Lawsuit Over EBITDA Earnout “Determined in Accordance With Buyer’s Historical Reporting Policies”

Introduction

This is another post-closing M&A dispute over an EBITDA earnout.

The deal

The seller was a San Jose based small security guard service. It sold its assets in September 2016 to a Georgia based nationwide security company with about 160 branch offices.

The purchase price was $1.375 million payable in cash at closing and an earnout based upon the annual EBITDA of the purchased business over the next 3 years. An earnout would be payed in any of the three years that the annual EBITDA for the business reached $500K. The asset purchase agreement said that the buyer would determine EBITA “in accordance with buyer’s historical reporting policies.”

The lawsuit

The seller’s business was operated by the buyer after the closing as its San Jose branch. The seller’s owner received buyer’s monthly financials for the branch after the closing which calculated EBITDA for the branch.

The branch financials said that the San Jose branch reached the $500K annual EBITDA target in the first post-closing year. However, the buyer did not pay an earnout for that year, claiming that EBITDA needed to be calculated for the year by factoring in the seller’s owner’s historic salary as a proxy for the branch’s share of the buyer’s corporate overhead. No corporate overhead had been included as an expense in the interim monthly EBITDA branch calculations prepared by the buyer during the year.

The seller sued the buyer in a federal California district court. The court held that the APA language requiring the branch’s annual EBITDA to be determined “in accordance with buyer’s historical reporting policies” was ambiguous, meaning that the court would not preliminarily decide how corporate overhead would be dealt with as a matter of law. The result meant that the matter would, if not settled, go to trial.

This case is referred to 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

Comment

Use of an earnout to bridge the buyer and seller view of value is always risky. Much more so when the earnout target is based upon profit or EBITDA as opposed to revenue.

There was also more to this fight than corporate overhead allocation. Seller also accused the buyer of breaching its duty of good faith and fair dealing by grossly mismanaging the San Jose branch and causing the branch to earn substantially less income than it should have, thus depressing the seller’s earnout. The court also permitted the seller to take this claim to trial.

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

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Posted in bad faith, corporate overhead, de facto merger exception, earn outs, EBITDA Tagged with: ,

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