In a current case at the High Court, Hewlett Packard is suing Mike Lynch, the founder of Autonomy plc, over allegations that he fraudulently inflated the value of the business prior to its acquisition in 2011. Could the outcome of this high-profile case prompt more, costly, post-deal litigation?
Now adjourned until September, this case comes at a time when the accountancy profession is facing greater scrutiny over the quality and reliability of financial statements. As such, it is becoming even more important for businesses embarking on any deal-making process to take steps to ensure the financial data upon which they are basing their decisions is robust and accurate.
Due diligence and fair representation
This might involve reviewing the terms of contractual agreements in order to assess whether their projected value is accurate, concentration risks, length of contractual terms and the re-tendering process. Depending on the due diligence findings, further scrutiny of the customer relationship may be required to assess the risk of the contract(s) coming to end earlier than expected. Reviewing reported financial data alone will not present the full picture.This high-profile litigation is a reminder that prospective buyers should ensure that due diligence processes are thorough and dig deeper than merely headline financial data, regardless of its audit opinion. When considering the projected earnings of the business, for example, due diligence providers apply a greater degree of professional scepticism and test the figures provided and stress testing the likelihood of projections being achievable.
Similarly, for the seller, it is important to ensure that the financial position presented to the prospective buyer is a fair representation of the underlying business to ensure representations and warranties/protections can be given with confidence. Not only will this help to streamline negotiations and minimise the need for late-stage adjustments, it could also mitigate the risk of costly litigation should a post-transaction dispute arises.
It’s entirely natural for deal negotiations to give rise to tensions – the seller is pursuing the optimum valuation while the buyer wants to receive the best deal possible including warranties and other protections. The parties involved may need to compromise their position to bring the deal to completion but the importance of access to reliable and accurate financial data should never be overlooked. If either party has cause for concern or believes over-optimism may be clouding the facts, closer scrutiny may be required to protect their interests – it’s better to be safe than sorry.
Once deal negotiations are underway, and the ‘data room’ is open, it is important for all parties to stay alert to potential issues and undertake further due diligence enquiries if required. For example, a buyer’s due diligence team would normally expect a seller to share accounts and other financial data in an open and transparent way. If any reluctance is shown or unnecessary barriers are imposed, this should be treated as a red flag warranting further consideration.
During the deal-making process, whilst tightly drafted SPAs and accompanying warranties can provide the parties involves with legal and financial protections, over reliance on them can be costly. It is far better to truly understand the risks and rewards ahead of time.Other potential red flags include over-complex group structures; the late filing of accounts; late changes; re-statements or a general lack of clarity in the financial data provided. For example, the latter might include a major asset being locked into the accounts without a breakdown of how its value has been determined. Understanding the reasons for delays, lack of clarity or restatements is an important step in the process.
The costs of post-deal disputes should not be underestimated and they are not just financial. Employing legal and accounting professionals to review matters after the event, in order to unpick what should have been known by whom and when, is rarely a quick process. This coupled with the uncertainty and distraction caused to the enlarged business could undermine its value and could even mean missing out on opportunities to grow the business and/or complete further deals.
Ross Wiggins is corporate finance director specialising in due diligence and Matthew Haddow is a forensic accounting specialist, both at accountancy firm, Menzies LLP.