For Clients Selling Their Businesses, M&A Can Get Messy

There are few events that have as large an impact on a client’s investable wealth as the sale of his or her business. If the client is still relatively young, the capital may fund the next venture down the road or fuel a pursuit of philanthropic passions. For clients that are set to retire, the sale may supply the capital base that is needed to live out their lives and support future generations. Either way, the client and his or her financial advisor may start drawing up plans for the deployment of the new capital, including needs, wants and the asset allocation of the remaining investable capital, as plans for the sale progress.

The price for which the business is expected to be sold is a crucial factor in this process. Determining the anticipated proceeds is, however, not always as simple as it seems. Transactions are often negotiated on a cash-free/debt-free basis, while the business, of course, has cash and debt. In addition, there can be a variety of other post-closing adjustments to the agreed-upon purchase price, such as working capital adjustments and earnouts.

The post-closing impact can range from uneventful — i.e., some minor true-ups and an earnout payment in line with expectations — to significant post-closing adjustments, a protracted dispute before a neutral accountant and/or other litigation, and the risk of evaporation of a large part of the purchase price.

Several current developments can serve to mitigate or exacerbate some of those adjustments from the seller’s perspective:

  1. Earlier this year, the Delaware Supreme Court interpreted a contractual working capital adjustment mechanism and the associated GAAP requirements narrowly — i.e., in the seller’s favor — in a large post-closing dispute (more than $2 billion at issue). As a result, it is reasonable to expect continued tweaking of the customary contract language covering adjustment mechanisms. Caution should be exercised to avoid unintended consequences.
  2. Generally accepted accounting principles are continuously subject to change, which can impact working capital adjustments and to a larger degree earnouts. For example, new revenue recognition standards are going into effect later this year, starting with public companies and with private companies to follow suit later on. The effects of future GAAP on the company’s financial position and performance should be carefully considered, especially in earnout situations.
  3. The use of representation and warranty insurance has been on the rise. For a onetime premium, such insurance can cover potential payments to the buyer, which would otherwise be owed by the seller, in case of a breach of seller’s representations and warranties. In addition to the general benefit of coverage, such insurance policies can also help limit the need for post-closing escrows.
  4. Finally, this list of current developments would not be complete without pointing out the continued and seemingly ever-rising importance of intellectual property in the broader sense and when, for example, considering the extent of pre-closing disclosures and structuring earnouts.

Given the long-term, high-trust relationship between the financial advisor and his client, the financial advisor may play a vital role in warning the client against unintended side effects and undue optimism. Although entrepreneurial optimism may have brought the client much business success, it can be a shaky foundation for structuring an M&A transaction. Indeed, the client may disproportionally benefit from exercising caution in relation to the sale of the business and the realization of the expected proceeds.

A buyer that is enthusiastic and accommodating before closing may turn out to be more cynical and aggressive when the time comes to determine the purchase price adjustments post-closing. To avoid surprises, it generally serves the client well to critically assess his or her business and its accounting as part of the pre-closing process. The identified issues may be irrelevant for the day-to-day running of the business, but — when unacknowledged — can turn out expensive in the context of a transaction when the buyer points them out after the fact. For example, some excess inventory or a silent contingent liability may not be a big deal in the daily course of business or when identified pre-closing, but could result in dollar-for-dollar deductions post-closing if they were not anticipated.

Similarly, the client can benefit from critically assessing what could go wrong with the earnout. For example, if achieving the earnout relies on certain capital investments, those should be baked in.

Raising specific risk awareness can be a natural fit for the financial advisor, who deals with both short-term and long-term opportunities and risks for their clients on a continuous basis across a variety of asset classes, financial products and life events. Even if the only result of the financial advisor’s input is that the client solicits the input of experienced transaction counsel, the client may well have greatly benefited.

--- The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position or policy of Berkeley Research Group, LLC or its other employees and affiliates.

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