Case Study: Presentation of Financial Statements

When acquiring a company, the buyer typically requires the seller to represent and warrant that its financial statements “fairly present in all material respects the financial condition and operating results of Seller as of the dates, and for the periods, indicated therein.”  In fact, according to data available in our Forsite™ M&A Deal Tool that we have collected from over 500 M&A transactions where we have served as shareholder representative, 98% of all merger agreements contain such a representation:

With the prevalence of such a representation, and the importance of that representation to the buyer in completing a merger, it does not surprise us that this representation is frequently the basis of post-closing claims.

Recently, a public company buyer acquired a private company, and required that the seller make the standard “fair presentation” representation in the purchase agreement.  In addition, the buyer required the seller to represent that the financial statements had been prepared in accordance with “generally accepted accounting principles.”  Post-closing, the buyer determined that the selling company had incurred a number of liabilities pre-closing that were not reflected in the financial statements.  Based on that, the buyer brought a claim against the escrow established in the acquisition, alleging that, because of the undisclosed liabilities, the financial statements did not “fairly present” the financial condition of the company nor were the financial statements prepared in accordance with general accepted accounting principles.

As representative of the selling shareholders, Fortis stepped in to investigate and resolve the matter.  The seller provided to us detailed information regarding its accounting practices, demonstrating that the seller operated on a “cash basis,” meaning that they did not record revenues until the cash arrived (even if performance was complete), and did not record liabilities until they received an invoice (even if the services were complete).  The undisclosed liabilities in question represented consulting services completed pre-closing but not billed until post-closing, and software and hardware licensing fees that were not due until after closing, although the contract for the software and hardware was entered into pre-closing.

The buyer argued that failure to include these liabilities on the financial statements violated GAAP as required under public company accounting.  We pointed out that the seller was not a public company, and using the cash basis of accounting is a “generally accepted” principle of accounting.  In addition, the agreements underlying the claimed liabilities were fully disclosed as part of the due diligence process, and were listed in the disclosure schedule to the merger agreement.  The buyer argued that nowhere was it stated that the seller’s financial statements were developed using the cash method of accounting.

Ultimately, the parties reached an amicable resolution; however, this issue suggests that during negotiation of the merger agreement, the seller could have disclosed  its financial statements were based on the cash method, or the buyer could have made clear it required  public company GAAP to apply to the representation.

M&A transactions present a wide range of situations where post-closing claims can arise.  As a leading post-closing shareholder representative on private M&A transactions, we have faced these issues many times on behalf of selling shareholders, and can effectively deal with these issues through our experience, judgement and the ability to work with and establish credibility with all parties to the transaction.  Please contact us if you would like to discuss this issue or any other post-closing matter in connection with M&A transactions.

Also, please check out Fortis Advisors’ Forsite™ M&A Deal Tool, our reference tool for the M&A community to empower dealmakers with the data they need to understand “market,” negotiate better deals and follow emerging trends.  For additional insights into the data, along with practice tips on M&A transactions, please visit our After Closing Series and Fortis Insights.