Business Seller Accuses Buyer of Earnout Manipulation

Introduction

A seller of a business wants to receive the highest price, and payable in cash at closing. The buyer might want to pay seller’s price but is not sure it is worth that much. How do you bridge the gap?

This can be done by making some of the purchase price based upon the post-closing performance of the business. An example would be the EBITDA performance of the business over the first year after the closing. This payment structure is often called an earnout or earn-out.

The seller may think that the business can perform well enough to trigger the earnout. But will it under the buyer’s management? Is buyer capable of operating the business well enough? More cynically, would the buyer play games with expenses and revenue over the earnout period to avoid triggering the earnout payment?

The deal

Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.

The seller sold the chemical division to the buyer, a subsidiary of an Italian chemical firm for $8.4 million in cash at closing and assumption of $18.6 million of seller debt. The buyer also agreed to pay the seller an earnout of $5.5 million if the chemical division hit an EBITDA earnings target for the first year post sale year. The buyer promised the seller in the asset purchase agreement to refrain from taking any bad-faith actions to avoid the earnout payment.

The lawsuit

The business did not meet its earnings target and no earnout was paid to the seller. The seller sued the buyer in an Ohio federal district court for allegedly manipulating its earnings and revenue to avoid hitting the earning target.

The buyer claimed that seller’s allegations, if true, did not amount to buyer’s breach of its promise to refrain from taking bad-faith actions to avoid the earnout payment.

The court disagreed. The court said that these seller allegations could establish bad faith. The seller accused the buyer of: (1) steering the chemical division business to the buyer’s Italian parent company, (2) delaying the receipt of customer payments;  (3) incurring $3 million in unreasonable strategic costs during the earnout period; (4) failing to contemporaneously track and account for strategic costs; and 5) obscuring and concealing strategic costs.

The result? The seller gets to push forward in its litigation.

This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019)  https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]

Comment

Earnout deals come with risk because the seller loses control of the business. Always best to at least consider taking a lesser amount at closing than agreeing to a larger amount payable after the closing that is dependent upon the buyer.

By John McCauley: I help businesses minimize risk when buying or selling a company.

Email: jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

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