Seller beware – how to avoid post-deal disputes

At a time of heightened market uncertainty and with stubborn inflation plus a flatlining economy, deals are being scrutinised in much more detail, both before and after completion. And in some instances, buyers who have seen post-deal performance fail to meet expectations are becoming far more willing to pursue a claim to recoup lost value. 

Most deals are structured around ‘deferred payments’. In simple terms this means the buyer is required to pay the seller once certain financial or other performance measures are met, typically over a one- to three-year period. In theory, this should provide some protection in the event of market shocks. If the appropriate warranties and indemnities are included in the sale and purchase agreement (SPA), the buyer should have sufficient protection in place if the deferred payments mechanisms prove insufficient. 

But changing markets can make it difficult for buyers and sellers to gauge the value of a business being transferred. This can result in a valuation gap when trying to agree a price. Typically, contingent consideration – such as earn-outs – is used to bridge that gap; that way, the buyer and seller share some risk. The reliance on such mechanisms is on the rise, but they can sometimes lead to disputes as buyers seek to reduce amounts payable post-deal and sellers seek to demonstrate achievement of earn-out consideration. 

On completion of a transaction, buyers may also find things they hadn’t bargained for – there could be undisclosed issues such as supply-chain disruptions, dissatisfied customers or regulatory interventions. 

Different times

In buoyant economic conditions, buyers are generally able to grow their business post-deal, regardless of any underlying performance or other issues specific to the acquired business. Acquirers are also less likely to incur time and cost of pursuing a claim against a vendor for perceived breaches of warranty. For example, the seller might have told the buyer that it had three key ongoing contracts in place, but the day after the deal completes, one of them is cancelled. Depending on the circumstances leading up to the cancellation, in a buoyant market the buyer might focus on securing further contracts and its growth strategy, rather than bringing a potential claim.

In a period of challenging economic conditions, however, a buyer may be more motivated to explore any grey areas in the wording of an SPA. They are more likely to seek advice about whether it would be worth bringing a breach of contract or, as seems to be more prevalent in the current market, a breach of warranty claim. In some circumstance, dispute resolution clauses in the SPA may dictate a remedy, which may stipulate expert determination on specific matters to produce an out-of-court settlement. However, if there are grounds for a legal claim, litigation could result.

Value added

Damages in a breach of warranty claim are paid to compensate the acquirer by putting them in the position they would have been in, had the information as warranted by the seller party proved accurate – in other words, had it reflected the actual position of the target company. This exercise effectively compares the value of the business the buyer was expecting to buy with what was actually purchased – the starting point for which is likely to be the agreed price prior to the dispute.

Where a breach relates to earnings, the impact on valuation is likely to be a multiple of the alleged breach, such that the impact can be significant. For example, if the seller alleges the buyer knew earnings had been overstated by £1m and the price finally struck was based on a 6 x EBITDA multiple, the impact of the £1m discrepancy would be £6m. The buyer’s claim against the seller could be even greater if it is subsequently deemed that the earnings multiple used was overstated as a consequence of the breach and should have been, say, 4 x EBITDA.

Tread carefully

For business owners who might be planning an acquisition in the next year or so, it is especially important to apply rigorous due diligence from the outset. Getting the right team of professional advisers, with appropriate sector experience and understanding, will help to identify where value exists in the target business and the key risk areas that might adversely affect the securing of that value. Understanding whether the value is in an order book, for example, or in the people or intellectual property rights, or a combination of these, will determine the appropriate focus of due diligence.

But despite the increased focus on due diligence on both sides of the dealmaking process, post-deal disputes are continuing to arise. And if advisers aren’t asking the right questions during the dealmaking process, important protections could be omitted from the SPA, or may not be sufficiently defined to mitigate the risk of misinterpretation. Even if the right protections have been included, a lack of clarity with regard to key definitions could give rise to disputes at a later date.

With interest rates and costs rising and geopolitical uncertainty continuing to unsettle the markets, the current propensity for post-deal disputes seems likely to continue. To guard against this, businesses need to apply rigorous due diligence throughout the dealmaking process, based on a thorough and holistic understanding of both value and risk. Contractual arrangements must be clearly defined and understood by both sides.

There are signs that due diligence processes are becoming more rigorous, and that if issues are identified, they are explored more fully. While costs are increasing as a result, due diligence activity is usually phased, so they are incurred as the deal process progresses. From the vendor’s perspective, if issues emerge during the deal process, they are inclined to negotiate a way round them as pulling out would only mean the next buyer is likely to find the same issues.