merger & acquisition disputes: accounting & valuation issues

Merger & Acquisition Disputes: Accounting & Valuation Issues

Presented by: Jeff Litvak Jason Tolmaire

Clear Law Institute | 4601 N. Fairfax Dr., Ste 1200 | Arlington | VA | 22203

www.clearlawinstitute.com

Questions? Please call us at 703-372-0550 or email us at

[email protected]

All-Access Membership Program

● Earn continuing education credit (CLE, CPE, SHRM, HRCI, etc.) in all states at no additional cost

● Access courses on a computer, tablet, or smartphone

● Access more than 75 live webinars each month

● Access more than 750 on-demand courses

Register within 7 days after the webinar using promo code “7member” to receive a $200 discount off the $799 base price.

Learn more and register here: http://clearlawinstitute.com/member

Clear Law Institute, © 2018

www.ClearLawInstitute.com

(703) 372-0550

Accounting and Valuation Issues in Merger and

Acquisition Disputes

Jeff Litvak, CPA/CFF/ABV,

ASA

Senior Managing Director

FTI Consulting

Chicago

[email protected]

312-252-9323

Jason Tolmaire, CPA/ABV

Senior Director

FTI Consulting

Chicago

[email protected]

312-252-4031

Issues To Be Covered

Introductions

The Current Merger & Acquisition Environment

Overview of Merger and Acquisition Transactions and

Disputes

Measuring Damages in Representation and Warranty

Disputes

2



(703) 372-0550

Issues To Be Covered (Cont.)

Buyer and Seller Considerations

Hypothetical Case Study

Conclusion

3

The Current Merger and Acquisition Environment



(703) 372-0550


5

Source: Factset Flashwire US Monthly October 2018


6

Metric

LTM

9/2018

LTM

9/2017

Pct.

Change

Number of Deals 12,688 12,376 2.5%

Transaction Value ($Billions) $2,056 $1,898 8.3%

Source: October 2018 Factset Flashwire U.S. Monthly

Based on L3M ending 9/30/18

• Top sectors by activity: Commercial Services, Industrial Services,

Consumer Services

• Top sectors by value: Industrial Services, Technology Services,

Energy Minerals



(703) 372-0550


Factors Driving Deals in 2018: Synergies

Investors typically reward buyers that include synergy estimates in their announcements with higher returns

Investor enthusiasm appears to be waning as buyers’ announcement returns in recent transactions have decreased in recent years

Buyers are giving away a higher share of total synergies in order to afford their deals

Historically, buyers have kept two-thirds of value of expected synergies while today buyers are keeping less than half

7

Source: 2018 M&A Report Synergies Take Center Stage- bcg.com


Other Factors Affecting M&A in 2018

Investor support, cheap-funding and slow organic growth helped fuel deal making in early 2018

Corporate tax reform in U.S. creating a favorable back drop for deal making

Investor activism focusing on M&A related agendas

Megadeals have been driving M&A activity in 2018

8

Source: 2018 M&A Report Synergies Take Center Stage- bcg.com



(703) 372-0550


Largest Announced Merger & Acquisitions for 2018:

Health Services: Cigna Corp. acquires Express Scripts for $67.6 billion

o Combination of insurance company and pharmacy benefits manager

o Cash and stock transaction with assumption of debt

o Consideration 31% premium to Express Scripts Shareholders

o DOJ cleared acquisition in September 2018 and companies expect to close the deal by the end of 2018

Source: Factset Flashwire US Monthly April 2018

9



Consumer Services: Comcast Corp. acquires Sky Plc $38.8 billion

o Comcast’s offer of £17.28 top Fox’s highest bid of £15.67

o Winning bid represents premium more than doubling Sky’s value

o Fox currently owns 39% of Sky

10



(703) 372-0550



Consumer Non-Durables: Keurig Green Mountain acquires Dr. Pepper Snapple Group for $25.2 billion

o Pay $18.7 billion in cash to shareholders ($103.75 per share)

o Shareholders of Dr. Pepper Snapple Group retain 13% ownership

o Cash payment 9% above most recent closing price

o Deal structured as a reverse merger

11

Overview of Mergers and Acquisition Disputes

Damages



(703) 372-0550

Overview of M&A Transactions and Disputes

The Purchase and Sale Agreement

Determining The Purchase Price

Types of M&A Disputes

Material Adverse Changes

Post Closing Purchase Price Adjustments

Claims for Indemnification

13




(703) 372-0550


Legal document memorializing the agreement of the parties

■ Purchase price and post-close adjustment mechanisms (e.g. working

capital/balance sheet true-ups/excess cash calculations)

■ Provisions governing earn outs (if applicable)

■ Representations and warranties of parties

■ Indemnification provisions

The purchase and sale agreement can offer protection but can

also present hazards

15

Provisions Triggering Most Disputes

Representations and Warranties

Indemnification Obligations

Working Capital True-Up Provisions

Earn-Out Provisions

16



(703) 372-0550

Provisions Designed to Limit or

Avoid Disputes May Not be Effective in All Cases

Indemnity Caps

Non-reliance and Integrations Clauses

Choice of Law Provisions

17

Determining the Purchase Price



(703) 372-0550

The Purchase Price

Reflection of investment value specific to transacting parties.

Reflects “bargained for”:

• Anticipated stream of future earnings or cash flows

• Measure of capital necessary to support operation in the normal

course

Often, the purchase price incorporates a control and synergistic

considerations.

19

Purchase Price: Valuation Approaches

Market approach (financial element x multiple) ■ Earnings measurement (e.g., EBITDA) or balance sheet measure (e.g.,

assets) depending on business

– Multiple – Based on multiples used by guideline comparable

companies or transactions

Income approaches ■ Discounted cash flow (DCF) valuation

■ Required internal rate of return (IRR) based on DCF projection

Cost approach ■ Not applicable in most deals

20



(703) 372-0550



Pre-acquisition Disputes

■ Occur when one party seeks to withdraw from a transaction

■ Without the consent of the counterparty

■ Subsequent to execution of purchase agreement but prior to close

■ Common reason for withdrawal alleged occurrence of material adverse

change (MAC) or fraud

22



(703) 372-0550


Post-acquisition Disputes

■ Subsequent to the close of the transaction

■ Disputes over contractually prescribed adjustments to, or components

of, the purchase price

■ Claims for indemnification from alleged breaches of representations and

warranties

■ Earn-out disputes

23

Material Adverse Change



(703) 372-0550

Material Adverse Change (MAC)

Representation by seller that since a given date there has

been no MAC in the business

In addition, no event has occurred or circumstances exist that

may result in such a MAC

Provide a mechanism to terminate a merger or an acquisition

agreement prior to closing in the event that a MAC occurs that

damages the target’s business operations or assets

25


Considerations by Court whether a given adverse change

constitutes a MAC:

■ The significance of the event’s impact on the target

■ The duration of the event

■ Whether the event had a disproportionate impact on the

company compared with the rest of the industry

■ Whether the party seeking to avoid the transaction knew of

the event prior to entering the merger agreement

26



(703) 372-0550


Valuation Issues to Consider in MAC Claims:

■ If Court ruled that MAC did not occur, buyer may be able to

seek rescission of the deal

■ Rescission based upon a breach of certain representations

and warranties made by seller

■ Representations and warranties relate to the conditions of the

business at closing

27

Post-Closing Purchase Price Adjustments



(703) 372-0550

Timing of Key Stages to M&A Process

29

12/31/X1

and prior

4/30/X2 6/30/X2 9/30/X2 12/31/X2 2/28/X3 4/30/X3

Negotiations Period

Pending

Closing

Due Diligence Closing

Review

(Seller)

Buyer’s

Post

Closing

Review

Closing

Balance

Sheet

Dispute

Resolution

(if needed)

Initiate

Negotiations

Execution

of Letter of

Intent

Execution of

Acquisition

Agreement

Closing Date of

Transaction

Presentation of

Closing

Balance Sheet

to Buyer

(Prepared by

Seller)

Expiration of

Notice of

Objection –

Closing

Balance

Sheet

Buyer’s

Post Closing

Due Diligence

Expiration of

Period to Make

Claims for

Indemnification

12/31/XX

Indemnity

Claim

Dispute

Resolution

(if needed)

Normal course assessment of

post-closing Purchase Price

Adjustments

Circulation of historical financial

information about target via

Offering Memorandum or other

means of interest solicitation

Post Closing Purchase Price Adjustment

Recall: The Buyer is acquiring both a stream of future

earnings/cash flows and a measure of capital necessary to

generate such cash flows.

Acquisition agreements commonly feature purchase price

adjustment provisions to address variations in acquired capital

(e.g., differences between the balance sheet of the business

“bargained for” and the balance sheet of the business received

by the buyer at the close). ■ Against a measure from a historical date evaluated by buyer in due

diligence…

■ Against a “peg”…

30



(703) 372-0550

Example Language: Closing Net Working Capital

“The Closing Net Working Capital [or Closing Balance Sheet]

shall be prepared in accordance with United States generally

accepted accounting principles, consistently applied.”

“…. except for (1) normal year-end adjustments and (2) the

omission of footnote disclosures as required by GAAP…”

“If the Closing Net Working Capital exceeds $30,000,000, the

Purchase Price shall be increased by the amount of such

excess. Conversely, if the Closing Net Working Capital is less

than $30,000,000, the Purchase Price shall be decreased on a

dollar-for-dollar basis to reflect the shortfall.”

31

Commonly Arising Post-Closing

Purchase Price Disputes

Generally accepted accounting principles

(“GAAP”)

”GAAP” vs. “ Consistency”

Subsequent Events

32



(703) 372-0550

Common GAAP Disputes

Accounts receivable and related allowances for doubtful

accounts

Inventories and related reserves for excess and obsolescence

Employee accruals (e.g., commissions, bonuses, payroll,

vacation)

Warranty reserves

Contingent loss accruals ■ Probable? Reasonably estimable?

General disputes about the realizability of assets and

existence of obligations 33

“GAAP” vs. “Consistency”

Often the most hotly contested issue in a post-acquisition

dispute.

Seller’s position is that a consistent/past practice, which

results in a GAAP presentation, is a winning strategy at trial.

Buyer’s position is that Seller’s past practice is not GAAP and

seriously understates the reserve/accrual/presentation.

If Seller’s past practice/methodology does not result in a

GAAP presentation, then GAAP often trumps consistency.

However, this is of course dependent on the facts and

circumstances of the case.

34



(703) 372-0550

Subsequent Events

Under GAAP, a “recognized subsequent event” is an event in

which additional information becomes available about

conditions that existed on the balance sheet date. ■ Type I and II subsequent events.

Under GAAP, this additional information is used to adjust the

financial statements.

In general, consider the following questions: ■ What is known or knowable at the date of the preparation of the closing

balance sheet, or “report date”?

■ Do later subsequent events indicate that the Seller’s position is

unreasonable regarding what was known or knowable?

Buyer typically attempts to hold the books open for as long as

possible.

35

Claims for Indemnification



(703) 372-0550

Indemnification

Operative language varies (e.g., indemnify, hold harmless, pay

and reimburse)

Indemnification provisions can cover representations and

warranties, covenants and other items (e.g., taxes, pending

litigation)

Common limitations: ■ Time

■ Eligible claims (de minimis)

■ Baskets and thresholds

■ Caps/ceilings

■ Setoffs (e.g., tax benefits, insurance proceeds)

Limitations may be subject to carve out if, for example, there is

an intentional misrepresentation or fraud.

Losses/damages may be defined (e.g., out of pocket v.

diminution in value)

37

Common Disputes: Breaches of

Representations and Warranties

Buyers will require certain assurances from sellers, such as: ■ Financial statements are in accordance with GAAP

■ Material information with respect to the business has been disclosed

(e.g., litigation, environmental hazards, status of key customer

relationships, significant contracts)

■ There has been no Material Adverse Change

■ Business has been operated in the ordinary course

These and other matters are the subject of extensive

representations and warranties.

Contracts often provide for indemnification with respect to

breach of a representation or warranty.

Indemnification provisions are often subject to limitations,

which further reflect risk allocation between the parties.

38



(703) 372-0550

A Typical Seller’s Representation …

39

“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.”

Measuring Damages in Representation and

Warranty Disputes



(703) 372-0550

Benefit of the Bargain Damages

Benefit of the Bargain:

A measure that awards the plaintiff the difference between the

gain had the misrepresentations been true and what the plaintiff

actually received.1

41

1 Litigation Service Handbook, Fourth Edition, 18.7

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.

42



(703) 372-0550

Measuring Damages: Example #1

Assumptions:

■ $10 MM of undisclosed and unrecorded one-time liability associated

with environmental remediation costs

■ Potential liability known to Seller during negotiations, but not disclosed

■ Not probable/reasonably estimable at time of negotiations or at time of

close

■ Purchase price of $750 MM

– EBITDA of $150 MM

– 5x Multiple

43

Measuring Damages: Example #1

Observations on Measuring Damages:

■ Buyer did not contemplate these costs in its valuation

■ Based on fact pattern, non-recurring impact on future earnings

■ Appropriate measure of damages likely dollar-for-dollar to reflect gain

Seller would have received “but for” misrepresentation/failure to disclose

■ Reduce purchase price by $10 million to $740 MM

44



(703) 372-0550

Pitfalls to Avoid in Assessing Damages

Analyze the purchase and sale agreement 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 claim

■ Interplay of contractual overlays v. GAAP working capital requirements

Consult with counsel in matters requiring contract

interpretation.

45

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.

46



(703) 372-0550

Buyer and Seller Considerations

Illustration of Hypothetical Seller’s

Perspective vs. Buyer’s Perspective

The Seller:

Past practice/consistency will result in a GAAP

presentation/Seek a specific “carve out” of problem accounts

Extensive access to Buyer’s books & records, ability to make

copies, interview personnel

Seek to negotiate a basket or threshold for post-closing

adjustments and indemnity claims

48



(703) 372-0550


Perspective vs. Buyer’s Perspective, Cont’d

Limit escrow

Seller’s accountants should prepare closing balance sheet

Consistency is retroactive to the target balance sheet and

offsetting to claims in the closing balance sheet

Define losses to be dollar for dollar, exclude lost profits and

diminution of value and a multiple of EBITDA

Define purchase price as a multiple of EBITDA

49


Perspective vs. Buyer’s Perspective

The Buyer:

Negotiate a mechanism in the contract to increase or decrease

the purchase price based upon EBITDA fluctuation before the

close

Losses would include lost profits, diminution in value, and a

multiple of EBITDA or other relevant measures

GAAP trumps consistency

Asserts a very conservative GAAP position/no “carve out” of any

accounts

50



(703) 372-0550


Perspective vs. Buyer’s Perspective, Cont’d

Be careful not to overpay for Synergies

Limit the Seller’s access to Buyer’s books &

records/copies/interviews

Limit basket/threshold issues of any kind

Set up adequate escrow

Buyer’s accountants should prepare closing balance sheet

Buyer seeks a specified amount of net assets

51

Hypothetical Case Study



(703) 372-0550

Facts of the Hypothetical Case

Valassis 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 2015 Valassis commenced merger discussions with

ADVO.

On July 7, 2016, Valassis and ADVO signed the SPA,

whereby, Valassis would pay $37/share in cash.

53

Facts of the Hypothetical Case, Continued

PRIOR to the signing of the SPA, ADVO represented: ■ Forecasted operating income for FY2016 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, 2016.

AFTER the signing of the SPA: ■ ADVO disclosed that April and May’s 2016 financial statements were

misstated by $2.6M;

■ August 10, 2016, ADVO adjusted its $68 million forecasted operating

income to $54.8 million, nearly identical to an internal April 2006

forecast of $54.5 million;

■ Actual FY results ending 9/30/16 were $37.9 million, some $30 million

below expectations.

Negotiations stalemated. On October 31, 2016 Valassis filed

suit to rescind the merger.

54



(703) 372-0550

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?

55

Demonstration of Dramatic Downturn



(703) 372-0550

ADVO’s Recent Operating Income is

Below the Historical Mean

57

Declined 70% From Q1 2016 to Q4 2016

5M

10M

25M

($) in Millions

20M

15M

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2013 2014 2015 2016

$20.0

$18.7

$21.6

$21.3 $19.8

$19.0

$20.7 $21.6

$14.1

$18.5

$22.4

$14.1

$22.1

$12.6

$11.6

$7.0

Mean = $19.5

(1)

(2)

(3)

ADVO’s Material Misrepresentation



(703) 372-0550

ADVO’s Fiscal Year 2016 Operating Income

Forecasts

59

10M

20M

30M

60M

($) in Millions

40M

80M

50M

7/6/2016

Merger Agreement $76.1

(Original Budget)

70M

$54.5

$65.0

$68.6 $68.0

$54.8

$37.9

4/14/2016 5/4/2016 5/10/2016 6/23/2016 8/10/2016 Actual

(unaudited)

ADVO’s Operating Below Industry Expectations



(703) 372-0550

ADVO’s Performance is

Disproportionate to the Industry

61

2015 2013 2014 2016

Q1 Q2 Q3 Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

5M

10M

15M

25M

20M

30M

35M

40M $38.1 $38.1 $37.4

$32.2

$35.3

$36.3 $37.3

$36.6 $37.4

$35.9

$37.2

$37.1

$35.3

$35.8

$35.1

(4.3)% Change

(69.5)% Change

$14.1

$20.6

$10.3

$18.7

$21.6 $21.3

$25.6

$23.1 $23.2

$21.6

$18.5

$25.9

$14.1

$6.3

Industry Average*

ADVO

($) in Millions

Time between Q1 & Q4

$9.2

(2)

Q1 Q2 Q3 Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Valassis Did Not Receive the Benefit of its Bargain

62

Purchase Price Overpayment Calculation

In Millions (except multiples)

Pre-Signing Forecasted Fiscal ‘16 Op. Income - Misrepresentation $68.0

Less: Pre-Signing Forecasted Fiscal ‘16 Op. Income – Realistic (54.5)

Operating Income Misrepresentation $13.5

% of Misrepresented Operating Income 19.9%

ADVO ‘16 EBITDA (Valassis/Bear Stearns Projection) $119.0

Less: Misrepresentation (13.5)

Corrected ADVO ‘16 EBITDA $105.8

EV/EBITDA Purchase Price Multiple 9.0x

Adjusted Enterprise Value $950

Less: Actual Enterprise Value Purchase Price (1,291.3)

Purchase Price Overpayment $(341.8)

% of Actual Purchase Price 26.5%

9.0x Multiple



(703) 372-0550

Valassis Did Not Receive the

Benefit of its Bargain

63

www.aicpa.org/fvs

Multiple of EBITDA Based on Guideline Companies

Value at July 5, 2016 $1,291

FY 2016 EBITDA $105.5

Multiple 9.0x

Value at August 10, 2016 950

($342)

Income Approach (Free Cash Flow)

Value at July 5, 2016 $1,080

Value at August 10, 2016 676

($404)

(3)

(1) (2)

(2)

ADVO Misled Valassis into Overpaying by $300 - $400 Million

Summary of Issues Covered

Be careful not to overpay for Synergies.

“Carve out” items which should not be represented to be

GAAP.

Negotiate language which would allow for an indemnity claim.

Set a limit on what can be recovered.

Only items affecting future earnings are recoverable at the

multiple.

Cannot obtain a “double recovery” for working capital/benefit

of the bargain damages.

64



(703) 372-0550

Questions

65

Thank You for Your Time

merger & acquisition disputes: accounting & valuation issues

Documents