Mitigating and managing post-completion disputes from value adjustment mechanisms 5 min read
Parties to M&A transactions seeking to bridge bid/ask spreads and ensure their deals reflect the fair value being acquired will often employ value adjustment mechanisms such as earnouts, deferred consideration and escrow releases. While these mechanisms can be effective, they are increasingly giving rise to disputes post-completion. In some cases, the quantum in dispute can be so significant as to undermine or recalibrate the original economics of the deal.
In this Insight, we explore some of the types of disputes that arise from value adjustment mechanisms and other completion account adjustments and suggest ways to avoid (or at least mitigate) such disputes.
Key takeaways
Value adjustment mechanisms hold a firm place in M&A transactions and allow buyers and sellers flexibility in structuring their deals. It is against that background that we encourage parties adopting them to keep in mind the following three simple points:
- Take care drafting.
- Know how the value adjustment mechanisms will work in practice, stress-test them and try to anticipate the types of disputes that might arising when the mechanisms are triggered (and, of course, obtain accounting and tax advice).
- Ensure the dispute resolution processes are 'fit for purpose' having regard to the types of disputes and scenarios that might arise and think through how they will work in practice.
Value adjustment mechanism disputes and dispute resolution
Types of disputes
Value adjustment mechanisms, such as those referred to above, do give rise to disputes—increasingly so in recent times. Set out below are some examples of the types of disputes that arise from value adjustment mechanisms.
Earnouts and deferred consideration
- Disputes over the accuracy or method of calculating the earnout or deferred consideration —eg has the formula in the contract been applied correctly?
- Disputes related to EBITDA normalisation. Often, earnouts are tied to EBITDA that is normalised by reference to normalisation principles. While statutory EBITDA is typically viewed as an objective starting point, disputes often arise during the normalisation process, particularly when the definitions or procedures outlined in accounting terms are ambiguous. For example, does the term 'excluded' mean to deduct an item if included, but not add if not already included?
- Disputes over the performance of the business in the relevant period—have there been material changes to the business and/or its operating environment since the contract was entered into, and what effect, if any, does that have on the value of the earnout or consideration?
- Challenges related to payment hurdles. Such hurdles, if met, lead to payments, but if the performance falls below the hurdle, might result in no payment. This all-or-nothing structure can be viewed as blunt and often leads to disputes.
Completion account adjustments
- Disputes regarding the hierarchy and application of Accounting Standards and other accounting principles (including prior accounting treatment by the company that is the subject of the transaction)—eg how should certain adjustment items be accounted for in the completion accounts, and have the parties used the relevant Accounting Standards or accounting principles appropriately?
- Disputes concerning the clarity and specificity of items in the completion statement.
- First, each item in the completion statement should link to a general ledger account. For example, does each item correspond with a relevant general ledger code?
- Second, items in the completion statement should be underpinned by a relevant completion principle. When drafted properly, this completion principle should explain how that item is to be interpreted and, if applicable, adjusted when compared against the general ledger amount.
- Disputes as to whether a purported adjustment is within the scope of the mechanism and/or the relevant timeframe—eg is there an actual crystallised liability or merely a contingent liability? Has the requisite event 'arisen' by the cut-off date under the contract?
Escrow releases
- Disputes regarding the factual circumstances giving rise to a release of funds in escrow and/or whether an escrow release has been triggered pursuant to the terms of the contract.
- Claims for specific performance of clauses requiring payments from escrow accounts.
- Disputes stemming from ambiguities in escrow agreements. Specifically, issues arise when an escrow agent's duties, the instruction process or the responsible parties are not clearly defined. An agreement should address these ambiguities and outline the steps the agent should follow in the event of a dispute between the involved parties.
Dispute resolution mechanisms
Subject to any express provisions in the relevant agreement, parties will typically resort to the following mechanisms for addressing disputes relating to value adjustment mechanisms:
- commercial negotiation
- expert determination
- court litigation, and/or
- arbitration.
Tips for avoiding and mitigating these disputes—prevention is key!
In seeking to avoid or mitigate disputes arising from value adjustment mechanisms, it is crucial to focus on (i) the value adjustment mechanism itself and (ii) the dispute resolution mechanism that will apply in the circumstances. Taking each of those in turn, we suggest the following tips at the negotiation and contract drafting stages of the transaction.
The value adjustment mechanism itself
- Consider carefully the drafting used in the clauses relating to the adjustment mechanism. Clear and precise drafting is important, and it helps to ensure that the parties are aligned on how the mechanism will actually work, as vague and ambiguous terms can give rise to differing interpretations and applications.
- Consider building worked examples into the schedules of the agreement(s) to illustrate how the parties intend the mechanism to operate and 'stress-test' whether the clause, as drafted, works in practice.
- Where possible, adopt 'known' or more 'objective' financial metrics in the mechanism (eg parties might choose to use figures from audited financial accounts) as they are less prone to subjective interpretation and potential manipulation.
- Consider 'milestone' or tranched payments (where possible and practical) – with an objective measure on whether the milestone has been achieved.
- Consider the interplay of the adjustment mechanism with other clauses in the contract, eg:
- Clauses providing for completion account adjustments and clauses relating to warranties and indemnities might both be triggered in certain factual circumstances. Include express drafting to make it clear which clause applies in different scenarios.
- Clauses relating to earnouts and clauses in respect of management/employee incentives—are management/employee incentives aligned with the earnout mechanism?
- Consider whether there are any particular features of the adjustment mechanism that, objectively, might be more likely to give rise to disputes, eg:
- The larger the percentage consideration that is deferred, the more likely there will be a dispute regarding the value of that consideration and/or the application of the contractual mechanism used to calculate the deferred consideration.
- The longer the term of the earnout, the more likely there will be a dispute regarding the performance of the business in the intervening period and the expected value of the earnout.
- Seek advice on the operability of the relevant clauses before signing the agreement.
The dispute resolution process
- Consider carefully the drafting used in the dispute resolution clauses of the relevant agreement (particularly where the chosen dispute resolution method involves commercial negotiation, expert determination or arbitration). Ensure the drafting is clear and precise.
- Consider how and when the dispute resolution process will be triggered and operate. For example:
- Is the chosen forum actually suitable having regard to the likely complexity, subject matter or quantum of any dispute? Eg, is an independent accounting expert (in an expert determination process) going to be qualified to resolve a dispute that turns on the answer to a complex legal question or other technical input? If not, is there an avenue in the dispute resolution process to have the legal question determined by someone suitably qualified/a court, or the technical input procured, before the expert determination process begins?
- Does the dispute resolution mechanism work in practice? Are the timeframes adequate and steps in the process appropriate if the dispute is particularly complex?
- Is there sufficient flexibility within the dispute resolution process for the parties to adapt the process should they need to in certain circumstances and/or have the matter determined via another process (other than by contract amendment)? For example, does the dispute resolution process allow for the parties to set the timetable, add procedural steps to the process as circumstances dictate or to make supplementary submissions?
- Are there competing dispute resolution processes within the contract which might allow parties to circumvent the chosen dispute resolution process for value adjustment disputes in certain circumstances (eg directing the matter to a court instead of an accounting expert)?
- For parts of the process that depend on future agreement between the parties (eg choice of arbitrator or expert), does the contract adequately provide for the possibility that the parties do not agree?
- Consider what will happen if the parties are unhappy with the outcome of the dispute resolution process. For example, in an expert determination process, will there be a contractual right of appeal to a court in certain circumstances (beyond the usual entitlement)? If a court finds that there has been a manifest error in an expert's determination, do the parties want to have the matter referred back to the expert for redetermination or would they prefer that a different expert be selected to resolve the dispute?