17 February 2003
A typical source of complaint for buyers is when nasty surprises regarding the company's accounting or financial position materialise post-acquisition. And when disgruntled new management turn for recourse to the accounting warranty schedule in the sale agreement, all too often it is found wanting in key respects, and financial remedy through a breach of warranty claim may be frustrated. So, how can the pitfalls be avoided so that buyers avoid overpaying for their acquisitions?
The first common problem is when the warranties refer to the company's statutory accounts, but not to other important financial documents on which the buyer has relied and which, post acquisition, appear flawed. Consider seeking warranties on all relevant pieces of financial information used in due diligence - the vendor may not be prepared to give them, for example in respect of financial forecasts, but it can force useful disclosure. Think about whether previous years' statutory accounts and, in the case of a group, the individual companies' statutory accounts are of relevance. Also, consider any reliance on interim financial statements, monthly management accounts and the company's budgets and forecasts. Warranties regarding management accounts may be particularly important when only a part of the financial entity is being acquired, as the relevant business unit will, in all likelihood, not be visible in the aggregated results of the company.
A second general problem that arises is the use of imprecise accounting speak. Examples include terms such as 'true and fair', or 'material errors' without further definition. The expression 'true and fair' is an audit term referring to the subjective opinion reached on a set of financial statements as a whole, but potentially useless when trying to prove a breach in a specific part of the financial statements. Deciding what a 'material error' is can also be a minefield, not least because what is material to the relevant business unit being acquired may not be material to the financial entity as a whole. Lack of precision in language can also occur when accounting terminology not relevant to the jurisdiction concerned is used. A phrase such as 'in accordance with generally accepted accounting principles' has far more relevance to accounting treatments for US business - the principles are contained in a specific book published and updated each year - than it does in the UK. Here, the phrase has no statutory definition or regulatory authority and would allow more than one accounting treatment to be argued in the context of a claim.
The matter complained of may, on the face of it, constitute a breach of warranty, but the effect of the breach on the valuation of the business may be very difficult to show and so a financial loss difficult to prove. Be guided by the way the business is being valued and priced when considering the extent and detail of the accounting warranties required. Damages for breach of warranty are generally assessed on the basis of the difference between the market value of the business had the warranty been true, and value of the business as is - its 'true' market value. Establishing what these market values are, and whether these values correlate with the actual price paid for the business, is not always straightforward. Many businesses are valued according to non-financial considerations, for example their customer lists or their staff, rendering financial warranties irrelevant. The moral is that if you have relied on a particular aspect of a company's financial information to formulate a valuation and offer, then documenting this contemporaneously can be valuable in the context of subsequent claims.
The test of a good accounting warranty should be measured by the disclosures it may produce and the ease with which it facilitates subsequent financial recovery if post-transaction issues arise. Arguably, disclosure is more important because of the immediate opportunity it presents to reduce the purchase price when compared with the delay, uncertainty and cost associated with pursuing a warranty claim. Ironically, if some of the pitfalls described above could be avoided, buyers would negotiate better accounting warranties that they would never need to rely on after completion. I would be out of a job too.
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