Page 61 - M & A Disputes

If, in fact, it is deemed that the buyer is only entitled to dollar-for-dollar damages under an indemnity
claim, the practitioner should consider whether the buyer recovered dollar-for-dollar amounts for the
same adjustments in a prior working capital proceeding. Typically, the acquisition agreement will estab-
lish a specific venue and timeline for working capital adjustment negotiations. As such, the buyer may
have already received a dollar-for-dollar amount pertaining to the same accounting adjustment that it
now claims under an indemnity claim.

Although indemnity claims may result in damages at a dollar-for-dollar amount, most often, this is not
the case; rather, the adjustments that the buyer is claiming have a long-term effect on the target’s finan-
cial results. As previously mentioned, a disputed adjustment’s impact on the target historical earnings
may continue to have the same impact on the future earnings of the business, leading to damages award-
ed at some multiple of earnings (that is, the disputed adjustment amount is multiplied by a multiple that
may have been used to determine the purchase price).

The practitioner should evaluate whether the buyer can demonstrate that the disputed adjustment was in-
appropriately included or excluded from the target’s financial statements. The buyer may then be re-
quired to prove that it relied on this misstated financial statement in determining its acquisition price.

If the disputed adjustment amount was a working capital adjustment arising from the parties assessing
the closing balance sheet and working capital adjustment, the adjustment may have not affected the in-
terim financial statements that the buyer likely used in determining its purchase price.

Example: Buyer Claims That a Disputed Adjustment Amount Equates to Damages at an
Implied Multiple Based on That Buyer’s Valuation of the Target

The buyer claims that $10 million of invoices were not recorded as accounts payable on the bal-
ance sheet and submits that amount as a working capital claim for the purchase price adjustment.
In addition, the buyer may also assert an indemnity claim alleging that the seller misstated the fi-
nancial results of operations by failing to record certain activity that was material to the buyer.
As a result of not recording the invoices, the target’s expenses were understated, and EBITDA
was overstated. The buyer claims that the purchase price was based on 8 times the target’s TTM
EBITDA, which should have included these invoices; therefore, the buyer overpaid for the busi-
ness by $80 million. An argument will ensue as follows: the seller will assert a position that the
material misstatement of accounts payable did not affect future periods; therefore, the buyer
should only be awarded $10 million. The buyer’s argument would have more strength before the
court if it can be shown that the adjustment affects future operating periods.

In other words, the TTM EBITDA, as expected, is used as a proxy for the expectations of the target’s fu-
ture earnings. The multiple will incorporate the risks and growth prospects of those future expected
earnings. If the TTM earnings are overstated as a result of a breach of the financial statement representa-
tions, as demonstrated in the preceding example, the buyer’s expectations of future earnings of the target
may be overstated. This would result in the buyer overpaying for the target; therefore, the buyer did not
receive the value of the business that it expected.

Using the preceding example of $10 million of unrecorded invoices, the question to consider is, will
these expenses affect the target’s future performance? If the invoices relate to costs to execute a particu-
lar transaction (one-time items), they may be assumed to be nonrecurring and have no impact on the fu-
ture earnings stream. However, if the invoices represent incremental ongoing expenses for the target,
then the buyer may be entitled to damages into future periods or at a multiple, and these unrecorded in-
voices would have altered the buyer’s valuation analysis in deriving the acquisition price.

© 2020 Association of International Certified Professional Accountants 59