Explore the complexities of cost allocation in M&A as a buyer takes legal action against a seller over disputed costs in the acquisition of a chemical division. Get insights into the lawsuit, defense, and the court’s decision.
M&A Stories
May 17, 2019
Introduction:
In the world of M&A, purchasing a division from a seller, known as a divestiture, comes with its unique set of risks. Assessing the financial health of a standalone business is relatively straightforward, but when it comes to divisions, allocating costs can be a complex task, as they often need to be distributed from the larger company.
The Deal:
Our story revolves around a private equity firm based in Akron, specializing in investments in distressed or underperforming middle-market companies. Among its holdings was a chemical division, catering primarily to biotech, pharmaceutical, food, flavor, fragrance, and specialty chemical customers. This division was sold to a buyer for $27 million, with an additional $5.5 million earnout if certain earnings targets were met in the first-year post-acquisition.
The Lawsuit:
However, the post-acquisition period saw a souring of relations between the buyer and seller. The buyer was dissatisfied with the division’s performance, and the seller did not receive its expected earnout. The dispute eventually landed in an Ohio federal district court.
The buyer’s accusation centered on the seller’s understatement of the division’s costs, particularly regarding the allocation of companywide expenses. Two types of costs were contested: administrative costs (comprising salaries and benefits for sixteen employees in HR, finance, and IT) and support group costs (related to quality assurance and product management). The buyer argued that these costs should have been allocated differently – administrative costs by employee headcount and support group costs by revenue. The seller used this approach internally, resulting in an allocation of $2.3 million in cost to the division, but represented to the buyer in the purchase agreement $500K in costs.
The buyer alleged that the seller intentionally downplayed the division’s costs to inflate its apparent profitability.
The Seller’s Defense:
In response, the seller contended that the costs outlined in the agreement were not inaccurate. They argued that these figures represented “pro forma” income statements, essentially hypothetical costs if the chemical division operated as a standalone company, not the actual costs incurred while part of the seller’s organization. Moreover, the seller pointed out that the assumptions and projections used to arrive at these pro forma estimates were detailed in the confidential offering memorandum provided to the buyer, making the financial representations reasonable.
The Court’s Decision:
The court, in this preliminary legal skirmish, refused to definitively rule that the seller had understated costs. The key issue was whether the figures represented actual 2016 costs or were, as labeled, “Pro Forma FY 2018 income statement” estimates. The court acknowledged the material fact dispute regarding the buyer’s claim.
In Conclusion:
This legal battle extends beyond this initial phase, leaving both parties to grapple with the complexities of cost allocation in the world of M&A. It also raises the question of whether the buyer could have uncovered historical cost allocations during due diligence, perhaps through a quality of earnings assessment.
Case Reference:
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]
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
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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