Completion accounts: a science or an art?

In a climate of increasing economic uncertainty, buyers tend to apply greater scrutiny in valuing potential M&A targets. In such circumstances, buyers may opt for a completion accounts mechanism for determining the purchase price as this can offer greater opportunity to test the robustness of the target’s actual balance sheet and seek retrospective value adjustment as appropriate, in a way that locked box mechanisms cannot. In this blog, we consider the main causes of M&A disputes and how both buyers and sellers can plan ahead to remove a substantial element of subjectivity and take a rigorous, scientific approach.

Choose the right mechanism for the deal

Most M&A transactions follow either the completion accounts or locked box approaches to pricing, with a few deals attempting a hybrid of the two. Completion accounts include the actual balance sheet of the target company at completion whereas locked box accounts provide a balance sheet at an agreed point in time prior to signing the sale and purchase agreement (“SPA”). Parties will need to consider whether the advantage of the relative certainty of a locked box approach outweighs the risk introduced by the inability to adjust the purchase price for the business as it actually is when the deal closes.

In the present conditions of relative economic uncertainty, it may be harder, for buyers in particular, to feel sufficiently confident in the historical balance sheet of their M&A targets, where they opt for a locked box approach, even in apparently sound and well-controlled entities.

Buyers and sellers alike need to consider whether a completion accounts approach, with all its inherent challenges, is worthwhile pursuing to mitigate these risks. Fortunately, there are ways that all parties can add greater certainty to the completion accounts process and avoid future disagreements. It is these areas that we will now turn to.

Respect the hierarchy

Lack of clarity in the order of precedence set out in the SPA is at the root of many of the M&A disputes that we see. This accounting hierarchy will vary from deal to deal but typically includes three levels: (i) specific accounting policies set out in the SPA itself; (ii) consistency with a set of historical reference accounts; and (iii) Generally Accepted Accounting Principles (GAAP).

Usually, these levels are arranged in a ‘waterfall’ structure. However, we still see SPAs where a clear ‘waterfall’ has not been adopted or there are inconsistencies in the order of precedence. In these circumstances, there is the potential for ambiguity and alternative interpretations of the accounting treatment of a particular balance sheet item. This, in turn, creates greater scope for disagreement between the parties as to the appropriate purchase price adjustment.

In particular, we often see requirements that a set of completion accounts (or particular balances therein) are both compliant with GAAP and consistent with a set of historical reference accounts. This is based on an assumption that the reference accounts are themselves compliant with GAAP, but what if they are not? Or at least, not fully compliant? Positioning these two levels of the hierarchy as equal to one another creates space for a party to argue that the reference accounts are not compliant with GAAP and that, therefore, the completion accounts should be adjusted. This creates a particular challenge where the approach drives a wedge between the basis on which target working capital was set and the ultimate assessment of actual working capital at closing.

Parties who want to mitigate against M&A disputes should, as part of their SPA review and negotiation before signing, make sure that they:

• ensure the order of precedence is clear and unambiguous.
• be particularly aware of the understandable assumption that previous sets of reference accounts are fully compliant with relevant GAAP.

Relieving tensions

Inconsistencies in the SPA also reach beyond the accounting hierarchy. M&A disputes often arise from a tension between two or more of the accounting policies or definitions, both apparently relevant to a particular balance, but giving rise to a different value.

The definitions in the SPA, such as those of Cash, Debt and Working Capital, typically underpin the preparation of the completion accounts and understanding their interaction with the accounting policies and an understanding of the target is critical. For example, it is generally in the Buyer’s interest to categorise liabilities as debt rather than working capital, as this ensures a pound-for-pound deduction to the purchase price, rather than being limited to the difference between target and actual working capital. By way of example, provisions are susceptible to differences in classification and valuation by the parties, particularly where it is not clear cut as to whether those provisions form part of the ordinary course of the target’s business and how they are to be assessed.

Parties should also consider the assumptions used in valuing the target company when drafting the accounting policies for certain balances to avoid ‘double counting’. For example, the headline price of a property in a real estate deal may assume a certain level of capital expenditure to maintain the property and its rental income. Providing a separate deduction for this capital expenditure as part of the completion accounts mechanism could be duplicative in arriving at the final purchase price.

Parties who want to mitigate against M&A disputes should, as part of their SPA review and negotiation before signing, make sure that they:

• look for potential inconsistencies both within in the completion accounts policies themselves (such as requiring both consistency with GAAP and with a set of reference accounts) and between the completion accounts policies and the relevant definitions;
• consider the approach they took to valuing the deal and make sure that this is appropriately reflected in the completion accounts policies; and
• carefully consider how the purchase price mechanism might be manipulated.

Reduce the ambiguity

Another regular source of M&A disputes is the inclusion of completion accounts policies that are potentially ambiguous. We often see SPAs which specify that a particular accounting standard or approach should be followed, but do not specify how judgement required by the standard or approach should be applied.

For example, the SPA may specify that bad and doubtful debts should be fully provided for, but not specify how those debts are to be identified.

Parties who want to mitigate against M&A disputes should, as part of their SPA review and negotiation before signing, make sure that they:

• put themselves into the other party’s shoes and consider how they could use the accounting policies to their advantage; and
• carefully consider whether there is any ambiguity in either the accounting policies or key definitions.

Increase the science and reduce the art

Completion accounts are a set of special purpose accounts used to inform the final purchase price of a target company. As a consequence, they differ from audited accounts in terms of the timing, nature and materiality of balances captured. Specific accounting policies drafted in the SPA serve to address these differences and create greater clarity in completion accounts preparation, particularly for areas that are inherently more judgemental, uncertain, complex or new.

Completion accounts are an attractive approach, particularly to buyers, in a climate of considerable uncertainty. When deployed in conjunction with robust drafting, they are an effective tool in mitigating certain financial risks, whilst limiting the scope for dispute. Although there will always be an art to preparing and reviewing completion accounts, the use of precise and unambiguous accounting policies and a clear hierarchy removes a substantial element of subjectivity and allows for a rigorous, scientific approach. Above all, parties should, as part of their SPA review and negotiation before signing, make sure that they:

• consider the completion accounts provisions of the SPA carefully, with appropriate consideration to how they might be manipulated in favour of one party or the other;
• resolve any ambiguity or tension in these provisions at the SPA drafting stage – it is always harder to resolve once there is a value attached to it; and
• favour certainty and objectivity in accounting policies for key judgement areas, potentially even at the expense of flexibility after the event.

We are happy to assist you, either with advice on resolving a contentious M&A matter at the negotiation phase, or with navigating the expert determination process. If we can help, please get in touch with Claire Jolly, Matt Odams or Helen Lopez-Adams.