A ICPA Practice Aid: Mergers and Acquisition Disputes

1. AICPA Practice Aid: Mergers and Acquisition Disputes G. William Kennedy, Ph.D., CPA/ABV Managing Director FTI Consulting, Inc. Bill.kennedy@fticonsulting.com

2. When Do Shareholder Disputes Occur? Shareholder Class Action Minority Shareholder Buyout Minority Shareholder Dissent Minority Shareholder Squeeze out Former Shareholder Dispute M&A Transaction Buyer Benefitof the Bargain/ Breach/Fraud Material Adverse Change Purchase Price Adjustment Letter Of Intent

3. AICPA Mergers and Acquisition Disputes Practice Aid • The AICPA Practice Aid, Mergers and Acquisition Disputes was issued in early 2012 • The Practice Aid was authored by the AICPA Mergers and Acquisitions Dispute Resolution Taskforce • To supplement the Practice Aid, Taskforce activities included authoring articles for the AICPA Journal of Accountancy and providing presentations at AICPA National Forensic and Valuation Conference on M&A Disputes services provided by CPA’s

4. AICPA M&A Dispute Resolution Taskforce • The Taskforce was comprised of 5 attorneys representing the ABA M&A Committee and 12 CPA’s representing the AICPA Forensic and Litigation Services Committee • Members of the Taskforce were selected for their expertise in practice area of M&A disputes • Taskforce activities included reviewing and commenting on the • ABA’s Model Stock Purchase Agreement and the • ABA’s Model Asset Purchase Agreement

5. Introduction and Scope of Practice Aid • The Practice Aid was prepared for the CPA practitioner who serves in the role of the neutral accountant, consultant, or expert witness in engagements involving M&A purchase price disputes • Focus of the Practice Aid: • Theoretical • Legal • Accounting basis www.aicpa.org/fvs

6. Chapter 1: Overview of Merger and Acquisition Transactions and Disputes

7. The Purchase and Sale Agreement

8. 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) • Provisions governing earnouts (if applicable) • Representations and warranties of parties • Indemnification provisions • Offers protection but can also present hazards www.aicpa.org/fvs

9. Representations, Warranties, and Covenants • To gain comfort in the valuation of the target, Buyers often require certain assurances from Seller. • Financial statements provided by management during due diligence are prepared 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, etc.) • No undisclosed Material Adverse Changes have occurred • Operation of business in ordinary course www.aicpa.org/fvs

10. Determining the Purchase Price

11. 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 incorporates synergistic considerations www.aicpa.org/fvs

12. The Purchase Price • Market Approach (Financial Element x Multiple) • Financial element can be earnings measure (e.g. EBITDA) or balance sheet measure (e.g. assets) depending on business • Multiple – Based on multiples derived from companies determined to be guideline comparable companies • Income Approach • Discounted cash flow valuation • Required internal rate of return (IRR) based on earnings projection • Cost Approach • Not applicable in most deals www.aicpa.org/fvs

13. Concluding a Purchase Price • While relevant, valuations of the parties do not always result in the precise purchase price agreed upon. • A number of factors may influence the ultimate purchase price determination. • The ultimate purchase price is the result of the negotiation between the parties.

14. Chapter 2:Post Closing Purchase Price Adjustments

15. Post Closing Purchase Price Adjustments • Introduction-Post Closing Purchase Price Adjustments • Background of a Purchase Price Dispute • The Role of a CPA in a Post-Acquisition Dispute • Post-Acquisition Dispute: An Overview • Illustration of a hypothetical Seller’s perspective and Buyer’s perspective

16. Background of a Purchase Price Dispute • An acquisition price may reflect a negotiated or implicit valuation multiple of earnings/EBITDA between a Buyer and a Seller • As a consequence of the transaction, there is a negotiated mechanism in the purchase agreement to “true-up” the balance sheet acquired by the Buyer • Usually, the parties are entitled to the following post-closing adjustments: • GAAP adjustments • Other “dollar for dollar” adjustments provided for in the agreement • The Buyer may additionally or alternatively be entitled to: • “Benefit of the bargain” damages, if there is a material misrepresentation of the financial statements by the Seller

17. The Role of a CPA in a Post-Acquisition Dispute • As an Expert • As an Arbitrator • As a Mediator • As Advisor to the Attorney as Arbitrator

18. Post-Acquisition Dispute – An Overview • Seller’s Representation • “GAAP” vs. “ Consistency” • Subsequent Events • Comparison of the Seller’s perspective vs. Buyer’s perspective

19. Seller’s Representation • “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.” www.aicpa.org/fvs

20. “GAAP” vs. “Consistency” • 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 would probably trump consistency (depends on the facts and circumstances of the case)

21. Subsequent Events • A hotly contested issue • In general, the Arbitrator would consider what is known or knowable at the date of the closing balance sheet. In addition, the Arbitrator is often asked to consider: • What is known or knowable at the date of the preparation of the closing balance sheet, or “report date” • Whether later subsequent events indicate that the Seller’s position is unreasonable regarding what was known or knowable

22. Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s Perspective Seller’s • 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

23. Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s Perspective Seller’s, Continued • Limit escrow • Seller’s accountants should prepare closing balance sheet • Consistency is retroactive to the Target Balance Sheet (TBS) and offsetting to claims in the CBS • 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

24. Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s Perspective Buyers • 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

25. Illustration of a Hypothetical Seller’s Perspective vs. Buyer’s Perspective Buyers, Continued • 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

26. Chapter 3:Earnout Provisions and Disputes

27. What is an Earnout? A contingent element of the acquisition’s purchase price determined post-closing based on the target business performance against certain contractually defined criteria or benchmarks. www.aicpa.org/fvs

28. What is an Earnout? Illustration of Earnout as Component of Total Purchase Price Closing Consideration – 12/31/09 $100 +/- Net Working Capital Variance from Peg – 2/28/10 5 + Earnout Amount – 12/31/10 10 Total Purchase Price $115 Where 2010 EBITDA was $22 million, and the Earnout Amount is defined by the Earnout Agreement to equal 5x EBITDA during 2010 in excess of $20 million. www.aicpa.org/fvs

29. Why do Parties to Deals Utilize Earnouts? Effective negotiating tool when differing perspectives on value and/or outlook for the target business 20% Growth 10 % Growth

30. Why Do Earnouts Appeal to Sellers? • Protect Seller from failing to realize value in their business. • May allow Sellers to obtain greater consideration that they might receive otherwise. • Can be advantageous in difficult economic climates (such as today). • May allow Seller to control its own destiny when Seller management will continue to be involved in business post-closing.

31. Why Do Earnouts Appeal to Buyers? • Protect Buyer from overpaying for the target business. • Effectively Seller financing – reduces cash necessary at closing. • Can distinguish Buyer’s bid when there are multiple suitors for target. • Indicates confidence of Seller. • Motivation of Seller management when Seller management will continue to be involved in business post-closing.

32. Why Don’t Parties Utilize Earnouts? • Shared concerns of the Buyer and Seller • Ability to “move on” post-closing. • Difficulty of administration post-close. • Challenge of negotiating for all contingencies. • Fear of post-acquisition disputes. Buyer-Specific Considerations • May restrict integration of target. • May indicate uncertainty. • Concern of compensating Seller for Buyer enhancements. • Fear of manipulation of earnout by Seller management. Seller-Specific Considerations • Lack of control of business. • Lack of custody of records. • Fear of manipulation of earnout. • Concern that value in business will not be realized. www.aicpa.org/fvs

33. Mechanics of Earnouts

34. Financial Benchmarks: Income Statement Measures Seller’s Negotiating Preference Buyer’s Negotiating Preference www.aicpa.org/fvs

35. Common Disputes Involving Earnouts

37. Areas of Dispute Regarding Operation of Target • When business is operated by Buyerpost-closing… • Perceived management of business to minimize performance measures and in turn the earnout. • Alleged deviation from consistent historical operating norms. • Alleged failure to invest in the business / provide for adequate capital. • Alleged failure to pursue opportunities. • Alleged impairment of earnout due to discontinuation of business. • Alleged shifting of sales or customer relationships from target to other Buyer entities. • When business is operated by Seller managementpost-closing… • Perceived management of business to maximize performance measures and in turn the earnout.

38. Disputes Regarding Accounting Areas Prone to Dispute in Earnout What should / should not be included when measuring the target’s performance against earnout benchmarks? www.aicpa.org/fvs

39. Valuation of Earnouts in M&A Transactions

40. Valuation of Earnouts • Old Standard – any expected contingent consideration would be recorded when earned • Revised Standard (SFAS 141R) – any expected contingent consideration is measured at Fair Value • Recognized at the acquisition date • Re-measured annually until all contingent consideration is paid

41. Valuation of Earnouts, Continued • Sample Facts: • Deal price – $1.8 billion • EBITDA – $100.0 million • Contingent Consideration Earnout: • 50 percent of every dollar of EBITDA that exceeded $100.0 million • Term of Earnout – 2 years • EarnoutCap – $40.0 million

42. Example: Buyer’s Projected EBITDA: Valuation of Earnouts, Continued Scenario Approach: [a] Calculated using the “mid-year convention,” which assumes that cash flows will be received evenly throughout the projection period rather than at the end of the period. www.aicpa.org/fvs

43. Chapters 4 & 5:Material Adverse Change Clauses and Representation and Warranty Disputes

44. Material Adverse Change, Measuring Damages, and Related Pitfalls

45. Standard Material Adverse Change Clause Purchase and Sale Agreements typically include a Material Adverse Change (“MAC”) clause containing language similar to the following: • Material Adverse Change: • Any event, development, circumstance, change or effect that is or would reasonably be expected to be materially adverse to the business, financial condition or results of the operations of the Acquired Company

46. Standard Material Adverse Change Clause, Continued Purchase and Sale Agreements typically include a Material Adverse Change (“MAC”) clause containing language similar to the following: • Representation of Seller • Since date XX, there has not been any Material Adverse Change in the business, operations, properties, prospects, assets, or condition of any Acquired Company, and no event has occurred or circumstance exits that may result in such Material Adverse Change.

47. What is a Material Adverse Change (MAC)? Based on VC Strine’s ruling in this case, a MAC may have been sustained if: • Dramatic downturn in earnings from the date of the signing of the SPA and before the closing. • There is a downturn in the business that is disproportionate to the industry. • The downturn is durationally-significant (or over a commercially reasonable period), meaning years and not months (is the downturn a blip or a trend?), and • The change in the business in unknown to the Buyer. IBP, Inc. v. Tyson Foods, Inc.

48. 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 1 Litigation Service Handbook, Fourth Edition, 18.7 www.aicpa.org/fvs

49. 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. www.aicpa.org/fvs

50. 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