This is the first installment of a two-part series highlighting M&A transaction issues for buyers and sellers to consider in light of COVID-19.
1. Letter of Intent
In many instances, COVID-19 will cause both buyers and sellers to hesitate prior to signing a letter of intent to enter into an M&A transaction because of the following potential issues:
- Supply chain interruptions, reduced consumer demand, and fear of recession will contribute to weakened revenues, earnings, and other financial metrics of sellers.
- Reconciling financial projections will make it challenging for buyers to formulate post-closing business models with which buyers will be comfortable.
- Lower valuations should be expected after a cycle of seller favorable valuations.
However, essential industries such as food and beverage, education, and health care are positioned well, due to pre-packaged foods, online educational tools, and medical supplies, to support higher valuations.
2. Valuation; Risk Allocation; Deferred Consideration
It’s likely that capitalized buyers will attempt to exploit lower valuations and sellers will attempt to postpone a deal until conditions stabilize. Alternatively, creative solutions to bridge the valuation gap may be utilized, which are discussed below.
- Earn-Outs
- Metrics to calculate earn-out milestones should be carefully considered.
- Sellers should attempt to negotiate earn-out provisions that allow for earn out payments even if milestones are not achieved as a result of COVID-19.
- Broad COVID-19 exclusions will be rejected by buyers but limited, enumerated, logical exclusions may be deemed more amenable.
- Seller Notes, Escrows, and RWI
- To mitigate risk, buyers may use a seller note as deferred deal consideration, which will be (i) subordinate to senior credit facilities, (ii) subject to restricted repayment terms, and (iii) for a term of at least three to five years.
- Escrows may be increased beyond the typical 10% of deal value and for longer periods of time, which historically were 12 to 18 months.
- Terms, conditions, and cost of Representation & Warranty Insurance (RWI) will change such that COVID-19 exclusions will be prevalent if not universal.
3. Third Party Debt
Despite reductions in lending rates, lenders may be more risk-averse, causing an increase in the level of their due diligence efforts of targets and buyers, which will reduce the number of consummated M&A transactions. Buyers dependent upon third party debt may need to reassess a target’s valuation based on the terms, conditions, and cost of securing such third party debt.
4. Considerations for Buyers
- Seek to minimize cash paid at closing through (i) earn-outs, (ii) seller notes, and/or (iii) escrows, each over an extended period of time, to address COVID-19 concerns.
- Propose an earn-out to address valuation gaps caused by a disagreement on the expected effect of COVID-19 on the target’s business.
- Require secured third party financing as a condition to closing and termination rights for any material adverse change caused by COVID-19.
5. Considerations for Sellers
- Minimize deal risk by using an escrow or RWI over a seller note.
- Propose very specific milestones, and seek more flexible achievement terms, to address any expected effect of COVID-19 on your business.
- Require a specifically drafted Material Adverse Effect clause that limits the ability of a buyer to walk away from a deal under COVID-19 related events.
- Determine if you actually need to sell now. If not, waiting may lead to a more favorable outcome once the current uncertainty subsides.
