The Sale and Purchase Agreement (SPA) has often been described as the battleground of M&A disputes – this is where a deal's blueprint is found, and the devil is in the detail. This article highlights how a clearly worded SPA is crucial to avoiding M&A disputes, particularly in relation to purchase price adjustments and other areas that have financial implications for the parties.
An M&A dispute is essentially any type of dispute that arises from a transaction involving the sale of a business or shares in a business. Some typical underlying causes of M&A disputes include unexpected market disruption and volatility (think Brexit and Trump election in the same year), buyer overconfidence in the target, ambiguity or fraud relating to the target's financial position and, naturally, unclear drafting in the SPA.
Whatever the cause, at the heart of every M&A dispute is that the value of the target has somehow been affected by a particular event, whether or not it is catered for in the SPA. Put simply, the event has led either the seller or the buyer to believe that they are not receiving the value they bargained for at signing.
While a dispute can arise at any stage of a transaction's lifecycle, most disputes occur after closing and will typically relate to the seller's post-closing obligations; indemnifications for items identified in the due diligence; earn-outs; alleged breaches of representations and warranties; and the calculation of purchase price adjustments.
The objective of a purchase price adjustment is to bring the final purchase price payable by the buyer in line with what the parties agreed to at signing. It achieves this by measuring certain agreed financial metrics of the target at closing as compared with signing. Where the value of the agreed financial metric is higher at closing, there is an upward adjustment to the purchase price and a consequent additional payment from buyer to seller or, in the converse scenario, a payment from seller to buyer.
In contrast to transactions with a fixed purchase price, which are generally considered seller-friendly, purchase price adjustments are generally considered buyer-friendly in that they protect the buyer from depreciation of the target during the closing period (the period between signing and closing), during which the seller is still in control of the target and will continue to trade on its behalf.
This protection becomes all the more significant in complex M&A transactions, which typically aren't signed and closed simultaneously. Closing can happen weeks, months or longer after signing, while competition and regulatory approvals are obtained and other closing conditions are met. Numerous events could affect the target during this time. In the wider sense, markets could rise or fall. Labour strikes or political or regulatory uncertainty could cripple the target's business. Closer to home, the target could undergo changes in management; lose major customers or suppliers; get sued or even become insolvent. These are all events that could impact the target's value and consequently the calculation of a purchase price adjustment.
Two financial metrics commonly used in determining purchase price adjustments are "net debt" and "net working capital". The following is a typical timeline of how these concepts are engineered into a purchase price adjustment.
While the broader methodology of calculating net debt or net working capital is generally accepted, it is the more granular concepts within these metrics, and the accounting principles used to define them, that may be open to interpretation and which therefore require pedantic attention when drafting the SPA. A lack of clarity in this area may well result in the buyer paying more or less than what the parties intended at signing, with or without a dispute arising.
Net debt, for example, is calculated by subtracting the value of the target's "debt-like" items from the value of its cash and cash equivalents. While many items on a balance sheet would almost always be considered debt-like items (such as borrowings and finance leases), other items (such as accrued bonuses and foreign exchange losses) would typically be excluded. A dispute is inevitable where the SPA does not clearly define which debt-like items should be excluded.
Valuations requiring a degree of estimation are also prone to disputes where too much reliance is placed on the "estimation", a largely subjective endeavour. An example is the valuation of inventory, a working capital item which may be valued at the lower of cost or its market value on the closing date. Especially in volatile markets, such be very difficult to determine the as the renewable energy sector, it can market value of an asset on a specific date. The SPA should clearly set out the accounting methods used to determine these values.
Purchase price adjustments are merely one area where a vaguely drafted SPA may lead to a dispute. Other dispute hot spots include the calculation of earn outs (contingent payments to the seller based on the financial performance of the target post-closing) and the quantification of damages or penalties for alleged breaches of warranties and indemnities.
Transacting parties must scrutinise their SPA carefully to ensure that all concepts, processes and methodologies used to value balance sheet items and all other areas impacting value, or which may otherwise trigger financial consequences for the parties, are as tightly defined and as little open to interpretation as possible. Seemingly standard definitions should not be considered impervious to disputes. A good example of this is the common tendency, particularly in the United States, to require net working capital to be prepared "in accordance with GAAP, consistent with the company's past practices". It is not difficult to see how this conflicting wording can lead to disputes – and it does, quite frequently. A notable example would be Chicago Bridge & Iron Company, N.V. v Westinghouse Electric Company, which involved a US$2.5 billion dispute, with the buyer arguing for GAAP consistency and the seller arguing for consistency with its own past practice.
Interpretation gaps can be covered by inclusion in the SPA of clearly set out dispute resolution mechanisms. There are several ways to agree how the uncertain can be made certain. Disagreements regarding valuations or calculations can be deferred to an agreed expert for a binding determination, or (where appropriate) an agreed public index whereby asset values can be objectively measured.
When emotions are high due to unexpected events occurring, a clearly worded SPA might not prevent a dispute from arising but it may certainly make the outcome less costly and time consuming to determine.
Yudaken is a Partner and Watson an Associate, Corporate and M&A practice, Baker McKenzie (South Africa).
The authors of this article referenced Volatility, disruption and fraud: the making of a modern M&A dispute – a research paper by Berkeley Research Group.