The M&A market weathered another difficult year in 2023, which was marked by tightening capital, the prospect of a potential recession, and an uncertain geo-political environment. Deal activity was sluggish and we saw both an increase in broken deals and a decrease in valuation. With 2024 underway, we are seeing signs that the deal market will pick up in the months ahead as the market emerges from the macroeconomic uncertainty that affected 2023. Even with this tentative optimism, we expect continued scrutiny on every aspect of deals that are going through.

Due to lower valuations, buyers and sellers alike are increasingly focused on strategies to mitigate risk and capture and protect value. As transactions become more and more sophisticated and every dollar is scrutinized, it is critical that buyers and sellers understand which aspects of the deal are within their control and can be used to address inherent risks. Comprehensive due diligence is the first step in mitigating risks in a transaction; however, if the due diligence findings are not properly reflected in the sale and purchase agreement (SPA), buyers and sellers may not actually be protected from identified risks.

To remain competitive in this evolving economic environment, both buyers and sellers would benefit from seeking outside support to assist with reviewing and negotiating the SPA as early in the process as possible. Hiring an SPA advisory expert can help mitigate risk in two ways: 1) protecting against value erosion and 2) preventing post-closing disputes.

Potential areas of misalignment

In our experience, value erosion often happens due to misaligned expectations between the parties, or a lack of sophistication in negotiating the terms of the agreement.

A seller facing unfavorable terms, or lacking protection from buyer’s post-closing judgments, may end up receiving less cash or equity consideration than they anticipated. A buyer dealing with a target that overstated assets/downplayed liabilities may not have the contractual wiggle room to adjust the final purchase price accordingly and could end up overpaying for its investment in the target.

It's important for buyers and sellers to be aware of trends and strategies to address valuation gaps identified during the diligence process and employ them in the negotiation of the SPA. Creative strategies for bridging valuation gaps include earn out provisions, specific escrow arrangements, representations and warranties insurance, staggered payments, and heavily negotiated post-closing adjustments.

We’ve also been seeing the concept of “retained cash” or “excess operating cash” used more frequently. In most cash-free, debt-free transactions, the buyer does not pay for cash or assume any debt. Any cash on the balance sheet at closing increases the purchase price and the seller is responsible for any debt (or accepts a decrease in the purchase price). With a retained cash concept, parties agree that the target business will retain an amount of cash on hand for operations that are not adjusted in the purchase price. The assessment and valuation of excess cash becomes important in the evaluation of valuation adjustments, acquisition financing, negotiation leverage, tax considerations, and pre-closing distributions.

During periods of macroeconomic headwinds, accounts receivable (AR) is another asset that can be difficult to value. In addition to ensuring the accuracy of the AR balances pre-closing, counterparties would benefit from negotiating specific terms that govern any post-closing working capital adjustments related to AR and the mechanism for handling any variances. This protects the buyer from any uncollectable AR and ensures the seller is appropriately compensated for this asset.

Purchase price disputes

Post-closing purchase price disputes are another area where significant value can be lost; not to mention the time, expense, and effort such disputes often require.

In the United States, most SPAs apply a “completion accounts” pricing mechanism where the final purchase price is adjusted for certain amounts (typically cash, indebtedness, working capital, and transaction expenses). Parties estimate these amounts at the time of closing and then true up to actual amounts after the deal closes. The post-closing purchase price adjustment is designed to protect the buyer from changes in the financial position of the business between sign and close, and/or compensate the seller for additional earnings/profits generated.

Disputes happen for a variety of reasons, but two of the most common are gaps in valuation and poorly drafted language. If a party takes issue with the deal pricing, the most efficient remedy is to address concerns in the SPA prior to signing with the help of an SPA expert. If the SPA language is vague or inconsistent relative to certain diligence findings and representations of the target company, this leaves the possibility of a dispute where a party may try to claw back value it feels was lost in the deal terms open.

Conclusion

The economic success of a transaction can be impacted by adjustments made to the agreed headline price. As referenced throughout this article, one of the most significant challenges in M&A deals is mitigating the risk of value erosion due to unfavorable or poorly worded contract terms in the SPA. Engaging an SPA advisory expert early in the M&A transaction process is no longer a “nice to have” option but rather a necessity to protect and retain value; an essential component of any deal strategy.