This article looks at the three main areas where we see disputes arising in transactions – completion accounts, earn-outs and warranty disputes – and explains that such disputes do not necessarily arise in isolation. Thus, one important question arises: like the chicken and egg, what comes first?
The euphoria of closing a deal. The exhilaration of signing. The deal teams have packed up, the exhaustion of negotiations slowly fading. All that remains is the ink slowly drying on the contracts and the final completion bits and pieces to tidy up. Cracking. Right? Well in most cases, yes. But not always. A small but not insignificant minority of M&A transactions will end up in a dispute. Reports vary as to how many. Some say 10% of deals, others say up to half. All I can tell you is that 100% of the deals that hit my desk had ended up in dispute. Well, I am a forensic accountant specialising in disputes, after all.
So, what goes wrong?
Completion accounts
First, we see arguments around completion accounts. Not all deals have a completion accounts mechanism – think “locked box” – but where there is one, the completion accounts are used to determine any final purchase price adjustments. At its simplest, a price adjustment will be based on the difference between a target balance sheet with the actual balance sheet at completion. The focus is usually on net working capital, net cash, or net debt.
Of course, that requires the parties to agree the balance sheet at completion. Cue arguments as each party attempts to push the balance sheet in its favour, usually helped by ambiguous drafting in the sale and purchase agreement.
The process for resolving completion accounts disputes is usually set out in the sale and purchase agreement. There will be a set timetable (normally quite short), and referral to a determining expert if the dispute cannot be resolved by the parties. We often assist parties in preparing completion accounts and in any disputes that arise, and we also take appointments as determining expert.
Earn-outs
Second, we see arguments around earn-outs. Earn-outs defer some of the purchase price to a later date and make it contingent (and often variable) on future performance. Many earn-outs are used to bridge “valuation gaps” where the parties have differing views as to future performance, essentially shifting some of the downside risk – but also upside risk – back onto the seller.
Earn-outs can also be used where there are key owner-manager shareholders, tying them into the business for a period post deal to facilitate handovers and incentivise continued performance. The calculation of the earn-out amounts will be set out in the sale and purchase agreement and is usually by reference to the profit and loss account.
Of course, that requires the parties to agree the earn-out profit and loss account. Cue arguments as each party attempts to push the profit and loss account in its favour, usually helped by ambiguous drafting in the sale and purchase agreement or some unintended consequences of ostensibly well-meaning bespoke accounting policies.
Sound familiar? Disputes around completion accounts and earn-outs broadly follow the same pattern and process, save that earn-out disputes necessarily happen after the earn-out period and typically one, two or three years after completion. As with completion accounts, we often assist in preparing earn-out accounts and in disputes that happen, and can provide determinations as required.
Breach of warranties
Third, we see disputes around breaches of warranties. Warranties are given by the seller to confirm a range of different points about the business and the information provided. The buyer will rely on these warranties; if it later turns out the warranty was false, the buyer can allege a breach of warranty and bring a claim for damages. The disputes we see centre on warranties over financial information, and whether it was true and fair, properly prepared, in accordance with accounting standards, not misleading, complete, accurate, or some variation on a theme. With our expertise, we can help both in relation to the liability aspects insofar as they relate to accounting issues (was there a breach?), as well as the quantification of losses, including providing expert evidence for court or arbitral proceedings.
When assessing claims, the starting position is that losses arising from a breach of warranty are assessed by considering the diminution in value of the business being acquired. This usually requires two valuations, both assessed at the date of completion: the value of the business “as warranted” and the value of the business “as it actually was”. The value “as warranted” is often taken to be the purchase price and informed by the deal actually struck, though sometimes an adjustment between price and value is required depending on the specifics of the deal and the circumstances of the parties. The value “as it actually was” then repeats the valuation “as warranted”, but taking into account the effect, and only the effect, of the breach. Everything else remains the same. In this way, loss is restricted to the breach and the breach alone. It is not an opportunity to renegotiate the price with the benefit of post transaction remorse. Sometimes a breach can be remedied by a pound-for-pound adjustment, in which case valuations may not be required, but that’s less common.
There is normally a time limit within the sale and purchase agreement for notifying a breach of warranty to the seller. One to two years is not uncommon – enough time for the buyer to get into the business and for any issues to surface, but not so long as to leave the seller exposed to the risk of claims for an extended period. Miss that time limit, and the opportunity to claim has gone. The exact form of the notification will be included in the sale and purchase agreement: usually identifying the warranty that’s been breached, outlining the issue at a high level, and an estimate as to loss where possible. Once notified, the buyer then has a further period in which to issue proceedings and particularise the claim. We’d always suggest clients seek the assistance of solicitors when making notifications and considering proceedings.
Disputes: individually poached or scrambled?
Although completion accounts, earn-outs and warranty claims are different, it’s perfectly possible for a dispute to arise in respect of one, two or all three. Both the buyer and the seller can instigate a disagreement over completion accounts and earn-outs, but warranty claims are the buyer’s domain. Indeed, from a strategic perspective, a buyer may well contemplate, threaten or even bring a claim for breach of warranty when trying to agree the completion accounts or earn-out accounts, especially if the breach of warranty route provides a more attractive remedy.
There can also be overlaps. Consider a misstatement in the warranted financial information, which the buyer first discovers as the completion accounts are being prepared. It may be possible to correct the misstatement under the completion accounts mechanism. But if the misstatement is also related to a warranted matter, then the seller could face a claim for a breach of warranty, with the attendant risk of litigation, a detailed court process, and a greater exposure to damages. There are usually protections against double recoveries, but that won’t necessarily stop a claim for a diminution in value beyond the price adjustment under the completion accounts.
Of chickens and eggs…
Which leads us to chickens and eggs and that perennial question, what comes first?
As noted above, losses for breach of warranty are assessed by considering the diminution in value between the value “as warranted” and the value “as it actually was”. The final purchase price – which informs the value “as warranted” – will only be known once the completion accounts and/or earn-out accounts are finalised. In many cases, you need this to assess a breach of warranty. Egg required for chicken.
When you just have completion accounts and warranty claims, this is not usually an issue. The timelines set out within the sale and purchase agreement for the preparation of completion accounts generally mean they will be finalised (including resolving any disputes) before any time limits on warranty claims bite. Completion accounts first, warranty claims second. Egg, chicken.
However, when there is an earn-out involved, the position can become a bit more complicated. The amount the seller pays under the earn-out forms part of the overall purchase price. It’s just paid later, and may vary depending on future performance. In effect, the purchase price isn’t really agreed until the earn-out amounts are finalised. If the earn-out amount only becomes known after the time limit for warranty claims passes, then it may not be possible to quantify the breach of warranty. Can’t have the chicken without the egg.
In practice, there are usually contractual protections and legal arguments to guard against warranty claims being barred because an earn-out hasn’t been agreed. Some careful drafting in the sale and purchase agreement, agreed pre-deal, may offer the contractual protections. Post deal, notifying the seller of a warranty claim in accordance with the sale and purchase agreement, even if it cannot be fully particularised or quantified, will prepare the ground for and go some way to preventing the claim being barred. But in any event, these situations need careful handling by solicitors and we would always advise obtaining appropriate legal advice.
Sometimes, the courts need to get involved. I gave evidence in a recent case ([2024] EWHC 867 (Comm)) concerning whether a breach of warranty was capable of being quantified whist an earn-out was in the process of being resolved through expert determination, and so whether the warranty claim was time barred. Legal commentators can do better justice to the facts and analysis of the case than I can. Suffice it to say that in that particular case and consistent with my evidence, the Court was not prepared to let the warranty claim hatch before final earn-out amounts had been determined.
Egg. Chicken. Was it any other way?
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