Financial due diligence and its impact on valuation and contractual negotiations

Introduction

Financial due diligence (FDD) is a critical process in M&A since it provides a thorough analysis of a target company’s financial health, its historical operating performance and its potential for future growth. It serves as a diagnostic tool that helps buyers and investors to identify the true value of a company and to detect potential risks. By thoroughly analysing a company’s financial statements, disclosed liabilities, profit margins, cash flows and revenue streams, FDD enables the incumbent parties to base their decisions on data rather than assumptions, thereby minimising uncertainty in what is often a complex transaction.

The importance of FDD extends beyond merely verifying financial information: it plays a central role in shaping the valuation of the target company, helping to determine whether the asking price may accurately reflect its financial realities. Through the process, buyers can uncover issues such as unsustainable revenue sources, aggressive accounting practices and unrecorded liabilities that may significantly impact the company’s perceived value. At the same time, FDD can also highlight growth opportunities and competitive advantages, providing a more nuanced perspective that influences the valuation positively.

In addition to valuation, FDD influences the negotiation process between buyers and sellers. For buyers, by uncovering potential risks and inconsistencies, FDD provides them with the information needed to negotiate protections in the contract, such as indemnities, escrow arrangements and purchase-price adjustments. For sellers, the findings from FDD can be used to proactively address buyer concerns, enhancing their credibility and strengthening their position during negotiations. This dynamic makes FDD not only a diagnostic tool but also a strategic lever that drives the terms and structure of the deal.

A key feature of effective FDD is its interdisciplinary nature, requiring collaboration between financial, and tax and legal professional advisers. In this sense, a joint rather than isolated assessment of the financial, tax and legal areas carrying out the due diligence of the target company is a highly advisable approach. While accountants and financial analysts focus on the quantitative aspects, such as verifying historical performance and forecasting future cash flows, legal experts ensure that identified risks are adequately reflected in the deal’s contractual framework. This integration bridges the gap between financial insights and legal protections, providing a comprehensive approach to risk mitigation and value creation.

FDD may also play a pivotal role in aligning the expectations of all parties involved. In an M&A transaction, discrepancies in valuation or risk perception can derail negotiations. The insights gained from a thorough FDD process not only facilitate transparency but may also foster trust, reducing information asymmetry and creating a stronger foundation for collaboration. This is of particular importance in cases in which the M&A transaction also implies future acquisitions or sales, as the insights can set the rules for call and put options between buyers and sellers.

This trust is especially crucial in cross-border transactions, where differences between jurisdictions in accounting standards, ways of conducting a given activity, the legal system and cultural approaches can complicate the understanding and the development of the transaction.

The purpose of this chapter is to briefly list some main findings and examine how financial issues that arise from FDD are effectively translated into legal clauses and definitions within the share purchase agreement (SPA) and other transaction documents in M&A transactions.

Financial aspects in contractual clauses: civil law perspective

In M&A, accurately addressing financial findings in the SPA is crucial to safeguarding the interests of both buyers and sellers. Under civil law systems, such as those of the Latin American countries, the contract is the primary source of rights and obligations, making the precise drafting of the transaction documents essential.

Civil law relies heavily on the express terms of the agreement; therefore, detailed clauses and tailored definitions of key financial concepts such as working capital are not only a best practice but a necessity to ensure the enforceability of terms in a civil law system context. For example, in Argentina, the Civil and Commercial Code emphasises the principle of good faith^[2] and the binding nature of contracts as law between the parties.^[3] Similar provisions are also found in Uruguay’s Civil Code^[4] and Commercial Code.^[5] The interplay of both concepts in M&A transaction documents requires precise clause drafting to minimise ambiguity and to align with the results of FDD and the expectations of both parties in a transaction to avoid conflict in the post-closing phase.

The FDD process often uncovers risks and irregularities that can significantly impact valuation and post-closing outcomes. For example, intercompany transactions that are not properly documented or sales that are undeclared may reveal potential tax liabilities. Other examples include providers of services where there is a potential dependency relationship and omitted social security contributions.

The following sections detail some of these risks and irregularities.

Undeclared sales

One common FDD finding in mid-market transactions in Latin America is the finding that the target is carrying out commercial activity that is not recorded in the accounting records but is considered operational for valuation purposes. These undeclared sales represent a significant risk for buyers as they may result in unexpected liabilities and even reputational damage.

To address these risks, the SPA must include clear and enforceable clauses ensuring the seller discloses all relevant information about the target company coupled with indemnification provisions to protect the buyer by allocating liability to the seller for any post-closing consequences of undeclared sales.

Potential dependency relationships

Another important FDD finding that must be carefully analysed is the existence of independent contractors that may be considered employees. In Argentina and Uruguay, there have been several cases in which an individual who is linked to a labour provider as an independent contractor initiates a labour lawsuit under the argument that the independent contractor relationship was fictitious and was, instead, a creation by the labour provider that was made to distract from the obligations related to the payment of social security contributions and other payment obligations. ^[6]

In those cases in Argentina, if the individual initiates labour claims and the labour judge concludes that there was an unregistered employment relationship, the individual will be entitled to collect the indemnities for wrongful dismissal contemplated in the Argentine labour legislation.^[7] In respect of social security, the tax authority may, upon receiving a complaint or conducting a routine inspection, conclude that the employer failed to comply with its obligations to pay contributions to the social security system and, therefore, determine a debt for the omitted contributions, plus accrued interest and the payment of a fine. It is relatively straightforward for the tax authority to detect such debt because of the correlative and consecutive invoicing of services arising from the accounting of the work provider.

In cases in Uruguay in which the individuals initiate labour claims and the labour judge concludes that a hidden employment relationship was in place, the employer may be ordered to pay all corresponding labour-related compensation, such as a severance payment in the case of involuntary termination, a year-end bonus and vacation payment, among other benefits. The Social Security Authority may also conclude that the employer failed to comply with its obligations to pay contributions to the social security system and may, therefore, determine a debt for the omitted contributions, plus accrued interest and the payment of a fine.

In M&A transactions, these types of contingencies are of utmost importance when analysing the documentation of the target company, since the social security contributions and the existence of unpaid labour obligations that may arise in cases of having a large number of independent contractors is substantial. As in any transaction, it is important to analyse the nature of the activity of the target that is being dealt with. This is especially important in Argentina, since over the past few years, and owing to the high inflation that has afflicted the country and the difference in foreign exchange rates, some activities have mutated their contracting model and set aside regulatory compliance to give way to the use of freelancers, as is the case in the IT industry.

When analysing the potential purchase of a company, it is essential to inquire about the number of people who may have rendered services under non-labour contracts, or even without any contract at all, since they could claim in court the recognition of their status as employees and, therefore, increase the litigious liability in labour matters.

Determining these contingencies is vital for M&A transactions and is analysed in detail when studying cases in Argentina or Uruguay.

In terms of statute of limitations, while in Argentina labour matters are subject to a two-year statute of limitations as of the date of enforceability or the date of termination of the relationship, social security matters are subject to a 10-year statute of limitations. In Uruguay, labour matters are subject to a double statute of limitations:

Labour claims expire one year from the day following the termination of the employment relationship on which they are based. The employee must file a claim before the Ministry of Labour and Social Security within that one-year period. If the employee fails to do so, its right to make a claim before the labour courts expires. If the employee files the claim before the Ministry of Labour and Social Security, a new one-year period begins in which the employee can make a claim before the labour courts.

• If the employee files a claim before the labour courts within the aforementioned one-year period, the employee may claim all labour-related compensation generated up to five years before the termination date of the employment relationship. Social security matters are subject to a five-year statute of limitations, which may rise up to 10 years in certain circumstances.

All these matters impact the indemnification clause and the extension of the escrow both in time and amount.

Omitted social security contributions

When analysing the compensation and benefits programmes that companies provide for their employees, it is necessary to thoroughly review the applicable internal policies in force. In this regard, certain benefits – whether by their nature, payment modalities or frequency of granting, among other things – may constitute remunerative items that are not properly registered, leading to implications in labour and social security aspects.

In Argentina when an item is considered remunerative from a labour perspective, it must be included in the calculation base for determining severance payments in the event of dismissal without just cause and for calculating the vacation bonus in accordance with the employee’s seniority. It will also be included in the calculation base to determine the final amount of the 13th salary or annual complementary salary, which is paid twice a year in June and December and is equivalent to 50 per cent of the best remuneration of the semester.

If an employee questions the nature of the benefits granted and requests recognition of their remunerative nature, they used to be able to file a claim seeking the payment of indemnity differences and fines for inadequate registration, although this possibility has now been removed.

In Uruguay when an item is considered remunerative from a labour perspective, it may have certain implications in the calculation of some salary benefits such as the 13th salary, leave bonus and vacation bonus. For the 13th salary, all remunerative items paid by the employer and in cash (payments in kind are excluded) must be considered. The 13th salary is paid twice a year (in June and December), and it corresponds to the sum of all items that meet these characteristics from the past six months, divided by 12.

In the case of leave and vacation bonus, all salary items that make up the worker’s usual remuneration must be included, so when the leave is taken, the employee continues to receive the same benefits as if they were working.

From a social security perspective, remunerative items form the tax base for employer and employee contributions (withheld by the employer), with both concepts aimed at the integrated social security system.

If the tax authority conducts an inspection and determines that certain benefits are remunerative in nature, it may issue a debt determination to demand the payment of omitted contributions on these items, plus the corresponding interest and applicable fines. In Argentina the statute of limitations for which the tax authority can require these payments is 10 years from each monthly non-compliance.

When analysing this type of situation in M&A transactions, it is common to discover unrecorded salary items or the absence of clear policies, as well as ambiguous actions from the employer in this regard.^[8] These contingencies occur only with employees registered on the payroll and not with independent contractors.

In Uruguay, the most common cases of incorrectly declared remunerative items are related to facilities^[9] that employers provide to their employees, which are not perceived as salary benefits, even though they are considered remunerative for both social security and tax matters.

All these considerations directly impact the indemnification clause and the extension of the escrow both in time and amount. These findings are usually part of negotiations among the parties to agree on how to deal with them once the acquisition is completed and the management is changed, since there will usually be opposing positions in respect of the extent to which those contingencies should be regularised and paid against the moneys in escrow.

Reported EBITDA and adjusted EBITDA

SPAs usually include formulas where the price is determined based on multiples of the earnings before interest, tax, depreciation and amortisation (EBITDA). Reported EBITDA is the EBITDA provided by the target company’s advisers, while adjusted EBITDA is the EBITDA determined after FDD.

From the buyer’s side, one of the main objectives of FDD is to review the reported EBITDA to identify factors that can be re-evaluated and to obtain an adjusted EBITDA.

In this sense, there are certain factors that are usually identified in the EBITDA analysis that, after agreeing on the adjustment of the EBITDA calculation, must be accompanied by the corresponding representations and warranties to avoid potential controversies.

Common adjustments to reported EBITDA include changes in accounting policies, reversals of capitalisations, changes in inventory estimates, non-recurring (or extraordinary) revenues, seasonality factors and carve-out cases.

Without prejudice to the definitions of the concepts that define EBITDA, criteria must be aligned with the financial advisers in charge of FDD to maintain harmony between the EBITDA adjustments and the representations and warranties included in the SPA.

For instance, extraordinary income, such as compensation payments from an insurance company, should be adjusted. Although compensation for a claim is intended to cover the damage suffered by a person – the target company in this case – such income often exceeds the actual loss suffered, either owing to depreciated book values assets or agreed over-coverage.

In this context, Latin American market practice involves including material adverse effect clauses to ensure that no events have adversely affected the target company within a specific period; however, it is less common to include clauses on extraordinary income, which could lead to an overvalued company.

If financial advisers identify the concepts to be adjusted in the EBITDA for extraordinary income beyond the usual business activities, it is crucial to include specific provisions within the representations and warranties to delineate those operations, particularly in the case of SPAs in which there is a time gap between signing and closing, which may include price adjustment clauses. It is important to incorporate material adverse effect clauses as representations and warranties in the absence of extraordinary income or to at least exclude them from the EBITDA.

It is a legal challenge to define what constitutes extraordinary income. While the payment of compensation from an insurance company is a straightforward case, extraordinary income resulting from a sudden and significant increase in a commodity price can lead a buyer to acquire a company at a value not supported by historical financial analysis and is unsustainable over time, distorting the enterprise value of the target company.

Quality of the financial information

Throughout Latin America, and especially in the mid-market, there are often target companies in which the quality of financial information is not optimal. There is a significant difference between a company with audited financial statements and a company without audited financial statements.

In mid-market target companies, it is not uncommon to come across historical practices of including founding shareholders or related individuals as board members with allowances that are close to the legal maximum.

In Peru, for example, board allowances cannot exceed 6 per cent of the company’s commercial profit before taxes. This deteriorates the quality of the financial information of the target company because these directors may not perform their roles adequately, and the allowances may not reflect market values, despite being within legal limits.

In those cases, taking FDD findings into consideration, including representations and warranties regarding board directors’ allowance payments and general hiring practices, should ensure that these items are at market value.

Importance of conducting VDD

From the seller’s perspective, vendor due diligence (VDD) is crucial. VDD (both tax and legal, and financial) provides the seller with various benefits, including:

• identification of the company’s strengths and weaknesses before the sale process;
• prior knowledge of the potential weaknesses, which will enable the seller to foresee the items that potential buyers may request be included in transaction documents, such as representations and warranties, indemnifications and escrow extensions;
• clear negotiation of the terms and conditions by the buyer’s advisers and the avoidance of surprises;
• greater agility in the closing of the transaction, especially in sophisticated industries where due diligence can take over six months; and
• prevention of the disclosure of confidential information outside the scope of audit. In Latin America, there are many cases in which the target company’s team (e.g., the company’s general accountant) does not dedicate adequate time to the transaction, performing their regular duties while also gathering information for a data room or answering auditors’ queries. This can lead to unintentional leaks of confidential information not covered by non-disclosure agreements.

The trust in VDD is backed by the reputation and market value of the firm that carries out the process and reports.

Conclusion

FDD is not just about numbers or providing assurance that management has presented a true and fair view of a company’s financial performance and position in accordance with well-defined rules and procedures: it is about understanding the story behind the financials, focusing on key areas like EBITDA, net debt and net working capital and, therefore, helping investors understand or helping the seller demonstrate a company’s earnings sustainability.

Because of the many factors that must be taken into consideration, it is crucial to have a rich source to work on and to use to help define contractual clauses in transaction documents.

Endnotes