By: Tariq Adawi
It has become clear from the past eighteen months that there is a new definition to what “normal” life looks like. For individuals looking to buy or sell a business, the question now becomes how exactly this new normal will affect their M&A transaction and how the M&A landscape has evolved since the pandemic.
The COVID-19 pandemic had a significant impact on M&A transactions. These impacts included structural changes to deals and changes to the terms that were negotiated into the M&A agreements. Some of these COVID influenced changes may be here to stay, while others may return to the pre-pandemic standards. This post highlights a few pandemic influenced changes relating to due diligence, earnouts, representations and warranties, and other provisions included in the deal documents.
It is especially important for purchasers to consider any business element which may be impacted by COVID-19. This will make the due diligence period even more crucial when considering whether to enter into an agreement or to proceed with closing. Some key things to look for and questions to ask include:
- Vendor Analysis – Does the business get raw materials or manufactured goods from certain suppliers or vendors? Did these vendors experience shortages, delays, or inefficiencies over the past year? What do the contracts say regarding non-performance or delays? Do the agreements contain force majeure clauses which could include this pandemic? If you cannot get the supplies needed, how would it affect the overall operation of the business? In what direction are industry-specific supply chains trending?
- Customer Analysis – Did customers of this business still purchase the product or service over the past year? If so, how have the margins on such products changed? Did local or state government orders force the business to cease or limit operation? What will it take for the demand to return to pre-COVID-19 levels?
- Insurance – Are losses due to COVID-19 covered by business insurance? Are such policies assignable? What type of coverage can you get if you cannot assume the seller’s policy?
- Financial Statements – How long can the business survive if economic conditions are prolonged? Will additional money need to be contributed to keep the business afloat in the short term? Are certain expenses able to be reduced?
- Post-Pandemic Trends – What trends can be identified over the last year of operations? Is the business seeing abnormal or artificial levels of sales? Does the business operate in an industry susceptible to trends driven by the pandemic (i.e., spikes in travel-related businesses, decreases in non-essential or disposable-income driven services)?
- Labor Force Issues – Has the business experienced issues in retaining a talented and productive workforce? Are there any outstanding employment claims? What does the turnover rate look like before and after the pandemic’s start?
Each business is unique and due diligence can help reveal particularly important information about a business. As discussed below, it is important for both sellers and purchasers to conduct extensive due diligence to ensure any findings are appropriately addressed in each party’s representations and warranties in the final purchase and sale agreement.
Valuation & Earnouts
A main concern for both purchasers and sellers will be the valuation of the business and therefore the price a purchaser is willing to pay, and the price a seller is willing to accept. It is likely that the value a business had in December 2019 is no longer the same. Some purchasers are pushing for a discounted price due to COVID-19. While sellers are reluctant to agree to a discount as these negative economic impacts may be temporary, and most sellers will harbor an expectation that the business will return to levels of profitability that existed pre-pandemic. Purchasers may counter such argument by stating that there is too much uncertainty as to when the business could return to normal and the Purchaser is the one assuming the risk of operating during this time. In addition, traditional valuation methods that rely on factors of revenue will surely be thrown off when compared to pre-pandemic figures. This ongoing back and forth could result in a failure to reach an agreement which is acceptable by both sides.
Over the past year the M&A market saw an increase in the use of an “earnout” to bridge the valuation gap between buyers and sellers. In addition, the earnout periods in M&A deals over the past year have been longer periods than the pre-pandemic norms. An earnout is essentially contingent consideration, where in addition to any up-front amount paid, future payments may be made to the Seller based on achievement of certain metrics. Typically, an earnout will be drafted in a way that Seller will be entitled to additional compensation if, after some agreed to period, the business (as run by the Purchaser) achieves certain levels of EBITDA. Depending on the business and the situation, earnouts can be crafted in various ways to ensure protection for both parties. However, it is important to note that SBA financing often prohibits utilizing an earn-out structure and other post-closing payments to seller.
Representations & Warranties
One of the most important parts of any M&A transaction is the representations and warranties section. The pandemic had a significant impacts on these provisions. Sellers focus on carving out additional protections to ensure that the Purchaser is unable to bring any over-inclusive claims. For example, with respect to the financial statements illustrating the historical financial health of a business, it should be specifically stated that financial statements may not be accurate during “Stay at Home” or “Shelter in Place Orders”.
Another especially important representation a Seller needs to be aware of is a “Material Adverse Effect” clause (an “MAE”). MAE’s state what happens if there is any event or condition which occurs that materially affects the business, such as an inability to perform certain obligations or materially affects the financial condition of the business. Sellers may want to include specific carveouts such as carveouts relating to any factors outside the control of the business (such as these government stay at home orders) or even provide a narrower carveout, excluding any event caused due to a “pandemic”. However, this tactic is becoming less effective as time goes on due to the ongoing nature of the pandemic.
Purchasers on the other hand are likely to seek additional reps and warranties based on their due diligence findings. Purchasers may want reps and warranties that the seller initiated any emergency response protocols needed in light of COVID-19 or that Seller complied with any health regulations promulgated by local and state officials. As stated above, each business situation is different and depending on what is uncovered in due diligence, there may be specific reps and warranties a Purchaser would want to see included.
Buyers will want to search to see if sellers have taken out EIDL or PPP Loans that have not been repaid or forgiven. Purchasers will be reluctant to close on the acquisition of a company with an outstanding loan, and if the loan is large enough, a security interest in the business’ assets. Selling a business with an outstanding PPP or EIDL Loan would likely violate the terms on which such loan was given. Therefore, an emphasis has been placed on sellers to receive forgiveness or pay off those loans prior to closing. For PPP Loans, it is important to apply for forgiveness as soon as possible to avoid having a holdback of the purchase price in the event that the loan is not forgiven. In addition, the SBA is experiencing delays expected to last six to eight months, placing an importance on sellers to coordinate with the Administration ahead of closing in the event that a security interest needs to be released.
The legislation from the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) allowed for certain tax breaks for certain businesses which may impact the tax provisions in M&A transaction agreements. The CARES Act allowed for deferral of the employer portion of social security payroll taxes for the period beginning March 27, 2020 until the end of 2020. Individuals who deferred these taxes will have to pay 50% by December 2021 and 50% by December 2022. Buyers may want to ensure that any payroll taxes which are deferred pursuant to the CARES Act would be included in pre-closing taxes to avoid having to pay any of these deferred taxes at the end of December 2021 or December 2022.
The CARES Act also allows certain taxpayers to carryback net operating losses in 2018, 2019, and 2020 to the previous five taxable years. Purchasers will want to ensure that they are allowed to carry back any net operating losses in post-closing tax period and retain any refunds attributable to such net operating losses (even if such loss is carried back to a pre-closing tax year). This modification to net operating loss may make businesses that are operating at a loss more attractive as it provides options to utilize existing net operating losses.
While COVID-19 has impacted how M&A transactions will proceed going forward, properly crafted agreements can provide for mechanisms to help make buying or selling a business in this new environment attractive while also implementing safeguards for to-be-determined risks.
To discuss specific concerns about your potential M&A deal and how Doida Crow Legal can assist with your transaction, please contact us to set up a consultation.