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Merger & Acquisition Disputes: Accounting & Valuation Issues
Presented by: Jeff Litvak Jason Tolmaire
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Accounting and Valuation Issues in Merger and
Acquisition Disputes
Jeff Litvak, CPA/CFF/ABV,
ASA
Senior Managing Director
FTI Consulting
Chicago
jeff.litvak@fticonsulting.com
312-252-9323
Jason Tolmaire, CPA/ABV
Senior Director
FTI Consulting
Chicago
jason.tolmaire@fticonsulting.com
312-252-4031
Issues To Be Covered
Introductions
The Current Merger & Acquisition Environment
Overview of Merger and Acquisition Transactions and
Disputes
Measuring Damages in Representation and Warranty
Disputes
2
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Issues To Be Covered (Cont.)
Buyer and Seller Considerations
Hypothetical Case Study
Conclusion
3
The Current Merger and Acquisition Environment
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The Current Merger & Acquisition Environment
5
Source: Factset Flashwire US Monthly October 2018
The Current Merger & Acquisition Environment
6
Metric
LTM
9/2018
LTM
9/2017
Pct.
Change
Number of Deals 12,688 12,376 2.5%
Transaction Value ($Billions) $2,056 $1,898 8.3%
Source: October 2018 Factset Flashwire U.S. Monthly
Based on L3M ending 9/30/18
• Top sectors by activity: Commercial Services, Industrial Services,
Consumer Services
• Top sectors by value: Industrial Services, Technology Services,
Energy Minerals
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The Current Merger & Acquisition Environment
Factors Driving Deals in 2018: Synergies
Investors typically reward buyers that include synergy estimates in their announcements with higher returns
Investor enthusiasm appears to be waning as buyers’ announcement returns in recent transactions have decreased in recent years
Buyers are giving away a higher share of total synergies in order to afford their deals
Historically, buyers have kept two-thirds of value of expected synergies while today buyers are keeping less than half
7
Source: 2018 M&A Report Synergies Take Center Stage- bcg.com
The Current Merger & Acquisition Environment
Other Factors Affecting M&A in 2018
Investor support, cheap-funding and slow organic growth helped fuel deal making in early 2018
Corporate tax reform in U.S. creating a favorable back drop for deal making
Investor activism focusing on M&A related agendas
Megadeals have been driving M&A activity in 2018
8
Source: 2018 M&A Report Synergies Take Center Stage- bcg.com
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The Current Merger & Acquisition Environment
Largest Announced Merger & Acquisitions for 2018:
Health Services: Cigna Corp. acquires Express Scripts for $67.6 billion
o Combination of insurance company and pharmacy benefits manager
o Cash and stock transaction with assumption of debt
o Consideration 31% premium to Express Scripts Shareholders
o DOJ cleared acquisition in September 2018 and companies expect to close the deal by the end of 2018
Source: Factset Flashwire US Monthly April 2018
9
The Current Merger & Acquisition Environment
Largest Announced Merger & Acquisitions for 2018:
Consumer Services: Comcast Corp. acquires Sky Plc $38.8 billion
o Comcast’s offer of £17.28 top Fox’s highest bid of £15.67
o Winning bid represents premium more than doubling Sky’s value
o Fox currently owns 39% of Sky
10
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The Current Merger & Acquisition Environment
Largest Announced Merger & Acquisitions for 2018:
Consumer Non-Durables: Keurig Green Mountain acquires Dr. Pepper Snapple Group for $25.2 billion
o Pay $18.7 billion in cash to shareholders ($103.75 per share)
o Shareholders of Dr. Pepper Snapple Group retain 13% ownership
o Cash payment 9% above most recent closing price
o Deal structured as a reverse merger
11
Overview of Mergers and Acquisition Disputes
Damages
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Overview of M&A Transactions and Disputes
The Purchase and Sale Agreement
Determining The Purchase Price
Types of M&A Disputes
Material Adverse Changes
Post Closing Purchase Price Adjustments
Claims for Indemnification
13
The Purchase and Sale Agreement
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The Purchase and Sale Agreement
Legal document memorializing the agreement of the parties
■ Purchase price and post-close adjustment mechanisms (e.g. working
capital/balance sheet true-ups/excess cash calculations)
■ Provisions governing earn outs (if applicable)
■ Representations and warranties of parties
■ Indemnification provisions
The purchase and sale agreement can offer protection but can
also present hazards
15
Provisions Triggering Most Disputes
Representations and Warranties
Indemnification Obligations
Working Capital True-Up Provisions
Earn-Out Provisions
16
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Provisions Designed to Limit or
Avoid Disputes May Not be Effective in All Cases
Indemnity Caps
Non-reliance and Integrations Clauses
Choice of Law Provisions
17
Determining the Purchase Price
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The Purchase Price
Reflection of investment value specific to transacting parties.
Reflects “bargained for”:
• Anticipated stream of future earnings or cash flows
• Measure of capital necessary to support operation in the normal
course
Often, the purchase price incorporates a control and synergistic
considerations.
19
Purchase Price: Valuation Approaches
Market approach (financial element x multiple) ■ Earnings measurement (e.g., EBITDA) or balance sheet measure (e.g.,
assets) depending on business
– Multiple – Based on multiples used by guideline comparable
companies or transactions
Income approaches ■ Discounted cash flow (DCF) valuation
■ Required internal rate of return (IRR) based on DCF projection
Cost approach ■ Not applicable in most deals
20
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Types of M&A Disputes
Types of M&A Disputes
Pre-acquisition Disputes
■ Occur when one party seeks to withdraw from a transaction
■ Without the consent of the counterparty
■ Subsequent to execution of purchase agreement but prior to close
■ Common reason for withdrawal alleged occurrence of material adverse
change (MAC) or fraud
22
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Types of M&A Disputes
Post-acquisition Disputes
■ Subsequent to the close of the transaction
■ Disputes over contractually prescribed adjustments to, or components
of, the purchase price
■ Claims for indemnification from alleged breaches of representations and
warranties
■ Earn-out disputes
23
Material Adverse Change
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Material Adverse Change (MAC)
Representation by seller that since a given date there has
been no MAC in the business
In addition, no event has occurred or circumstances exist that
may result in such a MAC
Provide a mechanism to terminate a merger or an acquisition
agreement prior to closing in the event that a MAC occurs that
damages the target’s business operations or assets
25
Material Adverse Change (MAC)
Considerations by Court whether a given adverse change
constitutes a MAC:
■ The significance of the event’s impact on the target
■ The duration of the event
■ Whether the event had a disproportionate impact on the
company compared with the rest of the industry
■ Whether the party seeking to avoid the transaction knew of
the event prior to entering the merger agreement
26
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Material Adverse Change (MAC)
Valuation Issues to Consider in MAC Claims:
■ If Court ruled that MAC did not occur, buyer may be able to
seek rescission of the deal
■ Rescission based upon a breach of certain representations
and warranties made by seller
■ Representations and warranties relate to the conditions of the
business at closing
27
Post-Closing Purchase Price Adjustments
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Timing of Key Stages to M&A Process
29
12/31/X1
and prior
4/30/X2 6/30/X2 9/30/X2 12/31/X2 2/28/X3 4/30/X3
Negotiations Period
Pending
Closing
Due Diligence Closing
Review
(Seller)
Buyer’s
Post
Closing
Review
Closing
Balance
Sheet
Dispute
Resolution
(if needed)
Initiate
Negotiations
Execution
of Letter of
Intent
Execution of
Acquisition
Agreement
Closing Date of
Transaction
Presentation of
Closing
Balance Sheet
to Buyer
(Prepared by
Seller)
Expiration of
Notice of
Objection –
Closing
Balance
Sheet
Buyer’s
Post Closing
Due Diligence
Expiration of
Period to Make
Claims for
Indemnification
12/31/XX
Indemnity
Claim
Dispute
Resolution
(if needed)
Normal course assessment of
post-closing Purchase Price
Adjustments
Circulation of historical financial
information about target via
Offering Memorandum or other
means of interest solicitation
Post Closing Purchase Price Adjustment
Recall: The Buyer is acquiring both a stream of future
earnings/cash flows and a measure of capital necessary to
generate such cash flows.
Acquisition agreements commonly feature purchase price
adjustment provisions to address variations in acquired capital
(e.g., differences between the balance sheet of the business
“bargained for” and the balance sheet of the business received
by the buyer at the close). ■ Against a measure from a historical date evaluated by buyer in due
diligence…
■ Against a “peg”…
30
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Example Language: Closing Net Working Capital
“The Closing Net Working Capital [or Closing Balance Sheet]
shall be prepared in accordance with United States generally
accepted accounting principles, consistently applied.”
“…. except for (1) normal year-end adjustments and (2) the
omission of footnote disclosures as required by GAAP…”
“If the Closing Net Working Capital exceeds $30,000,000, the
Purchase Price shall be increased by the amount of such
excess. Conversely, if the Closing Net Working Capital is less
than $30,000,000, the Purchase Price shall be decreased on a
dollar-for-dollar basis to reflect the shortfall.”
31
Commonly Arising Post-Closing
Purchase Price Disputes
Generally accepted accounting principles
(“GAAP”)
”GAAP” vs. “ Consistency”
Subsequent Events
32
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Common GAAP Disputes
Accounts receivable and related allowances for doubtful
accounts
Inventories and related reserves for excess and obsolescence
Employee accruals (e.g., commissions, bonuses, payroll,
vacation)
Warranty reserves
Contingent loss accruals ■ Probable? Reasonably estimable?
General disputes about the realizability of assets and
existence of obligations 33
“GAAP” vs. “Consistency”
Often the most hotly contested issue in a post-acquisition
dispute.
Seller’s position is that a consistent/past practice, which
results in a GAAP presentation, is a winning strategy at trial.
Buyer’s position is that Seller’s past practice is not GAAP and
seriously understates the reserve/accrual/presentation.
If Seller’s past practice/methodology does not result in a
GAAP presentation, then GAAP often trumps consistency.
However, this is of course dependent on the facts and
circumstances of the case.
34
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Subsequent Events
Under GAAP, a “recognized subsequent event” is an event in
which additional information becomes available about
conditions that existed on the balance sheet date. ■ Type I and II subsequent events.
Under GAAP, this additional information is used to adjust the
financial statements.
In general, consider the following questions: ■ What is known or knowable at the date of the preparation of the closing
balance sheet, or “report date”?
■ Do later subsequent events indicate that the Seller’s position is
unreasonable regarding what was known or knowable?
Buyer typically attempts to hold the books open for as long as
possible.
35
Claims for Indemnification
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Indemnification
Operative language varies (e.g., indemnify, hold harmless, pay
and reimburse)
Indemnification provisions can cover representations and
warranties, covenants and other items (e.g., taxes, pending
litigation)
Common limitations: ■ Time
■ Eligible claims (de minimis)
■ Baskets and thresholds
■ Caps/ceilings
■ Setoffs (e.g., tax benefits, insurance proceeds)
Limitations may be subject to carve out if, for example, there is
an intentional misrepresentation or fraud.
Losses/damages may be defined (e.g., out of pocket v.
diminution in value)
37
Common Disputes: Breaches of
Representations and Warranties
Buyers will require certain assurances from sellers, such as: ■ Financial statements are in accordance with GAAP
■ Material information with respect to the business has been disclosed
(e.g., litigation, environmental hazards, status of key customer
relationships, significant contracts)
■ There has been no Material Adverse Change
■ Business has been operated in the ordinary course
These and other matters are the subject of extensive
representations and warranties.
Contracts often provide for indemnification with respect to
breach of a representation or warranty.
Indemnification provisions are often subject to limitations,
which further reflect risk allocation between the parties.
38
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A Typical Seller’s Representation …
39
“The financial statements present fairly, in all
material respects, the financial position of the
business, as of the respective dates thereof
and covered by said statements in
accordance with generally accepted
accounting principles consistently applied
throughout the period involved.”
Measuring Damages in Representation and
Warranty Disputes
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Benefit of the Bargain Damages
Benefit of the Bargain:
A measure that awards the plaintiff the difference between the
gain had the misrepresentations been true and what the plaintiff
actually received.1
41
1 Litigation Service Handbook, Fourth Edition, 18.7
Measuring Damages: Indemnity Claims
Indemnity Claim:
A dollar-for-dollar measure of the difference between what was
“bargained for” versus what was received if affect earnings into
the future.
42
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Measuring Damages: Example #1
Assumptions:
■ $10 MM of undisclosed and unrecorded one-time liability associated
with environmental remediation costs
■ Potential liability known to Seller during negotiations, but not disclosed
■ Not probable/reasonably estimable at time of negotiations or at time of
close
■ Purchase price of $750 MM
– EBITDA of $150 MM
– 5x Multiple
43
Measuring Damages: Example #1
Observations on Measuring Damages:
■ Buyer did not contemplate these costs in its valuation
■ Based on fact pattern, non-recurring impact on future earnings
■ Appropriate measure of damages likely dollar-for-dollar to reflect gain
Seller would have received “but for” misrepresentation/failure to disclose
■ Reduce purchase price by $10 million to $740 MM
44
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Pitfalls to Avoid in Assessing Damages
Analyze the purchase and sale agreement and
contemporaneous documents carefully to understand
Buyer/Seller motivations and key data to parties.
Assess situations involving double recovery carefully. ■ Indemnity claim v. working capital claim
■ Interplay of contractual overlays v. GAAP working capital requirements
Consult with counsel in matters requiring contract
interpretation.
45
Pitfalls to Avoid in Assessing Damages, Continued
One time losses do not result in permanent earnings
impairments and should not result in damages at a multiple.
Only claims resulting in ongoing or permanent impairment to
the target company’s earnings warrant consideration of “at the
multiple” benefit of the bargain damages.
A post-close analysis of the deal may establish that Buyer
received benefit of its bargain irrespective of an alleged
breach.
46
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Buyer and Seller Considerations
Illustration of Hypothetical Seller’s
Perspective vs. Buyer’s Perspective
The Seller:
Past practice/consistency will result in a GAAP
presentation/Seek a specific “carve out” of problem accounts
Extensive access to Buyer’s books & records, ability to make
copies, interview personnel
Seek to negotiate a basket or threshold for post-closing
adjustments and indemnity claims
48
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Illustration of Hypothetical Seller’s
Perspective vs. Buyer’s Perspective, Cont’d
Limit escrow
Seller’s accountants should prepare closing balance sheet
Consistency is retroactive to the target balance sheet and
offsetting to claims in the closing balance sheet
Define losses to be dollar for dollar, exclude lost profits and
diminution of value and a multiple of EBITDA
Define purchase price as a multiple of EBITDA
49
Illustration of Hypothetical Seller’s
Perspective vs. Buyer’s Perspective
The Buyer:
Negotiate a mechanism in the contract to increase or decrease
the purchase price based upon EBITDA fluctuation before the
close
Losses would include lost profits, diminution in value, and a
multiple of EBITDA or other relevant measures
GAAP trumps consistency
Asserts a very conservative GAAP position/no “carve out” of any
accounts
50
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Illustration of Hypothetical Seller’s
Perspective vs. Buyer’s Perspective, Cont’d
Be careful not to overpay for Synergies
Limit the Seller’s access to Buyer’s books &
records/copies/interviews
Limit basket/threshold issues of any kind
Set up adequate escrow
Buyer’s accountants should prepare closing balance sheet
Buyer seeks a specified amount of net assets
51
Hypothetical Case Study
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Facts of the Hypothetical Case
Valassis and ADVO are in the direct mail advertising business.
Each company had sales in excess of $1B. The combined
entity will exceed $2.65B in sales.
Late in 2015 Valassis commenced merger discussions with
ADVO.
On July 7, 2016, Valassis and ADVO signed the SPA,
whereby, Valassis would pay $37/share in cash.
53
Facts of the Hypothetical Case, Continued
PRIOR to the signing of the SPA, ADVO represented: ■ Forecasted operating income for FY2016 of $68 million;
■ The integration of their SDR computer system was progressing as
planned;
■ That the April & May 2006 financial statements were materially correct.
The SPA is signed on July 5, 2016.
AFTER the signing of the SPA: ■ ADVO disclosed that April and May’s 2016 financial statements were
misstated by $2.6M;
■ August 10, 2016, ADVO adjusted its $68 million forecasted operating
income to $54.8 million, nearly identical to an internal April 2006
forecast of $54.5 million;
■ Actual FY results ending 9/30/16 were $37.9 million, some $30 million
below expectations.
Negotiations stalemated. On October 31, 2016 Valassis filed
suit to rescind the merger.
54
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Assignment
Investigate the following allegations:
■ Financially speaking, did ADVO’s business suffer a material adverse
change? More specifically:
– Was ADVO’s EBITDA materially misstated?
– Did ADVO sustain an dramatic downturn?
– Was ADVO performing disproportionately below its peers in the
industry?
– Was ADVO’s downturn known to the buyer prior to closing?
■ Did Valassis obtain the benefit of its bargain?
55
Demonstration of Dramatic Downturn
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ADVO’s Recent Operating Income is
Below the Historical Mean
57
Declined 70% From Q1 2016 to Q4 2016
5M
10M
25M
($) in Millions
20M
15M
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2013 2014 2015 2016
$20.0
$18.7
$21.6
$21.3 $19.8
$19.0
$20.7 $21.6
$14.1
$18.5
$22.4
$14.1
$22.1
$12.6
$11.6
$7.0
Mean = $19.5
(1)
(2)
(3)
ADVO’s Material Misrepresentation
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ADVO’s Fiscal Year 2016 Operating Income
Forecasts
59
10M
20M
30M
60M
($) in Millions
40M
80M
50M
7/6/2016
Merger Agreement $76.1
(Original Budget)
70M
$54.5
$65.0
$68.6 $68.0
$54.8
$37.9
4/14/2016 5/4/2016 5/10/2016 6/23/2016 8/10/2016 Actual
(unaudited)
ADVO’s Operating Below Industry Expectations
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ADVO’s Performance is
Disproportionate to the Industry
61
2015 2013 2014 2016
Q1 Q2 Q3 Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
5M
10M
15M
25M
20M
30M
35M
40M $38.1 $38.1 $37.4
$32.2
$35.3
$36.3 $37.3
$36.6 $37.4
$35.9
$37.2
$37.1
$35.3
$35.8
$35.1
(4.3)% Change
(69.5)% Change
$14.1
$20.6
$10.3
$18.7
$21.6 $21.3
$25.6
$23.1 $23.2
$21.6
$18.5
$25.9
$14.1
$6.3
Industry Average*
ADVO
($) in Millions
Time between Q1 & Q4
$9.2
(2)
Q1 Q2 Q3 Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Valassis Did Not Receive the Benefit of its Bargain
62
Purchase Price Overpayment Calculation
In Millions (except multiples)
Pre-Signing Forecasted Fiscal ‘16 Op. Income - Misrepresentation $68.0
Less: Pre-Signing Forecasted Fiscal ‘16 Op. Income – Realistic (54.5)
Operating Income Misrepresentation $13.5
% of Misrepresented Operating Income 19.9%
ADVO ‘16 EBITDA (Valassis/Bear Stearns Projection) $119.0
Less: Misrepresentation (13.5)
Corrected ADVO ‘16 EBITDA $105.8
EV/EBITDA Purchase Price Multiple 9.0x
Adjusted Enterprise Value $950
Less: Actual Enterprise Value Purchase Price (1,291.3)
Purchase Price Overpayment $(341.8)
% of Actual Purchase Price 26.5%
9.0x Multiple
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Valassis Did Not Receive the
Benefit of its Bargain
63
www.aicpa.org/fvs
Multiple of EBITDA Based on Guideline Companies
Value at July 5, 2016 $1,291
FY 2016 EBITDA $105.5
Multiple 9.0x
Value at August 10, 2016 950
($342)
Income Approach (Free Cash Flow)
Value at July 5, 2016 $1,080
Value at August 10, 2016 676
($404)
(3)
(1) (2)
(2)
ADVO Misled Valassis into Overpaying by $300 - $400 Million
Summary of Issues Covered
Be careful not to overpay for Synergies.
“Carve out” items which should not be represented to be
GAAP.
Negotiate language which would allow for an indemnity claim.
Set a limit on what can be recovered.
Only items affecting future earnings are recoverable at the
multiple.
Cannot obtain a “double recovery” for working capital/benefit
of the bargain damages.
64
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Questions
65
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