Overview and Key Practical Takeaways
It is common for M&A buyers, and particularly private equity buyers, to price a deal based on a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)—among other things. How, then, should damages be calculated if the seller is found to have breached representations that informed the buyer's financial assessments?
A recent Delaware ruling awarded damages to a buyer based on the EBITDA multiple the buyer used to set the purchase price, and is instructive for dealmakers both north and south of the border. Our key practical takeaways include:
- Representation and warranty insurance (RWI) data indicates that the frequency of post-closing M&A claims in North America seeking damages on a multiple basis (as opposed to a dollar for dollar basis) is trending steadily upwards.
- The Delaware court awarded damages using the buyer’s EBITDA multiple by applying common law principles. That said, the purchase agreement expressly defined “losses” to include damages “based on a multiple of earnings, revenue or other metric”, and this factored into the court’s analysis.
For more Fasken M&A thought leadership, visit our Capital Markets and M&A Knowledge Centre and subscribe. See also Fasken’s Private M&A in Canada: Transactions and Litigation (LexisNexis, 2024).
Claims for Damages on a Multiple Basis Are Rising
A recent RWI claims study (the Study)[1] reports that the frequency of RWI claims in North America seeking damages on a multiple basis (as opposed to a dollar for dollar basis) is trending steadily upwards. Whereas for RWI policies in North America incepted between 2016 to 2019, only 14 per cent of RWI claims were for losses greater than dollar for dollar, for policies incepted between 2021 and 2024, 23 per cent of claims were for losses greater than dollar for dollar.
Moreover, as the three year claim periods for policies incepted in policy years 2022, 2023 and 2024 have not yet ended, the Study anticipates that the 23 per cent average for the years 2021 to 2024 could still climb higher. The Study also states that in a survey of RWI insurers, 41 per cent of insurers “reported that claims alleging a multiple of damages are increasing and 0 per cent reported a decrease.”
This trend is noteworthy on its own. It is also complimented by court rulings addressing when damages on a multiple basis may be appropriate in post-closing M&A disputes.
Damages for Transaction Multiples in M&A Disputes
In Dura Medic Holdings, Inc.,[2] the Delaware Court of Chancery examined a dispute that arose from a private equity firm’s purchase of a medical equipment supplier. The buyer sought indemnification from the sellers for breaches of representations and warranties regarding the target’s contracts.
The EBITDA Multiple and Definition of “Losses”
The transaction’s purchase price was calculated using the target’s EBITDA for a 12 month period. The purchase agreement provided that the buyer would be indemnified for “losses” resulting from breached representations and warranties, with “losses” defined to include “damages based on a multiple of earnings, revenue or other metric.” That said, the agreement did not require a multiple-based calculation or address when a multiple should be used to calculate damages.
The breached representation provided that no significant customer had notified the target of an intent to reduce or terminate its business. This representation was incorrect with respect to two significant customers, and the buyer sought damages for the breach based on: the lost earnings from those two customers that would have been received over the 12 month period used to calculate the purchase price (being $433,322),[3] multiplied by the EBITDA multiple the buyer used to calculate the purchase price (being 6.7797). The court awarded damages on this basis, namely $2,937,793.[4]
The EBIDTA Multiple and Damages Award
Although the definition of “losses” contemplated damages on a multiple basis, the agreement did not require that damages be calculated on a multiple basis or specify in what circumstances a multiple should be used. Consequently, the court looked to the common law to determine if calculating damages on a multiple basis was appropriate. The court explained:
Because the agreement is silent, the court must look to the common law. Under the common law, a party can recover reasonable expectation damages based on a multiple where the price was "established with a market approach using a multiple." That reasoning applies here. The Buyers proved that they derived the Merger price by applying a multiple of 6.7797 to the Company's EBITDA. The court will calculate damages using the same multiple.[5]
The court held that “[w]hether a misrepresentation diminishes the value of the business sufficiently to warrant applying a multiple turns on the extent to which the misrepresentation affects future earning periods.”[6] This was the case in the current circumstances because “the customer losses resulted in recurring declines in revenue.”[7] The court also cited numerous Delaware precedents endorsing the possibility of damages in M&A disputes based on a multiple.[8] The court added that applying a multiple may be “particularly” appropriate “where the Merger Agreement contemplates multiple-based damages.”[9]
Key Practical Takeaways
North American M&A deal point studies do not yet track whether the parties define “losses” to include damages based on a multiple as in Dura Medic. Given that RWI insurers are reporting a marked increase in RWI claims in North America alleging damages based on a multiple, and given the ruling in Dura Medic (and the precedent it relied on), this may be a valuable deal point in M&A studies going forward.
We believe that a court hearing a post-closing M&A dispute in Canada could consider Dura Medic and that damages could similarly be awarded on a multiple basis in certain contexts. That said, whether or not damages based on a multiple would be appropriate will ultimately be a situation-specific analysis. We would also generally expect the court to require evidence that the breach had an adverse impact on the assumptions underlying the EBITDA (or other earnings or revenue) calculation, similar to Dura Medic.
A takeaway for M&A buyers is to consider negotiating for a reference to damages on a multiple basis in the definition of “losses”.[10] This will not assure a court takes this approach, but it may improve the likelihood. The buyer should also be prepared to provide evidence demonstrating the purchase price was calculated using a multiple and that the use of this method is in line with the corporation’s value (e.g., deal modeling, investment committee memoranda, and/or expert witness testimony). Both buyers and sellers should appreciate that, even where an acquisition agreement is silent on the matter, a court could still be persuaded (depending on the circumstances) to award damages based on a multiple under common law principles.
