The earn-out that missed target because of costs the business never used to carry

The situation

A regional logistics company was sold to a larger strategic acquirer for $5,200,000, with a three-year earn-out structured around annual EBITDA growth targets of 12%, paying out on a sliding scale up to $900,000 over the earn-out period. The purchase agreement defined “Earn-Out EBITDA” as net income before interest, taxes, depreciation and amortisation, calculated in accordance with the target’s historical accounting practices, consistently applied. It also included the standard ordinary-course operating covenant and a prohibition on action taken for the primary purpose of reducing the earn-out.

The problem

After closing, the buyer integrated the target into its existing corporate structure — consolidating back-office functions, moving IT infrastructure onto the group’s systems, and placing the target under the group’s insurance program. As part of that integration, the buyer began charging the target a $180,000 annual corporate management fee, a $65,000 IT allocation reflecting its share of group infrastructure costs, and its pro rata portion of the group’s liability and property insurance premiums — costs the target, as a standalone business before the sale, had never carried in anything like that form. Reported Earn-Out EBITDA came in 9% below the pre-closing trend for the first earn-out year, even though the underlying business — revenue, headcount, customer contracts, day-to-day operations — was flat to slightly ahead of the prior year.

The rule that decided it

No statute defines EBITDA, for an earn-out or otherwise — it is a purely contractual construct, and its content on any given deal is exactly what the defined term in that agreement says it is, nothing more and nothing less. The seller argued the ordinary-course covenant was breached because the buyer had taken action “for the primary purpose of reducing” the earn-out. That argument failed on the facts: the buyer’s integration steps were not primarily aimed at the earn-out at all — they were the buyer applying its standard post-acquisition integration playbook to every company it bought, earn-out or not, and it could show exactly that pattern across its other recent acquisitions. Intent-based covenants are hard to enforce against a buyer with a genuine, independent business reason for what it did. What decided the case instead was the definition of “Earn-Out EBITDA” itself: it referred to historical accounting practices “consistently applied,” and consistency cuts against the buyer, not for it — the target had never been charged a corporate management fee, an IT allocation, or an insurance pro rata share before closing, so applying those charges for the first time during the earn-out period was not consistent with historical practice, regardless of the buyer’s motive.

The numbers

The three new charges totalled $245,000-plus against a target generating roughly $2,100,000 of EBITDA on a standalone pre-closing basis — an 11.7% hit to the metric from allocations alone, comfortably explaining the 9% shortfall against the growth target once normal operating variance is netted out. Restated without the three charges, Earn-Out EBITDA showed 13% growth, above the 12% target.

The outcome

The seller succeeded, but on the accounting-consistency argument, not the intent-based covenant. The three charges were excluded from the Earn-Out EBITDA calculation as inconsistent with historical practice, the recalculated figure cleared the 12% threshold, and the earn-out paid out for that year. The dispute did not turn on whether the buyer had acted in bad faith — it plainly had not — but on whether the specific costs fit inside a definition that predated the buyer’s ownership.

What it would have cost otherwise

Had “Earn-Out EBITDA” been defined by reference to the buyer’s own accounting policies going forward, rather than the target’s historical practices, the same $245,000 of allocations would likely have been includable as ordinary post-acquisition costs, and the seller would have had no textual foothold to exclude them — the ordinary-course covenant alone, without the historical-practice anchor, would not have been enough given the buyer’s genuine, group-wide integration motive.

The tell

The tell was that the buyer never argued the charges were reasonable or market-standard — a strong argument on its own terms, since group management fees and shared-services allocations are entirely normal in corporate life. It argued instead that the definition of Earn-Out EBITDA permitted them, and lost on the words of the definition rather than on the reasonableness of what it did. That is the signature of a metric fight decided by drafting rather than by conduct.

Takeaways

• • No statute defines EBITDA for earn-out purposes — the definition inside the agreement is the entire universe of what counts, and it is worth negotiating like the money it is.
• • An exhaustive exclusion list inside the “Earn-Out EBITDA” definition — naming corporate management fees, IT and shared-services allocations, and group insurance pro rata charges as excluded — protects a seller even against a buyer acting in complete good faith.
• • An intent-based ordinary-course covenant is weak against a buyer with a genuine, independent business reason for its conduct; an accounting-consistency anchor to historical practice is strong regardless of motive.
• • This mechanic sits next to, but is distinct from, revenue-reallocation earn-out disputes: this one attacks the bottom line with costs the target never bore, not the top line with diverted customers.

Sources

• • No statute defines EBITDA or governs an earn-out’s cost allocations; the result turns entirely on the “Earn-Out EBITDA” definition negotiated into the purchase agreement and its anchor to the target’s historical accounting practices.
• • Treadstone Law — what protections does a seller have against a buyer suppressing earnings during an earn-out? — the closest treatment in Treadstone Law’s library; addresses earnings suppression generally rather than corporate cost allocations specifically, but covers the same family of buyer-side metric manipulation.