By Pete Miller, CPA, CFE
A new business agreement is generally cause for excitement and celebration. Most people enter into such agreements in good faith and with the best of intentions. However, it’s important to plan for contingencies that are not apparent during those days of handshakes and high aspirations. Business disputes frequently arise because of accounting issues that were not fully thought out when drafting the contract that underlies a major business transaction, whether it’s a compensation agreement, a merger or acquisition, or the sale of real property.
In Clark Nuber’s experience, disputes usually arise either because of contingent compensation arrangements or some aspect of an agreement that relies on an estimate rather than a hard number. Knowing this in advance, giving these areas extra scrutiny and structuring agreements with related risks in mind can help avoid those disputes. In this paper, we present some examples based on real-world experience in which such advance planning could have saved headaches—not to mention legal and accounting fees—after the champagne had lost its bubbles.
Case Study 1: The Compensation Cliff
A typical situation in which Clark Nuber is called in to consult on a business dispute is a purchase and sale agreement featuring a contingent, performance-based payment. There are many ways to structure such agreements, but some are more likely to lead to conflict than others. One such risky situation is when parties agree to a contingent payment that is “all or nothing.” For example, imagine someone sells a business. The contract states that if the business makes $1 million in the first year after it is sold, the seller will receive a one-time contingent payment of $250,000. If the business makes $999,999.99, the seller gets nothing.
Both parties probably start out thinking they will come out on top. The seller has a lot of confidence in the business and is excited about receiving a big payout. The buyer probably thinks they will be able to avoid making the payment, and even if they do, the seller deserves it because the business was so worthy. However, once the date approaches, the buyer is suddenly tempted to do everything legally and ethically allowed to avoid making the payment. And, of course, the seller is extremely motivated to contest the issue. Whatever happens, there’s no win-win—one party will inevitably feel that they “lost.”
The situation might have been avoided if the “prize” was not so extreme, or if it had some room to vary based on circumstances. In this case, the parties might have agreed to a sliding scale that provides more room for negotiation as the payment draws nigh. For example, the buyer could be awarded some share of the business’s revenue or profit, or there could be a sliding scale of payouts based on other criteria. This would have lowered the stakes and spread the risk out among both parties. To avoid creating uncertainty—which can itself generate disputes—the method of calculating the payment should be well-defined based on Generally Accepted Accounting Principles (GAAP) and agreed to explicitly in the contract.
Case Study 2: Working Capital Woes
Often, a business purchase and sale agreement requires the seller not to “leave the cupboard bare.” They provide working capital—inventory, money, or other assets to help the business operate successfully. Leaving this “working capital” is in the interest of both parties, so its inclusion is not usually a point of contention.
However, the exact amount of working capital actually transferred by the seller is not usually known at the time the agreement is signed, so it is estimated. After some period, for example, 60 days from closing, the buyer has the opportunity to look at the books and calculate whether the working capital was lower or higher than the agreement stipulated. The seller can dispute the findings of the buyer, and (hopefully) they come to an agreement: if the working capital was low, the seller compensates the buyer; if it turns out it was high, the buyer compensates the seller.
This is usually a friendly process, but it can turn contentious. The value of working capital can be legitimately interpreted in various ways unless the method is stipulated in the contract. In such a case, the buyer has an incentive to lowball the value and the seller to do the opposite. Enter the lawyers and accountants to sort things out. To avoid problems, ensure that the method by which capital will be calculated is laid out clearly in the contract.
Case Study 3: Don’t Know Much About (Company) History
Another case in which estimates can be the source of conflict is a “return reserve.” Picture a company that sells aftermarket car parts. They always maintain a stock of items to accommodate customer returns. The valuation of this return reserve affects the profitability of the company because it is counted as an expense. .
Now imagine that the company is sold to a larger competitor, and the sale agreement includes a profit-based contingent payment to the seller. When the time comes to make the payment, the buyer values the return reserve higher than the seller would have under the old rules. Facing a lower contingent payment, the seller will almost certainly dispute the buyer’s calculations.
The easiest way to avoid such a problem is to write language into the contract that says “as historically applied.” In other words, “x (in this case, the return reserve) will be valued based on how we’ve always valued it.” This does not always work in favor of one party or another, but it keeps things in line with the expectations both parties have when setting out.
Case Study 4: Keep the Exits Clear
People going into business together are so excited about the possibilities of their partnership that they sometimes forget to consider how they will manage it when they part ways—an event that could be years or decades away. When an equity partner leaves a business, the value of their equity can be complex to determine even if the books are meticulously kept.
On the other hand, if the parties are less than careful with their accounting procedures it becomes a challenge that requires significant professional help. Perhaps partners don’t track business costs carefully enough, mix business and personal expenses, or allow borrowers to repay loans with more flexible terms than are stipulated in a loan agreement. While these informalities are second-nature in many closely held businesses, they complicate the determination of assets and liabilities as well as the distribution of equity when one or more partners decides to exit.
Parties to a business agreement should consider their exit strategies at the beginning. They should also recognize that their equity status depends on good accounting and be faithful to the original terms throughout the life of the company. If new partners are brought on, they should get up to speed on how accounting affects their equity and why they need to keep their house in order.
Case Study 5: Unexpected Bounty
Salespeople are often compensated on a commission such as a percentage of sales or a bonus for hitting targets. These types of contingent compensation agreements are typically thought to motivate performance and spread the risk between the parties. It sometimes happens that an individual greatly outperforms initial expectations, which in theory is great for the employer. However, when the employer sees all those profits going to the employee, he or she may feel the need to reinterpret the agreement.
This is often an issue of being too conservative in examining potential scenarios at the beginning of a relationship. The parties should discuss what will happen if a person who is being paid for performance greatly exceeds the estimate. The business owner needs to consider if they can bear to pay out the maximum they think is possible, and then consider what would happen if that number was multiplied by a factor of two or ten. As well, the method by which the contingent payment is calculated needs to be—you guessed it—understood and agreed by both parties before they sign.
Case Study 6: Mind the GAAP
While most companies of any size or complexity rely on GAAP, not every company does. And GAAP is not always written into business agreements, either. This can lead to problems, especially for estimates. GAAP is a best practice for drafting most business agreements because it’s clear and definable and provides a sound basis for nailing down tricky accounting issues.
Furthermore, parties will have a hard time arguing against GAAP unless some alternative is specified and justified in the agreement, and mediators may default to GAAP anyway because it is the most widely-accepted set of standards. It’s better to include language from the start stipulating that GAAP will be the basis of accounting unless there’s good reason to do otherwise. And, all parties should understand the potential implications of GAAP on any estimated items or contingent payments they may be entitled to down the road.
Most business transactions involve negotiation in which the parties disagree but come to a mutually acceptable solution without real conflict. However, almost every businessperson will experience a heated dispute at one time or another. When such an event appears on the horizon, start with a rational cost-benefit analysis of the situation. If the money at stake is not significant, there are less expensive ways of satisfying your professional pride than hiring a team of accountants and lawyers.
On the other hand, if you have a lot to lose, get your team around you quickly. Whether you’re engaged in a friendly negotiation or a pitched battle, Clark Nuber can help you decide which of your points are worth pursuing, focus your efforts, and improve your chances of success. By carefully analyzing the underlying documents and relevant accounting records, we help you build a strong case and get what you deserve.
And don’t forget that a well-drafted agreement—one that considers risks, minimizes unknowns, and clarifies everyone’s position—can support faster and less costly resolution of conflict down the line. That means it’s never too early to prepare.
© Clark Nuber PS, 2013. All Rights Reserved