Evolving Private Company M&A Considerations in the COVID-19 Era
The COVID-19 Pandemic’s eruption on a global scale caused mass disruptions to several portions of the economy. As lockdown and safety measures came into effect, several businesses found themselves looking to sell or close up shop, while others skyrocketed in sales and size. Despite initially falling dramatically, the M&A industry has seen a strong resurgence; however, it faces new difficulties as sellers handle the recovery differently. Today we discuss challenges faced during these transactions, and look at the viability of different strategies buyers and sellers can take in combating the uncertainty of the next few months.
How were Valuations Affected Post-COVID?
As the pandemic continues, both buyers and sellers within M&A transactions face new challenges in bridging the valuation gap between both parties. Questions regarding the uncertainty of operations, whether historical performance is still accurate, as well as the optimal structure for deals, become increasingly harder to answer as time goes on. Given the uncertainty of the future and the polarizing effect that the pandemic had on many businesses, it is expected that a divergence between what buyers and sellers want would grow.
The effects of the pandemic on valuation are numerous and varying, however, several key items are consistently changed across many businesses as a result of lockdown and safety measures. The most immediate is changes in sales volume. Multiples of revenue or EBITDA to calculate value are common, however, they become obsolete when huge sales declines (or bursts) due to the pandemic are prevalent. Further, large one-time revenue streams or expenditures, such as government assistance or sanitation costs, can further bring into question the validity of these measures. Additionally, the net working capital of the target, which represents the normalized level of working capital the business uses, may dramatically shift from historical averages. As the net working capital is often used for purchase price adjustments, difficulties in ascertaining these values further cause the gap to grow.
Despite these difficulties, creative solutions are becoming more common to effectively spread the uncertainty between both buyer and seller. One such strategy is to defer part of the purchase price or even make it contingent on future performance metrics. This would account for the lowered price caused by reduced multiples in the pandemic environment but would allow appropriate compensation to the seller if contingent conditions were met. Another strategy is that of an equity rollover for private equity buyers, where senior management and founders of the target take a percentage of the purchase price as equity in the buyer, aligning the acquirers and targets interests. This is an effective way to spread risk given the uncertainty of tomorrow. Another effective tool is that of an earnout, which we cover further below.
Although difficult, through effective due diligence, analysis, and preparation, creative solutions to bridge widening valuation gaps can be arrived upon. Deals in the coming months will likely become more structured and varied, as parties attempt to split uncertainty and risk. Buyers will need to be more prepared, especially when bidding for companies that have benefited during the last few months. Sellers will have to be creative, to ensure that despite valuation uncertainties, they account for the true performance of the company.
Key Considerations in Structuring Earnouts during COVID-19
As the M&A environment has been hit with a wave of uncertainty following the pandemic, a key challenge has been price discovery. Due to a number of variables that would impact a company’s cash flows, buyers have been cautious in deploying capital this year. In this backdrop, earnouts have been gaining popularity. Earnouts offer many advantages to both the buyer and the seller. The main objective that an earn-out achieves is to align the interests of the buyer and the seller. An earnout is an agreement in which a portion of the asking price is tied to the company’s future performance. Sellers and shareholders tend to gain from such deals if the company meets performance expectations such as EBITDA thresholds or revenue growth targets. In doing so, the buyer reduces his/ her own risk if the company does not perform as expected. Secondly, the shareholders are motivated to help the business through its transition and post-merger integration so that it achieves earnout targets which leads to a higher payout.
Advantages of Earnouts
- Earnouts bridge the gap between expectations of value on the buy-side and sell-sid
- Earnouts allow buyers to defer a portion of the payment and finance it through the company’s cash flow, thus helping the financing process
- Earnouts speed up the M&A process by sweetening the deal for both sides; higher motivation also increases the likelihood of successful transaction completion
Here are some other considerations regarding earnouts:
Be specific when defining financial metrics
It is important to state clearly defined performance objectives that are realistic and measurable. It is always better to structure an earnout based on targets that can be quantified such as revenue growth and EBITDA. If the targets are vague and subject to interpretation, this could lead to disputes during payout.
Consider what types of interim operating covenants are appropriate
Challenges can arise in an earnout deal when the buyer operating the company post-acquisition makes changes that make it difficult for the company to achieve its earnout objectives. This is detrimental to the seller and can lead to disagreements. For this purpose, operating covenants are required which balances the buyer’s desire to freely operate the business with the seller’s desire to control the ability of the business to meet the earn-out objectives.
Consider catch-up and/or proration terms
All or nothing payout structures can lead to no payout despite positive growth and development in the business. Sellers must consider sliding scale payout which caps the maximum and minimum earnouts payments or use multiple thresholds that offer a different payout based on multiple scenarios. This way, at least some value from the earnout is preserved and the sellers benefit as long as the company made progress even if it fell short of earnout targets.
Consider alternate dispute resolution procedures
Parties involved must identify an unbiased third party to handle any dispute resolution beforehand to avoid hiccups during the earnout period. Having a neutral and objective party monitor any disagreements can help bring the deal back on track in the event of disagreement or conflict between the buyer and seller.
Is an Earnout the best option?
While earnouts present benefits for buyers and sellers, they open up the gateway for future disagreements. An earnout does not allow sellers a clean exit. In addition, earnouts can sometimes end in litigation over the outcome and thus create additional stress for both parties involved. Before deciding to go this route, parties involved must consider these factors.
What has changed in the Legal Due Diligence Process?
The unpreceded and volatile nature of this pandemic has forced businesses to reevaluate their strategies and in particular, their mergers and acquisitions agreements. The “material adverse change” or “material adverse effect” (MAC) clauses allow a party to walk away from a transaction where a material adverse change has occurred between signing and closing. Although these provisions have been interpreted narrowly and they place a heavy burden on the purchaser, many have begun to argue that COVID-19 is truly a unique circumstance. As a purchaser considering invoking a MAC clause to avoid closing a transaction, the following should also be considered.
While there is no free-standing definition of a MAC, many acquisition agreements specifically discuss the effects of pandemics, earthquakes, floods, hurricanes, tornados, or other natural disasters. These events are then deemed “systematic risks,” that the seller accounts for to the buyer in the purchase price. Under this reasoning, the party assuming the systemic risks (the buyer) would assume the risks associated with COVID-19. This fact remains true unless there has been a disproportionate effect on the company. A particular company may be more vulnerable to the effects of the pandemic than others in its industry because of higher leverage, worse distribution, production, access to supply, intellectual property, or goodwill. Note that insolvency does not constitute a MAC.
Some other considerations regarding COVID-19 and the MAC clause include:
- Whether the financial impact can be traced to the pandemic or if it reflects a change in the long-term value of the company. This judgment may change over time as the pandemic continues past foreseeable lengths.
- Whether COVID-19 is deemed a “foreseeable risk” by courts. More likely than not, the extreme impact of COVID-19 could not be viewed as something parties would have contemplated as a regular risk of doing business.
- Whether there are other remedies to the acquisition agreement that suits the seller and buyer.