3 questions to smart minds

Damage evaluation for company purchase agreements

For this 3 questions to K. Schumacher

Alva­rez & Marsal
Photo: K. Schu­ma­cher | Alva­rez & Marsal
26. June 2013

In the tran­sac­tion of a company, many details must be thought through and desi­gned as opti­mally as possi­ble. The enter­prise value must be calcu­la­ted. The fore­casts for the future deve­lo­p­ment of the company must be reali­stic and plau­si­ble. The tax orien­ta­tion should also be desi­gned with fore­sight. All these para­me­ters are also sources of error. What dama­ges can arise in company purchase agree­ments and how can they be coun­te­red or, better yet, avoided?

For this 3 ques­ti­ons to Senior Direc­tor at the manage­ment consul­tancy Alva­rez & Marsal in Munich

1. How often do conten­tious situa­tions actually arise in corpo­rate transactions?

Nobody really wants dispu­tes in connec­tion with corpo­rate tran­sac­tions. Due to the high purchase prices, howe­ver, dispu­tes arise more frequently than expec­ted — from post-contrac­tual discus­sions and renego­tia­ti­ons to liti­ga­tion before a court or arbi­tra­tion tribu­nal. Toge­ther with a busi­ness part­ner, we conduc­ted a study on this based on over 1,300 corpo­rate tran­sac­tions. This study concluded that curr­ently about 10 percent of all tran­sac­tions result in renego­tia­ti­ons or become conten­tious in one form or another. The parti­ci­pants in our survey even anti­ci­pate an increase in dispu­tes in the future. The back­ground to this is that the current econo­mic condi­ti­ons and compli­ance regu­la­ti­ons leave many market parti­ci­pants with no choice, as they would other­wise have to forego a purchase price of seve­ral million euros or pay too much when buying. More than 12 percent of study parti­ci­pants even repor­ted redu­cing the purchase price by more than 50 percent in at least one tran­sac­tion through renego­tia­tion or dispute.

2. How is damage deter­mi­ned in a sales contract in the first place? What are the possi­ble sources of error?

In prin­ci­ple, the inju­red party should always be placed in the posi­tion he would have been in had the injury not occur­red. Howe­ver, this rela­tively simple prin­ci­ple of damage assess­ment must be adapted depen­ding on the juris­dic­tion and the contract of sale. And these adjus­t­ments can be rela­tively complicated.

The most commonly used form of damage assess­ment is the “but-for scena­rio.” It compa­res the actual situa­tion (with damage) with the target situa­tion (without damage). In the course of the diffe­rence analy­sis, loss-incre­asing and loss-redu­cing compon­ents such as tax effects, inte­rest, loss reduc­tions or simi­lar can also be taken into account. It beco­mes more diffi­cult if the damage affects, for exam­ple, the EBIT or EBITDA of the stan­dard year and the parties have deri­ved the purchase price using the EBIT/EBITDA multi­plier. In this case, the ques­tion always arises whether the damage should be compen­sa­ted only once or seve­ral times (in the amount of the multi­plier). — These are extre­mely exci­ting ques­ti­ons, and not only from a legal perspective.

The most common source of errors in prac­tice, on the other hand, are accoun­ting errors or occur in the case of balance sheet guaran­tees. If, for exam­ple, a provi­sion was omit­ted, even expe­ri­en­ced liti­ga­tors still assume that the damage “only” repres­ents the balance sheet short­fall — euro for euro. Howe­ver, inte­rest effects, taxes, conse­quen­tial losses and loss miti­ga­tion quickly lead to actual losses that can be 40 percent or more above or even below that. Parti­cu­larly in the case of larger balance sheet defi­cits, we ther­e­fore advise our clients to make more precise determinations.

3. What tips and recom­men­da­ti­ons would you give before/ during a corpo­rate tran­sac­tion to prevent ‘misun­derstan­dings’?

Our tips are very prag­ma­tic. First of all, we cannot empha­size enough how important it is to have an expe­ri­en­ced legal advi­sor on your side who does not just copy text modu­les toge­ther, but above all considers the interactions.

From the buyer’s perspec­tive, it also crea­tes trans­pa­rency to disc­lose the deter­mi­na­tion of the purchase price in the purchase agree­ment. From the vendor perspec­tive, access to records in the event of a dispute is always a vexing issue. Here, a good purchase agree­ment should alre­ady contain appro­priate anti­ci­pa­tory provi­si­ons for the contingency.

Due to the incre­asing number of dispu­tes after the closing, the preser­va­tion of docu­ments and, above all, of the commu­ni­ca­tion conduc­ted is beco­ming more and more important. Finally, nume­rous post‑M&A lawsuits fail solely because of the evidence requi­red. Also, one or two lost post‑M&A lawsuits at a private equity fund can be enough to put pres­sure on the requi­red target return.

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