Tips from our webinar: Breach of warranty claims - a review of the key issues
Is the buyer’s loss always a multiple of the overstatement of profits? Many businesses are valued based on a multiple of “underlying EBITDA” so if that can be shown to be overstated then the loss suffered would likely be the amount of the overstatement times by the purchase multiple (e.g. if “underlying EBITDA” was overstated by £1 million and the purchase multiple was 6, the loss suffered would be £6 million). However, it’s not always as simple as that, if the overstatement of financial performance is down to a one-off non-recurring expense, then it may be that there is no impact on “underlying EBITDA” and therefore no loss. The buyer has discovered that net assets of the target business are overstated, what is the loss? Where a buyer has had to write off fixed assets because they are impaired, stock which is unsaleable or debtors which are uncollectable the question is whether there is a resulting loss suffered by the buyer. There are three possible outcomes: 1. There may be no loss, for example if the write off has been caused by the application of a different accounting policy, or there is no cash cost to the buyer (e.g. the discovery of old stock items which can simply be thrown away).
The first of our 2022 webinars looked at the key issues arising in breach of warranty claims from a forensic accountancy perspective. Many of the warranty claims we get instructed on involve allegations that the sellers overstated the financial performance or position of the target in the run up to the transaction, thereby inflating the sale consideration. During the webinar we addressed questions we are often asked by instructing solicitors: The target’s accounts were audited, does that mean they can’t be challenged? Sellers often give a “true and fair” warranty over audited accounts and take comfort from the fact it mirrors the audit opinion. That doesn’t mean there can’t be a warranty claim, for example events may have occurred between the date the auditors gave their opinion and the date the warranty was given which now call into question the accuracy of the accounts. Ultimately, it’s the sellers who are giving the warranty and not the auditors so they should consider carefully whether there’s anything that has occurred that might give rise to a claim. It’s also important to note that many companies’ annual financial statements are not audited and thus warranting the accuracy of those accounts presents a higher risk to sellers.
The sale price was agreed by negotiation, how do you measure the loss? 3. There may be a loss on a multiple basis, for example if the target has routinely overvalued stock meaning an overstatement of underlying profits. 2. There may be a loss on a pound for pound basis, for example if the buyer has to incur repair costs to a fixed asset. For many mid-market transactions, the sale price is often the result of a commercial negotiation or “horse trade”
between buyer and seller. Consequently, it can be more difficult to establish how a buyer would have reacted had it been aware of the true situation. While it may not be recorded in a valuation model, there will usually be some logic behind the purchase price negotiation. Having understood this, we can use commonly accepted valuation methodologies to quantify the loss suffered. That said, keeping a contemporaneous record of the basis of valuation, key assumptions etc. is a good way to avoid any future debate.
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