Explore a post-closing dispute in mergers and acquisitions (M&A) involving an earnout disagreement related to EBITDA. Learn about a case that highlights the complexities of earnout arrangements and potential legal challenges.
June 18, 2019
M&A Stories
Introduction:
In this mergers and acquisition (M&A) post-closing dispute, we delve into an earnout disagreement revolving around post-closing earnings before interest, taxes, depreciation, and amortization (EBITDA).
The Deal:
A San Jose-based small security guard service sold its assets to a nationwide security company based in Georgia in September 2016, boasting around 160 branch offices. The purchase price amounted to $1.375 million, with cash paid at closing and an earnout contingent on the annual EBITDA performance of the acquired business over three years. The earnout would trigger if the annual EBITDA reached $500K in any of those years. The asset purchase agreement stipulated that the buyer would calculate EBITDA “in accordance with buyer’s historical reporting policies.”
The Lawsuit:
Following the closing, the buyer operated the seller’s business as its San Jose branch. The seller’s owner received monthly financial reports from the buyer, which included EBITDA calculations for the branch. In the first post-closing year, these reports indicated that the San Jose branch had met the $500K annual EBITDA target. However, the buyer declined to pay the earnout for that year, contending that EBITDA should factor in the seller’s owner’s historic salary as a stand-in for the branch’s share of the buyer’s corporate overhead. Interestingly, the interim monthly EBITDA branch calculations prepared by the buyer during the year did not include corporate overhead as an expense.
The seller took legal action against the buyer in a federal California district court. The court determined that the language in the asset purchase agreement, requiring the annual EBITDA of the branch to be determined “in accordance with buyer’s historical reporting policies,” was ambiguous. Consequently, the court would not make a preliminary legal judgment on how corporate overhead should be handled. This left the matter headed for trial if a settlement could not be reached.
Comment:
Using an earnout to bridge the gap in perceived value between buyer and seller can be precarious, especially when the earnout hinges on profit or EBITDA rather than revenue. Such arrangements often lead to disputes over expense allocations rather than revenue sharing.
In this case, the conflict went beyond corporate overhead allocation. The seller also accused the buyer of breaching its duty of good faith and fair dealing by poorly managing the San Jose branch, resulting in significantly lower income than expected and, consequently, a reduced earnout for the seller. The court granted the seller the opportunity to pursue this claim at trial.
Case Reference:
Miranda v. US Security Associates, Inc., Case No. 18-CV-00734-LHK., United States District Court, N.D. California, San Jose Division, (May 2, 2019) https://scholar.google.com/scholar_case?case=517692208462449496&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017
By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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