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The importance of a solid sale and purchase agreement

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Paul Smethurst

Paul Smethurst – Partner

Despite the lingering uncertainty within the UK business landscape, merger and acquisition activity remains strong, due in no small part to beneficial exchange rate movements. As a consequence, the demand for sale and purchase agreement (SPA) reviews has increased.

Fundamentally, to ensure a smooth transaction when selling a company, it is important to establish any potential problem areas by conducting a thorough due diligence process and a detailed review of the SPA. But what are the issues that commonly cause disputes in SPAs and how can these be mitigated?

WHERE DO THE ISSUES ARISE?

During the transitory period between the agreement of sale terms and completing, the risks and rewards of ownership of the target company are transferred to the buyer, yet control of the business remains with the seller. To address the issue of this misalignment of interests, most SPAs use techniques such as earn-out provisions, price adjustment mechanisms and warranties to protect both parties to the transaction. To avoid controversy and to minimise the risk of disputes, specific attention is required when drafting these components.

HOW TO AVOID DISPUTES

Updated financial information will have to be presented to the buyer upon completion. It is important that the SPA clearly specifies who is responsible for preparing this information (typically the buyer, given they are in control of the relevant documentation at this point), and the timetable for preparing it. The period for challenging the financial position, the accounting approach and the conventions that will be applied should also be clearly defined as so much may depend on it.

Many accounting treatments are open for interpretation, especially more subjective areas of accounting estimates, such as provisions. Therefore, having the SPA define the exact accounting standards, policies and practices that should be followed, is critical to limit ambiguity.

Nevertheless, there are several ways to prevent a potential post-completion dispute. We are often required to address the tension that arises between a stated accounting convention that it is agreed in the SPA should be applied, e.g. UK Generally Accepted Accounting Practice (“UK GAAP”), and also a stated requirement to follow the entity’s historic or usual practices and approaches when determining estimates or provisions. Clauses can be included that establish an order of preference, or even to provide precise mechanisms for the calculation of key figures such as bad debt or stock provisions.

For practical reasons, accounting conventions and practices used for management or audited accounts will generally allow for a certain level of materiality. However, the SPA may not provide for any level of materiality to be applied in the preparation of the completion accounts. To avoid potential issues arising as a result of this disparity, the inclusion of a specific materiality or de minimis claim level should be considered when drawing up an SPA.

Earn-outs based on pre-agreed KPIs are also often included and, if well-drafted, can be used to incentivise sellers and key management to stay focused on optimising the value of the target. However, this can come with a risk of manipulation of the results, which are prepared by the buyers and who may seek to reduce the payment of deferred consideration.

We have seen many cases where one party has exploited the terms of the SPA to extract value from the business, for example, by accelerating asset write-offs, or by increasing investments in areas such as marketing, people or equipment with the effect of lowering current results and generating higher returns to the buyer in future periods. A robust SPA is therefore necessary to provide protection against the potential risks of post completion reported results being exploited, or value being extracted from the business in any other way.

WHAT CAN MENZIES DO TO HELP?

At Menzies we have first-hand experience of dealing with the issues and consequences of the matter raised above, and many others. We can provide informed guidance at an early stage to ensure your SPA is drafted in a manner which anticipates and addresses potential financial manipulation.

While it can be tempting to assume that accounting practices and sale terminology that has worked well in the past will hold up, this should never be taken for granted – a forensic eye can be invaluable.

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Paul Smethurst - FCA MAE

Forensic Services Partner

For further information around Sales and Purchase Agreements please contact Paul Smethurst an expert forensic accounting services Partner.