Where Deals Go Wrong and How to Reduce the Risk
The final purchase price for a business often emerges after completion through post-completion adjustments. These are usually achieved via completion accounts and earnout mechanisms, designed to ensure fairness based on the business’s financial position at completion or its performance post-completion.
Earnout arrangements can help bridge valuation gaps between buyer and seller and incentivise sellers to remain engaged. Both mechanisms reduce buyer risk by aligning price with actual financial reality.
In practice, however, both mechanisms are a frequent source of dispute. These disputes can strain relationships, absorb significant management time, and become expensive to resolve.
Drawing on extensive experience as a forensic accountant and expert determiner, this article explores the most common causes of completion and earnout account disputes and how the risk of disagreement can be reduced.
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What Are Completion Accounts and Earnout Mechanisms?
Completion Accounts
Completion accounts adjust the initial purchase price to reflect the actual financial position of the business at the completion date. Adjustments typically relate to working capital, cash, and debt.
Earnout Accounts
Earnouts link part of the purchase price to the future performance of the business over a defined period. They are often used where buyer and seller expectations differ on value.
While both mechanisms are commercially sensible, they rely heavily on precise drafting and clear financial definitions.
Prevention Is Better Than Cure
The Sale and Purchase Agreement (SPA) must describe adjustment mechanisms clearly and comprehensively, accounting for all foreseeable scenarios.
Key considerations include:
Clear Hierarchy of Account Preparation
The SPA should define a strict hierarchy for preparing the relevant accounts:
- Specific accounting treatments
- Consistency with clearly defined historical accounting practices
- Compliance with an identified accounting framework, such as UK GAAP or IFRS
Where historical practices do not comply with the chosen accounting framework, the SPA should state which takes precedence. If a known non-compliant practice is to be followed, it should be explicitly included as a specific treatment and disclosed in the warranties.
Use of Proforma Schedules
Proforma schedules that map accounting records to completion or earnout accounts provide clarity and highlight complexities early. They often expose issues that would otherwise surface only after completion.
Common Causes of Completion and Earnout Account Disputes
Ambiguous SPA Drafting
Vague phrases such as “UK GAAP consistent with past practices” are a frequent source of disagreement. If past practices do not align with UK GAAP, the SPA must specify which prevails.
Subjective Accounting Judgements
Disputes commonly arise around stock valuation and debtor provisions. These can often be avoided by specifying objective criteria, such as:
- Stock provisioning percentages based on age or movement
- Debtor provisioning based on days overdue
Misaligned Target Figures
Problems occur when target figures do not reflect how completion or earnout accounts are prepared. For example, if certain assets are excluded from the completion accounts, they should also be excluded from target net assets.
Poorly Defined Financial Terms
Definitions of “revenue”, “cost of sales”, and “gross profit” are often insufficiently precise. For example, stock write-offs are standard accounting concepts but are frequently overlooked in bespoke SPA definitions, creating uncertainty when disputes arise.
Working Capital Manipulation
Working capital adjustments are one of the most contentious areas. Sellers may inflate working capital before completion, while buyers may argue for higher normalised targets.
Dispute risk can be reduced by:
- Setting a carefully calculated working capital target
- Analysing historical working capital trends
- Explicitly prohibiting manipulation around completion
Resolving Disputes Through Expert Determination
Most SPAs include an expert determination clause. While this provides a structured resolution mechanism, expert determinations often highlight the same underlying issue: inadequate drafting at the outset.
Engaging an experienced forensic accountant to review the SPA before completion can significantly reduce the likelihood of disputes and deliver long-term value.
To discover more, please call us on 0330 118 8200 or Make An Enquiry
Frequently Asked Questions
1. What is the most common cause of completion account disputes?
The most common cause is ambiguous drafting in the SPA, particularly around the hierarchy of accounting standards and historical practices.
2. Why do earnout disputes occur so frequently?
Earnout disputes often arise from unclear performance metrics, vague definitions of revenue or profit, and disagreements over accounting policies applied during the earnout period.
3. How can working capital disputes be avoided?
By setting a clearly defined working capital target based on detailed historical analysis and including explicit anti-manipulation provisions in the SPA.
4. Should a forensic accountant be involved before completion?
Yes. Involving a forensic accountant during SPA drafting can identify risk areas early and significantly reduce the likelihood of post-completion disputes.
5. What role does expert determination play?
Expert determination provides an alternative to litigation, but it is most effective when the SPA is clearly drafted. Poor drafting complicates the expert’s task of reaching a decisive outcome and increases costs.
Completion and earnout mechanisms are valuable tools in business acquisitions, but they require precision, foresight, and robust financial input. Clear drafting, objective criteria, and early forensic review remain the most effective ways to prevent disputes before they arise.
Disclaimer
The information contained in this article reflects the observations and experience of the author in the field of forensic accounting and is provided for general informational purposes only. Nothing in this article should be construed as legal advice, nor should it be relied upon as a substitute for professional legal advice, which (if required) readers should seek by consulting a suitably qualified and experienced legal adviser regarding their specific circumstances. Neither the author nor Frenkels Forensics makes any representations or warranties regarding the accuracy or completeness of any discussions of legal concepts. Neither the author nor Frenkels Forensics accepts any liability for any actions taken or not taken based on the content of this article.
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