Damages Based on Financial Misstatements

There are many nuances to the definition of damages in merger agreements: Should they be net of insurance proceeds? Should tax impacts be taken into account? One issue that can have a significant impact on damages calculations and is often less than clear is the calculation of loss related to a misstatement of financial statements.

Parties should define in the merger agreement how such damages are to be calculated.

Sellers will typically assume that if there was a mistake in the financial statements, the amount of damages would be equal to the amount of any misstatement. For example, if the income statement understated revenue by $250,000, a seller might assume this would be the amount of a possible indemnification claim.

Buyers, on the other hand, will sometimes make the argument that they determined the purchase price based on some multiple of revenues or EBITDA, and if the applicable variable has been misstated, the amount of loss must be equal to that misstatement times the multiplier. In other words, if a hypothetical buyer is willing to pay 10X revenue and revenue is misstated by $1 million, then the amount of the buyer’s alleged loss is $10 million, because that is how much less the buyer would have paid for the business had the misstatement been identified prior to closing.

The buyer’s position puts the sellers in a very difficult spot. In many cases, the selling shareholders may not even be aware of the buyer’s original methodology for determining purchase price. Even if they were aware that the buyer’s pricing was determined by applying a multiplier, they also recognize that many other variables were likely at play during the negotiation that impacted price. The final purchase price is often based on projected future revenues (rather than past revenues included in the financial statements in question), strategic or synergistic analyses and/or the outcome of a competitive bidding situation. Therefore, when sellers hear the argument from a buyer that they paid a multiple of some variable and want that to be the basis of damages, the sellers often are unable to confirm whether such claim is legitimate.

To avoid this risk, the parties should define in the merger agreement how such damages are to be calculated. If they want to limit the damages to the amount of any misstatement, then including language, such as the following is advisable:

Notwithstanding anything herein to the contrary, no party shall be liable to the other for any consequential, special, incidental, exemplary, or punitive damages or for diminution in value, lost profits or lost business opportunity that arise out of or relate to this Agreement or any liability or responsibility assumed or retained hereunder.

If buyers insist on an ability to seek to recover diminution in value and/or lost profits, sellers should nonetheless seek to make it clear that the damages are not subject to a multiplier with language such as the following:

The Indemnified Parties shall not use “multiple of profits” or “multiple of cash flow” or any similar valuation methodology in calculating the amount of any Losses in the nature of “lost profits” or “diminution in value.”

Alternatively, if the calculation of damages for financial misstatements is to be multiplied by something, make that clear. SRS Acquiom suggests language such as:

The parties agree that the purchase price was based in significant part on the Seller’s Financial Statements. In the event of any Misstatement that impacts Net Income or Shareholder Equity, the amount of damages for which the Buyer shall be entitled to indemnification shall be equal to the amount of such Misstatement multiplied by Z.

Either way, parties should have this discussion prior to closing and make agreements clear in the documents.

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