Managing Purchase Price Adjustment Disputes

Stephen Glover

Ron Hauben

Marshall King

Michelle Gourley

Christen Morand, EY

May 10, 2022

Today’s Presenters

Stephen Glover is a partner in Gibson Dunn’s Washington, D.C. office and has served as Co-Chair of the firm’s Mergers and Acquisitions Practice Group. Mr.

Glover has an extensive practice representing public and private companies in complex mergers and acquisitions, strategic alliances and joint ventures, as well as

other corporate matters. Mr. Glover’s clients include large public corporations, emerging growth companies and middle market companies in a wide range of

industries. He also advises private equity firms, individual investors and others.

Michelle M. Gourley is a partner in Gibson Dunn’s Orange County office and is a member of the firm’s Corporate Department. Ms. Gourley practices general

corporate and business law, with a focus on mergers and acquisitions and general corporate counseling. Ms. Gourley has significant experience with domestic

and international transactions, including acquisitions, mergers, round financings and buy-out options across numerous industries such as manufacturing, medical

device and software. Ms. Gourley regularly provides advice to senior management and boards of private companies in connection with their day-to-day

operations.

Ron Hauben is senior counsel in Gibson Dunn’s New York office and Co-Chair of the firm’s Accounting Firm Advisory and Defense Practice Group. Mr. Hauben’s

practice focus is on bringing the full scope of the firm’s legal services to the accounting profession, including regulatory enforcement and litigation defense,

corporate governance, counseling and advice on a wide range of risk, crisis management and professional practice issues. Mr. Hauben also has extensive

experience counseling with public and private company boards and management on the role of independent auditors and the importance of the independent

audit to stakeholders and capital markets.

Marshall R. King is a partner in Gibson Dunn’s New York office and is a member of the firm’s Class Actions and Securities Litigation Practice Groups. He has

extensive experience in commercial and business litigation matters, with particular focus on securities litigation, bankruptcy litigation, and disputes arising out of

acquisitions. He often represents buyers or sellers in disputes arising out of acquisitions and has advised companies in disputes concerning their rights under

bond indentures.

Christen Morand is a partner at Ernst & Young LLP in the Forensic & Integrity Services practice. She provides litigation support services and alternative dispute

resolution services on a variety of matters, including expert testimony, post-transaction disputes, purchase price disputes and analysis and resolution of

transaction or contractual provisions. Ms. Morand’s experience in providing arbitration and expert testimony services includes net working capital disputes,

earn-out disputes, GAAP vs historical consistency issues, GAAP vs IFRS issues and other complex accounting issues. She also has experience conducting

accountingand financial fraud investigations, including revenue recognition, asset misappropriation and earnings management.

▪ Mechanics of Purchase Price Adjustments

▪ Common Sources of Post-Closing Disputes: An Accountant’s View

▪ Litigating Purchase Price Adjustment Disputes

Topics to be Covered

Mechanics of Purchase Price

Adjustments

• Ensure target business is delivered with a “normalized” level of working capital

• Ensure target business has strong enough balance sheet to operate on day one

• Ensure sellers are compensated for profits of the business through closing

• Charge sellers for extraordinary expenses in connection with sale

• Validate buyer’s valuation assumptions

Purchase Price Adjustments

Why do private purchase agreements include purchase price adjustments?

Overview of Construct, Components and Timing

Purchase Price Calculation

Typical Construct:

Purchase price to be calculated on a cash

free,

debt

-free basis, and assuming a normalized

level of working capital

Components:

Cash

Debt

Working Capital

Timing of

Calculation(s):

Calculation at Closing

Calculation of Adjustment Post

-Closing

Purchase Price Calculation Components – Cash

Cash: “Cash” means, as at a specified date, the aggregate amount of all cash and cash equivalents of the

Company required to be reflected as cash and cash equivalents on a balance sheet of the Company as

of such date prepared in accordance with GAAP, net of (i) any outstanding checks, wires and bank

overdrafts of the Company, and (ii) any amounts relating to credit card receivables or Restricted Cash,

in the case of each of clauses (i) and (ii), whether or not required to be reported as such under GAAP.

“Restricted Cash” means all Cash and Cash equivalents that are not freely useable and available to the

Company because it is subject to restrictions, limitations or taxes on use or distribution either by

contract, for regulatory or legal purposes, or is cash and cash equivalents that is collected from

customers in advance, is being held on behalf of customers and represents a liability to such customers.

Cash is adjusted on a dollar for dollar basis. Other considerations may include (1) a cap on cash at closing and (2)

negotiations on the components of cash that are specific to the target’s business, including, for example, the treatment of

cash that is “trapped” in foreign jurisdictions for tax or regulatory reasons or that will otherwise be “restricted” on a post-

closing basis.

“Estimated Purchase Price” means (i) the Enterprise Value, plus (ii) the Estimated Cash, plus (iii) the Working Capital Overage, if any,

minus (v) the Estimated Indebtedness, minus (vi) the Working Capital Underage, if any, minus (vii) the Escrow Amount, minus (ix) the

Estimated Transaction Expenses.

Purchase Price Calculation Components -- Indebtedness

Indebtedness: “Indebtedness” means, without duplication (but before taking account the consummation of the

transactions contemplated hereby), (i) the unpaid principal amount of accrued interest, premiums,

penalties and other fees, expenses (if any), and other payment obligations and amounts due (including

such amounts that would become due as a result of the consummation of the transactions

contemplated by this Agreement) that would be required to be paid by a borrower to a lender pursuant

to a customary payoff letter, in each case, in respect of (A) all indebtedness for borrowed money of the

Company and its Subsidiaries, and (B) indebtedness evidenced by notes, debentures, bonds or other

similar instruments; (ii) all obligations of the Company and its Subsidiaries evidenced by any surety

bonds, letters of credit or bankers’ acceptances or similar facilities; (iii) all obligations under capitalized

leases with respect to which the Company or any of its Subsidiaries is liable, determined on a

consolidated basis in accordance with GAAP; (iv) any amounts for the deferred purchase price of goods

and services, including any earn out liabilities associated with past acquisitions; (v) all liabilities with

respect to any current or former employee, officer or director of the Company or any of its Subsidiaries

that arise before or on the Closing Date, including all liabilities with respect to any Plan, all accrued

salary, deferred compensation and vacation obligations, all workers’ compensation claims, any liability

in respect of accrued but unpaid bonuses for the prior fiscal year and for the period commencing on

[first day of fiscal year] and ending on the Closing Date, and any employment Taxes payable by the

Company or any of its Subsidiaries with respect to the foregoing; (vi) unpaid management fees; (vii) all

deposits and monies received in advance; (viii)

all indebtedness created or arising under any conditional

sale or other title retention agreement with respect to property acquired by the Company or any of its

Subsidiaries; and (ix) all obligations of the type referred to in clauses (i) through (viii) of other Persons

for the payment of which the Company or any of its Subsidiaries is responsible or liable, as obligor,

guarantor, surety or otherwise, including any guarantee of such obligations.

Indebtedness is adjusted on a

dollar for dollar basis. The

components of Indebtedness

are subject to negotiation and

may include components

specific to the target’s business

(i.e., earnouts, deferred

purchase price on acquisitions,

etc.).

Purchase Price Calculation Components – Working Capital

Working Capital: “Target Net Working Capital” means $[__].

“Net Working Capital” means, as at a specified date and without duplication, an amount (which may be

positive or negative) equal to (i) the consolidated current assets of the Company and its Subsidiaries

minus (ii) the consolidated current liabilities of the Company and its Subsidiaries, in each case before

taking into account the consummation of the transactions contemplated hereby, and calculated in

accordance with the Applicable Accounting Principles; provided, however, for the avoidance of doubt,

Net Working Capital shall exclude any amounts relating to or included in Cash, Indebtedness,

Transaction Expenses or Taxes (including current or deferred) to the extent such amounts are reflected

in the calculation of the Purchase Price (to avoid any double-counting with any other adjustments).

“Estimated Net Working Capital” means the Net Working Capital based on the Preliminary Closing

Statement.

“Working Capital Overage” shall exist when (and shall be equal to the amount by which) the Estimated

Net Working Capital exceeds the Target Net Working Capital.

“Working Capital Underage” shall exist when (and shall be equal to the amount by which) the Target

Net Working Capital exceeds the Estimated Net Working Capital.

Working capital results in a dollar for dollar adjustment only to the extent the Net Working Capital differs from the Target

Net Working Capital. Both the amount and the components of Net Working Capital are subject to negotiation and may

include components specific to the target’s business.

• Target working capital amount will be a specific agreed amount set forth in the acquisition agreement

Target will typically be fixed to approximate what working capital should be as of the anticipated closing date

(including, in appropriate cases, the effect of seasonal variations)

• Actual working capital amount will depend on what happens between signing and closing

• Purpose of working capital adjustment

▪ Protects Buyer and Seller against changes from the company’s normal operating working capital level, which can

significantly impact deal economics

▪ Ensures Buyer that acquired company will have sufficient working capital for a smooth transition and continued

operations in the ordinary course after the acquisition is complete

− Buyer does not want to have to borrow or contribute additional capital for the acquired business to run normally

▪ Prevents Seller from depleting working capital during the period between signing and closing to increase the

effective purchase price

− Accelerate collection of debts

− Delay purchase or sale of inventory

− Delay payment of liabilities

▪ Protects Seller if additional capital influx is needed due to unusual liabilities or other atypical adverse changes

Setting the Working Capital Target

The purchase price for a company to be acquired typically contemplates a “normal” level of working capital. A working capital

adjustment seeks to adjust for any deviation in the delivered working capital versus this assumed “normal” level.

Components Generally Included Components Generally Excluded

Trade receivables Cash (depends on treatment of cash)

Inventory Interest receivables

Prepaid expenses Fixed assets

Trade accounts payable Goodwill

Accrued wages and bonuses (< 1 year) Lines of credit

Accrued vacation (< 1 year) Long-term debt

Accrued medical insurance Current portion of long-term debt

Other accrued operating expenses Past-due accounts payable

Deferred revenue (if cannot negotiate as net debt) Restructuring reserves

Pension liability

Deferred taxes

What is Working Capital?

“Working capital”

represents the capital

necessary for a company

to fund its normal

commercial activities on a

day-to- day basis. It is

defined in its most basic

form as “current assets

less current liabilities”

Tax assets and liabilities are often excluded from the calculation of net working capital and treated as

Indebtedness (under a “your watch, our watch” approach. Sometimes parties negotiate to include the

current portion of certain tax liabilities in the calculation of the target and actual working capital numbers.

• Parties have different objectives for the adjustment

▪ Buyer seeks to have working capital target set as high as possible, to prevent upward adjustment of purchase

price

▪ Seller seeks to have working capital target set as low as possible, to prevent downward adjustment of

purchase price

• Working capital adjustment may not be a dollar for dollar adjustment, and can be made via various

mechanics

▪ Closing working capital v. target working capital

− Requires an adjustment only when amounts are greater or lesser than a stipulated peg dollar amount

▪ One-way only (cap or floor)

− Cap is the upper limit to any adjustment Buyer would have to pay Seller

− Floor is limitation on amount Seller would have to pay or return to Buyer

▪ Collar/band

− Includes both cap and floor

▪ De minimis threshold

− Range within which neither party has to pay adjustment

Preliminary Considerations in Calculating Working Capital

Working Capital Benchmark Considerations

 Seasonality

 Acquisitions during the measurement period,

whether planned or permitted by the purchase

agreement covenants

 Accounts receivable with extended terms

 Growth versus mature business

 Company’s past practices of managing working

capital, including stretching payables and

accelerating collection of receivables, adjusting

reserves, etc.

 Payment of income taxes during the

measurement period or post-closing

 Intercompany payables/receivables

 Unusual transactions

 Industry factors

 Interim versus year end accounting (true-up

of bonuses, reserves, etc.)

 Multinational business and currency

fluctuations

Target working capital and components of working capital need to be defined in

the purchase agreement. But there is no “right” or “wrong” in the definition – this is a construct of

the contract and is negotiated by the parties.

Typical factors to consider in pegging benchmarks:

Purchase Price Calculation Components (Continued)

Other Adjustments

to Purchase Price:

“Transaction Expenses” means the aggregate amount of any and all fees and expenses incurred by or

on behalf of, or paid or to be paid directly by, the Company Subsidiaries or any Person that the

Company pays or reimburses or is otherwise legally obligated to pay or reimburse (including any such

fees and expenses incurred by or on behalf of the Seller) in connection with the negotiation,

preparation or execution of this Agreement or the Ancillary Agreements or the performance or

consummation of the transactions contemplated hereby or thereby, including (i) all fees and expenses

of counsel, advisors, consultants, investment bankers, accountants, auditors and any other experts in

connection with the transactions contemplated hereby; (ii) any fees and expenses associated with

obtaining necessary or appropriate waivers, consents, or approvals of any Governmental Authority or

third parties on behalf of the Company or any of its Subsidiaries in connection with the transactions

contemplated hereby; (iii) any fees or expenses associated with obtaining the release and termination

of any Encumbrances in connection with the transactions contemplated hereby; (iv) all brokers’,

finders’ or similar fees in connection with the transactions contemplated hereby; and (v) any change of

control payments, bonuses, severance, termination, or retention obligations or similar amounts payable

in the future or due by the Company in connection with the transactions contemplated hereby,

including any Taxes payable in connection therewith.

“Inventory Amount

” shall mean the physical count of Inventory, as rolled forward or backward from the

date of the account, so as to be the amount of Inventory existing as of the Closing Date, as agreed to by

the Seller and the Buyer in accordance with this Section 2.4. If the parties cannot agree on the results

of such count, the Buyer shall use its calculation of the Inventory Amount for purposes of the Final

Closing Statement, and any disputes shall then be settled by the Independent Accounting Firm in

accordance with Section 2.4(d).

Preliminary and Final Closing Statements

Estimated Purchase Price

Enterprise Value 65,000,000

(+) Estimated Cash 902,900

(+) Estimated Net Working Capital Overage 115,098

(-) Estimated Indebtedness (364,899)

(-) Estimated Net Working Capital Underage -

(-) Adjustment Escrow Amount (3,000,000)

(-) Indemnity Escrow Amount (5,000,000)

(-) Estimated Transaction Expenses (506,250)

Estimated Purchase Price 57,146,849$

Estimated Purchase Price Original Amount Final Amount Difference

Enterprise Value 65,000,000 65,000,000 -

(+) Estimated Cash 902,900 795,094 (107,806)

(+) Estimated Net Working Capital Overage 115,098 66,999 (48,099)

(-) Estimated Indebtedness (364,899) (332,543) 32,356

(-) Estimated Net Working Capital Underage - - -

(-) Adjustment Escrow Amount (3,000,000) (3,000,000) -

(-) Indemnity Escrow Amount (5,000,000) (5,000,000) -

(-) Estimated Transaction Expenses (506,250) (575,000) (68,750)

Estimated Purchase Price $57,146,849 $56,954,550 ($192,299)

Purchase Price Adjustment Timeline

Post-Closing

Calculations

Review

Arbitration

• Seller prepares

closing statement

with reflecting

estimated cash,

indebtedness,

working capital and

transaction

expenses

• Buyer may have

opportunity to

comment upon or

challenge Seller’s

estimate

• Often, not enough

time to resolve

disagreement prior

to closing

• Closing of acquisition

• Payment of

purchase price

based on estimated

cash, indebtedness,

working capital and

transaction expenses

• Buyer typically

prepares actual closing

statement based on

closing accounts

• Seller may want to

prepare post-closing

statement, but Buyer

will be in a better

position as it controls

the books and records

• Preparing party has an

advantage in dispute

resolution due to

narrow parameters for

challenge

• Seller reviews Buyer’s

closing statement and

either accepts or

challenges statement

• Generally, silence is

presumed to be

agreement

• Final closing statement

becomes binding unless

challenged within

specified time period

• In the event of

dispute, parties will

negotiate further

• If cannot resolve

dispute, calculations

are submitted to

independent

accounting

arbitrator

Pre-Closing

Calculations

Closing Final True-Up

• Final settlement of

working capital

adjustment

CD – 3 to 5

Closing Date (“CD”)

CD + 30 to 60

CD + 60 to 120

CD + 75 to 150

CD + 80 to 160

• What accounting policies will govern?

▪ Buyer generally wants “in accordance with GAAP, consistently applied” (i.e., typically termed a GAAP override)

▪ Seller generally wants consistency with the prior accounting methodology and practices used as the basis for calculating

target working capital

• Conflicts often arise as to whether GAAP or consistency takes precedence

▪ Seller may have used a consistent practice, but historical amounts may not have been in compliance with GAAP, or may simply

have resulted from Seller’s bad accounting practices

▪ Buyer wants ability to go back and challenge the GAAP basis of original balance sheet amounts

▪ Seller wants to close off Buyer challenges to original balance sheet amounts, arguing that purpose of the adjustment is solely

to measure change between signing and closing

▪ Past poor accounting practices may distort the results, but lack of consistency in application (or less than optimal, but still

acceptable, practices) when the actual working capital is calculated can also cause distortion

• Even if GAAP is followed, it may not be followed consistently

▪ GAAP itself in many circumstances permits different methodologies in producing GAAP-compliant financials

▪ Variations in GAAP methodologies, such as for inventory valuation, can dramatically affect the working capital calculation

▪ Often, the acquisition agreement will provide for “GAAP, applied on a basis consistent with the preparation of the company’s

audited financial statements”

− Prevents Buyer from seeking that “preferable” GAAP policies be followed

Purchase Price Adjustment – Potential Sources of Dispute

A primary driver of working capital adjustment disputes concerns the accounting principles used to calculate working

capital.

Impact on Drafting

Closing Net Working Capital shall be calculated in

accordance with GAAP applied on a basis consistent with the

preparation of the Balance Sheet (provided, that in the

event of a conflict between GAAP and consistent application

thereof, GAAP shall prevail), subject to such differences in

accounting principles, policies and procedures as are set

forth on Schedule A hereto (GAAP as so modified pursuant

to Schedule A, the “Applicable Accounting Principles”).

Closing Net Working Capital (i) shall be calculated on a

basis consistent with Schedule A hereto and the

accounting principles, practices, assumptions,

conventions and policies referred to therein, including any

exclusions or deviations from GAAP therein (the

“Applicable Accounting Principles”) and (ii) shall be based

exclusively on the facts and circumstances as they exist

prior to the Closing and shall exclude the effects of any

event, act, change in circumstances or similar

development arising or occurring on or after the Closing

Date. To the extent any actions following the Closing with

respect to the accounting books and records of the

Company on which the Closing Net Working Capital is to

be based are not consistent with the Company’s past

practices, such changes shall not be taken into account in

calculating Closing Net Working Capital.

Buy-Side Language Sell-Side Language

• Selection of arbitrator

▪ Select arbitrator in advance (agreement as between Buyer and Seller)

− Industry qualifications – typically a big four or regional accounting firm

▪ Arbitrators may differ in how they view their role

− Strict construction v. parties’ business intentions

− Will arbitrator want to “split-the-baby”?

▪ Arbitrator is a financial expert, not a legal arbitrator

• Scope of authority of arbitrator

▪ Seller may want arbitrator to be able to determine solely whether amounts were calculated in accordance with agreed

accounting principles

▪ Buyer may want broader scope of authority, including ability to decide that original amounts calculated were not in

accordance with GAAP or were incorrectly determined

▪ Review only items in dispute

▪ Cannot go back and challenge adequacy of target working capital amount or other “fairness” issues

▪ Cannot specify amounts outside of range parties have determined

▪ Sometimes must choose between positions of each of the parties, not in between (“baseball arbitration”) – often the goal of

the dispute resolution mechanism is to limit discretion

• Access to arbitrator working papers and other information

▪ Parties may be unable to compel arbitrators to produce their working papers due to the accounting firm’s disclosure policies

• Arbitrator fees

▪ Can be split evenly, paid in inverse proportion to parties’ wins, or paid by party furthest away from arbitrator’s decision

Key Considerations in Dispute Resolution

Careful crafting of the

dispute resolution

provisions is critical to

the eventual outcome

of any working capital

dispute.

Common Sources of Post-

Closing Disputes: An

Accountant’s View

• The purchase/sale agreements don’t give full consideration to the potential for

disagreement

• Lack of clarity around specific terms gives one party a potential opportunity to

exploit ambiguous clauses in the sale and purchase agreement

• The buyer identifies key issues only post-closing, whether because diligence

was limited by agreement (e.g., auction process) or there were gaps in diligence

• Parties defer clear resolution of terms during the contract negotiation process

and attempt to “renegotiate” through the dispute resolution process (i.e.,

seeking “another bite at the apple”)

• Purchase price disputes are sometimes seen as a more efficient and less costly

means for adjustment vs. breach of warranty claims through the courts

What Causes Transaction Purchase Price Disputes?

Net working capital

▪ How is the accounting mechanism/post-

closing purchase price adjustment defined

(e.g., GAAP applied on a consistent basis)?

▪ How are assets and liabilities defined?

▪ Does the SPA include an example calculation?

▪ What are the relevant financial statements

(e.g., audited or unaudited?)

Earn-outs

▪ Consider how the earn-out definition

compares to GAAP definitions of revenue or

earnings (or another benchmark for the earn-

out) and/or audited financial statements

▪ Consider references or requirements to be

GAAP- compliant

Closing Mechanism Considerations and Common Disputed

Components

Inventory

•

Valuation

•

Consideration of true-up for physical

inventory count

Reserves

•

Accounts receivable

•

Inventory

•

Other reserves or areas of the

balance sheet requiring management

judgment (e.g. warranties, contingent

liabilities, etc.)

Non

-typical accruals

•

Legal accruals

•

Tax or other payables

•

“New” accruals not historically

recorded by the company

Revenue recognition

•

Balance sheet accounts related to

revenue recognition (e.g. unearned

revenue, deferred revenue)

•

Effect of new revenue recognition

standards (i.e. ASC 605 vs ASC 606)

Leases

•

Capital vs. operating lease

classification

•

Impact of ASC 842

Subsequent events

•

Timing of cutoff for consideration of

subsequent events

SPA Language:

The Estimated Closing Statement and the Parent Closing Statement, which set out, among other things, the Closing Cash,

the Closing Working Capital, the Closing Indebtedness, and Company Transaction Expenses, shall be prepared in the

following order of priority, as provided in the definition of Specified Accounting Principles in the Purchase Agreement:

i. The specific accounting principles set out in paragraphs 2-4 below;

ii. In accordance with GAAP; and

The Parent Closing Statement shall be prepared, and the components thereof shall be calculated, in accordance with this

Agreement and the Specified Accounting Principles. The Parties agree that the purpose of preparing the Parent Closing

Statement is to measure the amount of Closing Working Capital, Closing Indebtedness, Closing Cash and Company

Transaction Expenses, and the resulting Adjustment Amount, in accordance with this Agreement, and such processes are

not intended to permit the introduction of different judgments, accounting methods, policies, principles, practices,

procedures, classifications or estimation methodologies for the purpose of preparing the Parent Closing Statement or

determining the Adjustment Amount or the components thereof.

Example 1

SPA Language:

The Estimated Closing Statement and the Parent Closing Statement, which set out, among other things, the Closing Cash,

the Closing Working Capital, the Closing Indebtedness, and Company Transaction Expenses, shall be prepared in the

following order of priority, as provided in the definition of Specified Accounting Principles in the Purchase Agreement:

i. The specific accounting principles set out in paragraphs 2-4 below;

ii. In accordance with GAAP; and

The Parent Closing Statement shall be prepared, and the components thereof shall be calculated, in accordance with this

Agreement and the Specified Accounting Principles. The Parties agree that the purpose of preparing the Parent Closing

Statement is to measure the amount of Closing Working Capital, Closing Indebtedness, Closing Cash and Company

Transaction Expenses, and the resulting Adjustment Amount, in accordance with this Agreement, and such processes are

not intended to permit the introduction of different judgments, accounting methods, policies, principles, practices,

procedures, classifications or estimation methodologies for the purpose of preparing the Parent Closing Statement or

determining the Adjustment Amount or the components thereof.

Issue:

• The Specified Accounting Principles indicate GAAP prevails.

• However, typically if something is not in accordance with GAAP you have to introduce different judgements, accounting methods, policies,

practices, procedures, etc. to correct the accounting to be in accordance with GAAP.

• There is an inherent conflict between the GAAP requirement and the requirement to not introduce new accounting practices.

Example 1

Example 2

SPA Language:

The Pre-Closing Statement and the Post-Closing Statement shall be calculated… in accordance with the same accounting

policies, practices, principles, rules, estimation techniques and procedures and applied in good faith as were actually

used in the preparation of the Audited Financial Statements (including in relation to the exercise of accounting discretion

and judgement);

Example 2

SPA Language:

The Pre-Closing Statement and the Post-Closing Statement shall be calculated… in accordance with the same accounting

policies, practices, principles, rules, estimation techniques and procedures and applied in good faith as were actually

used in the preparation of the Audited Financial Statements (including in relation to the exercise of accounting discretion

and judgement);

Issue:

• The notes to the Audited Financial Statements stated that the Company recorded a 100% reserve for AR aged over 365

days.

• Despite the note, within the Audited Financial Statements the Company did not record a 100% reserve for certain AR

aged over 365 days.

• At Closing Buyer discovered the Company did not record a reserve for certain AR aged more than 365 days and

proposed a $9 million reserve in the Closing Statement.

• In the dispute resolution process, the decision-maker will likely focus on language in the Agreement that required the

parties use the estimation techniques and procedures “as were actually applied”

Example 3

SPA Language:

“Accounting Principles” means (i) with respect to Entity A and Entity B, US GAAP standards, (ii) with respect to Entity C

and Entity D, Israel GAAP standards, and (iii) with respect to Entity E, UK GAAP standards.

“Net Working Capital” means, as of 12:01 a.m. local time on the Closing Date, the Current Assets minus the Current

Liabilities, in each case determined in accordance with (i) the methodology set forth on Schedule 2.2(c);

Schedule 2.2(c) is an illustrative calculation of Working Capital using the Company’s historical financial reporting.

Example 3

SPA Language:

“Accounting Principles” means (i) with respect to Entity A and Entity B, US GAAP standards, (ii) with respect to Entity C

and Entity D, Israel GAAP standards, and (iii) with respect to Entity E, UK GAAP standards.

“Net Working Capital” means, as of 12:01 a.m. local time on the Closing Date, the Current Assets minus the Current

Liabilities, in each case determined in accordance with (i) the methodology set forth on Schedule 2.2(c);

Schedule 2.2(c) is an illustrative calculation of Working Capital using the Company’s historical financial reporting.

Issue:

• Buyer identified millions of dollars of slow-moving and unsaleable inventory post-Closing.

• The Company historically did not record a reserve for slow-moving and obsolete inventory

• Buyer thought it could include a reserve for slow-moving/unsaleable inventory in closing Net Working Capital in

accordance with the Accounting Principles. HOWEVER, the Company did not include a reserve when calculating the

working capital amounts set forth on Schedule 2.2(c)

Example 4

SPA Language:

“Accounting Principles” means: (i) IFRS in effect as of the date hereof; and (ii) to the extent not inconsistent with (i), the

accounting methods, practices, procedures and policies used in the preparation of the Financial Statements, including the

reporting period closing dates, consistently applied.

Seller shall prepare and deliver to Buyer on the basis of, and as determined in accordance with, the Accounting

Principles: (i) its estimate of Cash as of the Reference Time (“Estimated Cash”); (ii) its estimate of Working Capital, as of

the Reference Time (without giving effect to the Closing)…

Buyer will prepare and deliver to Seller on the basis of, and as determined in accordance with, the same principles used

to prepare the Estimated Statement, as promptly as reasonably practicable following the Closing Date, and in any event

no later than 60 days following the Closing Date: (i) its calculation of Cash as of the Reference Time; (ii) its calculation of

Working Capital, as of the Reference Time (without giving effect to the Closing)…

Example 4

SPA Language:

“Accounting Principles” means: (i) IFRS in effect as of the date hereof; and (ii) to the extent not inconsistent with (i), the

accounting methods, practices, procedures and policies used in the preparation of the Financial Statements, including the

reporting period closing dates, consistently applied.

Seller shall prepare and deliver to Buyer on the basis of, and as determined in accordance with, the Accounting

Principles: (i) its estimate of Cash as of the Reference Time (“Estimated Cash”); (ii) its estimate of Working Capital, as of

the Reference Time (without giving effect to the Closing)…

Buyer will prepare and deliver to Seller on the basis of, and as determined in accordance with, the same principles used

to prepare the Estimated Statement, as promptly as reasonably practicable following the Closing Date, and in any event

no later than 60 days following the Closing Date: (i) its calculation of Cash as of the Reference Time; (ii) its calculation of

Working Capital, as of the Reference Time (without giving effect to the Closing)…

Issue:

• Buyer included certain items in its Closing Statement arguing that these liabilities were required in accordance with

the Accounting Principles/IFRS including Provision for uncollectible receivables which the Seller had not reported to

the customer, finance leases and AROs

Example 5

SPA Language:

“Transaction Expenses” means: (i) any change of control payment payable by a Group Company as a result of the

consummation of the transactions contemplated by this Agreement …. (v) any retention or change of control bonus

payments, severance payments payable under any change in control agreements, tax gross-up payments or similar

liabilities (and the employer portion of any payroll, employment or similar Taxes associated with any of the foregoing

amounts) payable by any Group Company to any employee in connection with the transactions contemplated by this

Agreement, to the extent established prior to Closing…

Example 5

SPA Language:

“Transaction Expenses” means: (i) any change of control payment payable by a Group Company as a result of the

consummation of the transactions contemplated by this Agreement …. (v) any retention or change of control bonus

payments, severance payments payable under any change in control agreements, tax gross-up payments or similar

liabilities (and the employer portion of any payroll, employment or similar Taxes associated with any of the foregoing

amounts) payable by any Group Company to any employee in connection with the transactions contemplated by this

Agreement, to the extent established prior to Closing…

Issue:

• Buyer included change in control payments in Transaction Expenses for employees that had a bonus in their

employment agreement if (i) a change-in control occurred and (ii) the employee left for “good reason” or was

terminated within 12 months of the change in-control. These employees announced they were leaving 3 months after

Closing.

Example 6

SPA Language:

“Capital Expenditures” means out-of-pocket expenditures actually paid or payable (and, if payable, reflected as a

current liability in Working Capital) by the Regulated Utility Subsidiaries that are properly capitalized in accordance with

U.S. GAAP.

Base Purchase Price will be…. increased, dollar for dollar, by the total amount that actual aggregate Capital Expenditures,

by the Regulated Utility Subsidiaries from November 1, 2018 through the Measurement Time exceed the Budgeted

Capital Expenditure Amount, or decreased, dollar for dollar, by the total amount that actual aggregate Capital

Expenditures, by the Regulated Utility Subsidiaries from November 1, 2018 through the Measurement Time are less than

the Budgeted Capital Expenditure Amount for such period (a “Capital Expenditure Adjustment”);

Example 6

SPA Language:

“Capital Expenditures” means out-of-pocket expenditures actually paid or payable (and, if payable, reflected as a

current liability in Working Capital) by the Regulated Utility Subsidiaries that are properly capitalized in accordance with

U.S. GAAP.

Base Purchase Price will be…. increased, dollar for dollar, by the total amount that actual aggregate Capital Expenditures,

by the Regulated Utility Subsidiaries from November 1, 2018 through the Measurement Time exceed the Budgeted

Capital Expenditure Amount, or decreased, dollar for dollar, by the total amount that actual aggregate Capital

Expenditures, by the Regulated Utility Subsidiaries from November 1, 2018 through the Measurement Time are less than

the Budgeted Capital Expenditure Amount for such period (a “Capital Expenditure Adjustment”);

Issue:

• Buyer excluded capital expenditures for items recorded in AP at the start of the Measurement Period because these

amounts were expended and capitalized in accordance with GAAP prior to Measurement Period and included capital

expenditures in AP as of Closing Date.

Example 7

Arbitration/dispute resolution clause

1. Neutral arbitration with an SPA restriction – must agree 100% with one party’s amount

1 item in dispute: accrual

$0 or $2M

2. Recent trend towards “all or nothing” language in SPAs

3. Extreme example: the arbitrator must agree with the entire balance of either buyer’s or seller’s position

Consistency clause

1. Recent trend for consistency with past practice without consideration for facts/circumstances post-close

More extreme cut-off than as required by GAAP

Increasingly common in competitive deals

• Analysis of relevant contract terms, definitions and

schedules, and construction of the accounting

mechanism

• Price mechanism – does it work? How does the SPA

calculate net working capital or the earn-out?

• Who will prepare the statement? What is the closing

account process?

• Definitions of indebtedness, working capital, net assets,

etc.

• Are the contractual terms unambiguous?

• Accounting standards: IFRS vs. US GAAP vs. local/foreign

GAAP

• Accounting warranties and indemnities

Contractual Language Considerations and Tips

• Contractual language should not be generic.

• Discuss the potential impact of all due diligence findings

and reflect the due diligence findings in the contractual

language.

• Consider the underlying motives of all parties.

• Consider an example computation for all post-closing

mechanisms for the avoidance of doubt.

• Consider which party should prepare the post-closing

mechanism and understand the potential implications.

• Consider the relevant governing accounting standards

(e.g. GAAP vs IFRS), and any conversion adjustments

• Maintain a high level of skepticism.

• Understand brand exposure . . . including the

management and control of intellectual assets.

• Understand how the arbitration process will play out .

. . including the selection of an arbitrator.

• Document everything in the agreement.

Litigating Purchase Price

Adjustment Disputes

• Parties select and engage the independent accounting firm and/or the specific

accountant

• Preliminary conference with the independent accountant to set ground rules,

timelines

• Initial submissions – typically due in 2-4 weeks

• Rebuttal submissions – typically another 2-4 weeks

• Questions from the independent accountant

• Responses due in 1-2 weeks

• Decision – usually within 30 days

The Litigator’s Perspective – Typical Dispute Resolution Process

Even in the best of circumstances, resolution almost always takes longer than

envisioned in the purchase agreement

• Remember your audience!

▪ The decisionmaker here is an accountant, not a judge

▪ Technical arguments and jargon are not only acceptable, but sometimes

necessary

▪ The specific issues in dispute will determine who is best suited to draft –

lawyers and accounting advisors working together produce the best product

− Arguments about contractual language and definitions/priorities

− Accounting standards/practices

The Litigator’s Perspective – Strategic Considerations in

Submissions

• Selection of independent accountant and negotiation of engagement letter

• Timing/extensions

• Scope of accountant’s authority (“arbitrator” vs. “expert”)

▪ Adequacy of information provided

▪ What information can the accountant consider?

▪ Intersection of purchase price adjustments and breaches of representations

• Enforcement of accountant’s award

The Litigator’s Perspective – Potential Areas of Dispute

There are many ways the “typical” process can go awry – for legitimate reasons or

otherwise

• There is a well-developed body of law in Delaware that addresses the scope of an arbitrator’s

authority

▪ Generally, issues of substantive arbitrability (e.g., scope of an arbitration clause) are for the court

to decide

▪ Issues of procedural arbitrability (e.g., satisfaction of conditions precedent, information to be

considered) are for the arbitrator

• Many purchase agreements provide, however, that “the Independent Accountant shall act as an

expert and not an arbitrator”

• If so, that shifts nearly all of the contractual interpretation to a court, and limits the accountant

strictly to the functions provided by the contract, unless the contract expressly provides otherwise

• This can mean disputes in court about, for instance:

▪ whether the parties “negotiated in good faith” prior to commencing the dispute resolution

procedure

▪ whether the buyer has provided the seller with adequate information in response to requests,

and whether that is a condition precedent to the accounting procedure

▪ what information the accountant can consider

The Litigator’s Perspective – Accountant vs. Court

• Depending on how the contract is written, the buyer may have choices to make between seeking

redress through the purchase price mechanism or a claim for breach of representation or both

▪ Consider a contract with agreed accounting principles that prioritize GAAP compliance over

consistency with past practices

▪ Buyer could both “correct” the accounting for purposes of the purchase price adjustment and

assert an indemnification claim for breach of the financial statement representations

▪ Damages for the indemnification claim could be based on an earnings multiple, rather than the

dollar-for-dollar adjustment in the purchase price dispute resolution

• Where representations and warranties do not survive closing, buyers sometimes try to challenge

GAAP compliance via the purchase price adjustment process

▪ Chicago Bridge & Iron Co. v. Westinghouse Elec. Co., 166 A.3d 912 (Del. 2017) – court interpreted

the purchase agreement as prioritizing consistency of practices, and held that buyer could not

mount a back-door challenge to GAAP representation through the purchase price adjustment

process

The Litigator’s Perspective – Breach of Representation

• Accountant’s award is typically a written decision that addresses and explains

each of the items in dispute

• Purchase agreements almost always provide that the accountant’s

determination is “final and binding”

• Procedures for enforcement of or challenges to awards depend on whether the

accountant is an “arbitrator” or an “expert”

▪ Arbitration awards: Delaware and most states have specific “expedited”

procedures for enforcement of an arbitration award, and very limited grounds

for challenging arbitration awards

▪ Expert decisions: Enforcement is (presumably) via an action for specific

performance

• More opportunity for delay and obstruction by the “losing” party

▪ Fee shifting provisions can help deter bad faith obstruction

The Litigator’s Perspective – Enforcement of the Accountant’s

Award

Stephen Glover

Partner, Gibson Dunn

1050 Connecticut Avenue, N.W., Washington, DC 20036-

5306

Tel: +1 202.955.8593

SIGlov[email protected]om

Michelle M. Gourley

Partner, Gibson Dunn

3161 Michelson Drive, Irvine, CA 92612-4412

Tel: +1 949.451.4135

MGourley@gibsondunn.com

Ron Hauben

Senior Counsel, Gibson Dunn

200 Park Avenue, New York, NY 10166-0193

Tel: +1 212.351.6293

RHauben@gibsondunn.com

Marshall R. King

Partner, Gibson Dunn

200 Park Avenue, New York, NY 10166-0193

Tel: +1 212.351. 3905

[email protected]om

Christen Morand

Partner, Forensic & Integrity Services, Ernst &

Young LLP

Chicago, IL

Office: +1-312-879-2705

christen.morand@ey.com

Questions?

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