True-Up Pitfalls of the Asset Purchase Agreement
Written by: Jay Sickler, CPA, CFF, ABV, ASA
I have recently been involved as an expert in two very contentious, big dollar, pieces of litigation involving the purchase price true-up following the close of an asset purchase. The litigation and financial forensic expert costs were very significant and probably could have been avoided had the parties to the deals engaged a firm like Cogence Group. This article speaks to a few of the lessons learned from my involvement during the course of litigation.
Both asset purchases involved the sale and purchase of selected current assets and current liabilities, defined as net working capital. Both transactions included the net working capital of the entire operating business of the seller. In one of the cases, the main fight was over inventory value transferred. The seller was in the business of producing and purchasing, and then selling, agricultural products. There were finished goods, purchased goods and bulk unprocessed product. The asset purchase agreement called for the bulk unprocessed product to be valued under “net realizable value.”
Net realizable value is an inventory valuation method defined loosely under Generally Accepted Accounting Principles (GAAP). In essence it is defined as net sales price less the additional costs necessary to get the product to a saleable state. Since this is really all the accounting guidance provides, it become abundantly clear during the litigation that the parties should have carefully defined what inputs were to be included in determining net realizable value and how the inputs were to be determined.
In the agricultural products case, the parties disagreed how and what data should be used to calculate the net sales price and the further costs to process the product. For example, they disagreed about whether full prior-year’s sales price be used to determine the net sale price at the closing date of May 31 the following year versus using January-April data. These same arguments were raised with respect to processing costs. However, the real area of contention related to whether a net realizable valuation model that was developed by the parties during due diligence and specifically included in the asset purchase agreement was controlling for purposes of the true-up post-closing. The buyer argued that since this model was developed by the parties to set the estimated closing inventory at closing, the exact same model should be used post-closing for any inventory true-up. They argued that the only input to be altered was the closing pounds of product based on the final inventory count. The seller after closing, argued that not only were the pounds to be adjusted, but also all the other inputs in the model used to calculate net realizable value.
I enjoyed working on this case and testifying as an expert. I get great satisfaction in using my financial forensic skills to problem solve in ways that really help the litigators (non-numbers people) present their case. However, with this great satisfaction came the realization that this litigation could have been avoided had the parties hired me during the negotiations to clearly set how the financial measurements and calculations were to work post-closing. The lack of preciseness and ambiguity in the asset purchase agreement were at the root of the dispute. This is not a criticism of the lawyers’ skills who negotiated the deal, because both the lawyers and the clients need to first recognize the need for this additional component during due diligence and then be willing to allot the time and money to add the forensic accountant to the negotiation team. This is easier said than done, when everyone is so focused on word-smithing an agreement that is hundreds of pages long, almost always under a tight self-imposed deadline to ink the deal.