estimates, estimates give rise to increases in escrowed funds and escrow balances become a highly sought-after reward.
A primary cause of transferring estimated funds at closing is the closing date itself, which does not occur at a traditional reporting period, such as a quarter- or month-end, evading whatever financial reporting calendar processes a company may have adopted. What's worse, the closing occurs contemporaneously with the date of the financial statements impacting the funds exchanged at closing and both the buyer and seller are acutely aware that a subsequent true-up is necessitated to resolve this hastily assembled estimate.
In addition to the timing of the closing, the timing in the evolution of the acquisition target is often such that formal accounting closing processes have not been implemented. It is typically an entrepreneurial spirit that takes precedence over financial reporting rigor.
There are several successful techniques that the reader can apply to effectively minimize disagreements between a buyer and seller in a working capital calculation context.
The first of these techniques requires sellers to essentially acknowledge that they may be unable to prepare GAAP-compliant financial statements for some or all of the financial statement line items. This can result in a weakening of the sellers' negotiating position, at a minimum or jeopardizing the transaction entirely, both of which can seemingly be avoided by merely agreeing to prepare the closing working capital calculations in accordance with GAAP. Although it requires some careful draftsmanship and unconventional calculations, excluding certain financial statement line items from the estimation and subsequent true-up of closing working capital will both reduce the likelihood of a post-closing dispute as well as eliminate the impact on the transaction price for artificial changes attributable to differences between the seller and buyer judgments surrounding reserve accounts and estimates of loss contingencies.
For example, one selling company could have benefited from such a carveout in the area of accounts receivable reserves. In this transaction, multiple disputes existed with customers regarding the contractual right of the acquisition target to bill for certain expenses incurred on the customers' behalf. The seller had historically pursued these disputed account balances with some success, but the buyer did not concur with the seller's interpretation of the contractual terms and, accordingly, believed a reserve was necessary to reduce most of the outstanding account balances. A carveout of these accounts, whose balances were effectively unchanged but for the divergent views of the seller and buyer regarding necessary reserves, would have excluded them from impacting working capital estimates and permitted the exchange of monies limited solely to the change in agreed-upon working capital. By excluding the disputed accounts from the closing calculation, the parties could have agreed on any number of techniques beyond a GAAP determination, which was contested long after the transaction closing.
The timing of transaction closings are unpredictable and estimates of closing working capital can vary significantly from the amounts calculated post-closing. Although the timeline for a deal closing doesn't correspond with the financial reporting calendar, by preparing for and rehearsing a quick-close, financial reporting staff can limit their traditional period-end procedures to those accounts posing the greatest risk of post-closing dispute such as reserves for collectability, assessments of obsolescence and accruals for recurring expenses.
Additionally, certain transactions resulting in current liabilities which are addressed infrequently, usually with the urging of an annual audit, should be included within the quick-close exercise. One such category of transactions is leases and although the topic is deep in the throes of a "Joint Project of the FASB and the IASB," the current GAAP provides ample opportunity for generating closing working capital disputes. Specifically, the areas of capital lease recognition and the requirement for straight-line expense recognition for operating leases, produce liabilities and deferred credits, respectively, with current portions that impact working capital. These transactions should be addressed as items requiring a roll-forward analysis in order to reduce the impact to post-closing working capital determination.
When agreeing to abide by a GAAP basis of financial statement presentation, the parties must remember that transaction closings generally do not have materiality thresholds and accordingly, every dollar of adjustment to estimated closing working capital will result in an impact to monies exchanged between the parties so by taking advantage of calculation carve outs and rehearsing for the quick-close, parties will minimize potentially significant adjustments to purchase or sale proceeds.
Frank Lazzara is a managing director and Clara Chin and Dana Hayes are senior directors with the forensic & litigation consulting segment of FTI Consulting. (Pictured clockwise)