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Mitigating Merger & Acquisition Risks in the Era of COVID-19

November 12, 2020
By: Danielle Snyder Fadel and Scott E. Fiducci

Deals can be complicated and adding the COVID-19 pandemic to the mix certainly hasn’t made it easier to buy or sell a business.  As the pandemic continues to create uncertainty for businesses, buyers and sellers can take steps now to mitigate risk in their transactions.  Aside from taking the appropriate precautions to stop the spread of COVID-19, business owners should consider how they plan to undergo transactions that are impacted by this pandemic or similar events in the future.

Valuation and Financial Considerations

To determine the value of a business, common valuation methods often include taking a multiple of EBITDA or a multiple of revenue.  As a result of COVID-19, historical earnings may not be a predictable measure of a company’s value considering the amount of uncertainty caused by the pandemic related to future performance.  Thus, buyers and sellers may need to be creative regarding the financial considerations of the deal.

A key part of the financial negotiations in a deal includes net working capital estimates or earn-out provisions.

Buyers and sellers often disagree as to the net working capital estimates and reaching an agreement may be substantially more difficult when the parties are uncertain as to how the business will be impacted during the duration of this pandemic or thereafter.  As such, the parties may wish to define the reference period differently to account for the abnormalities that may have occurred or while occur during the pandemic.

An earn-out provision is often used to allocate purchase price risk to sellers. As earn-out provisions become more common and business owners become more likely to agree to a portion of the purchase price consisting of a contingent payment post-closing, business owners will want to consider the effect of a major disruption when determining earn-out calculations. By incorporating specific deadlines or metrics regarding performance, it will alleviate some uncertainty for the business owner.

In addition to the use of earn-out provisions, business owners should expect potential buyers to propose equity rollovers and creative incentive bonus plans as a way to both incentivize the key employees and allocate more risk to the seller.

Record keeping will be key as COVID-19 continues to impact the economy and the business. Business owners will want to track productivity, lost business, write-offs, supply chain interruptions, unexpected labor costs, and the like that result from the COVID-19 pandemic as they prepare for mergers or acquisitions.

CARES Act Considerations

In response to COVID-19, the federal government passed the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which included an SBA loan program for small businesses that would administer forgivable loans to eligible businesses (the “Paycheck Protection Program”) and business tax relief by modifying rules related to net operating losses, deductions, and tax credits. While this article is not intended to go into details on the SBA loan program or the business tax relief, business owners should consider the impact of those programs, if utilized, on the sale of their business.

Business owners that applied for a loan (“PPP Funds”) under the Paycheck Protection Program under the CARES act will likely need to determine whether the loan will constitute debt, if it is intended to be forgiven, and how to allocate the risk in light of the unknowns related to the program. Further, the Small Business Administration (“SBA”) issued guidance related to a change of ownership in an entity that received PPP funds, which defines when a change of ownership is deemed to have occurred, outlines how lenders may independently approve the ownership change, and how SBA approval is obtained. As a general rule, if the PPP note is satisfied via repayment or forgiveness there is no restriction on a change of ownership, however, if the PPP note is not satisfied PPP lender approval and/or SBA approval is required. See our article, SBA Issues “Change of Ownership” Procedures for PPP Borrowers: M&A Transactions Must Now Be Reviewed for Compliance, for a more detailed discussion on procedures for PPP borrowers with a change of ownership.

Due Diligence Considerations

Business owners should also expect additional diligence investigation by potential buyers related to COVID-19.  Buyers will want to know what business continuity and disaster recovery plans the business has, whether the business owner has issued or received force majeure notices due to business interruptions caused by COVID-19, whether the business owner has knowledge of or received notices of any threatened breach or default, modification or termination under any agreements due to business interruptions caused by COVID-19, whether any claims are being made or intended to be made to the business’s insurance, what accommodations are being made for employees to comply with public health protocols or guidelines, whether employee complaints had been made for the business failing to provide a safe working environment or accommodations related to COVID-19, and other various diligence items.

Additionally, the way diligence is conducted is likely to change because of COVID-19 where face-to-face meetings between the potential buyer, business owners, and the key employees are likely to be limited for several more months if they occur at all.  Because the buyer is going to want to ensure a culture fit is likely business owners should be aware that buyers are likely to insist on meeting the management team in person before closing, which may result in an extension of the due diligence phase. Further, if the type of assets the potential buyer is interested in acquiring are physical assets rather than intellectual property related assets, the ability to inspect physical assets may be limited and extend the diligence phase.

Representation and Warranty Considerations

Purchase agreements include a variety of representations and warranties that the seller provides to the buyer regarding the business. As such, business owners will need to specifically disclose laws, policies, and operations that have been modified or added in response to COVID-19 such as the addition of temporary employment policies, compliance with federal and state mandates, or the modifications to the operation of the business as a whole. The buyer is going to require the business owner to disclose all material impacts to the business related to COVID-19.

Furthermore, the use of the “ordinary course of business” may create heartburn amongst buyers and sellers alike. Buyers may not be comfortable relying on that language, especially if sellers seek exceptions to the requirement in the event of the pandemic or a similar event to allow the seller to act in response to the event that they normally do not take. Buyers will want to be cautious allowing too many exceptions to prevent a situation where the language allows the seller to take action that ultimately harms the business.

Material Adverse Condition Considerations

Potential buyers are going to be pushing for various protections in the purchase agreement in light of COVID-19, including a material adverse condition clause that will aim to allow the buyer the right to walk away if the business suffers materially due to the impact of COVID-19, and most buyers will seek specific references to COVID-19 (rather than generic references to pandemic, or public health event) so there is no ambiguity. Sellers, on the other hand, will likely seek carve-outs to any material adverse condition clause in the event the change is a result of a pandemic or the government requires shut down.

Representation and Warranty Insurance

The use of representation and warranty insurance has become more common and is often seen in middle-market transactions. Parties should be aware that underwriters of such insurance policies may begin to exclude COVID-19 claims in most transactions, and as such, the parties will need to take extra care in considering the impact of this exclusion on the deal terms.

Other Business Considerations

Business owners need to remain cognizant of the economic impacts COVID-19 will have on its key customers and vendors as buyers will need to be appraised of any change of circumstance related to those relationships, including supply chain problems, enactment of force majeure contract claims, impact on accounts receivables, and more.

Business owners will need to demonstrate adaptability as the world continues to deal with the impacts of COVID-19. The shutdown of nonessential businesses, social distancing requirements, restrictions on travel, and related COVID-19 mandates have had and will continue to have an impact on the efficiency of business owners and their advisors alike. As a result, it has caused and may continue to cause delays in closing deals or due diligence being completed so businesses and their advisors will want to allow for flexibility when it comes to timelines and due dates.  However, business owners will also need to be prepared for business to return to normal and have a plan in place to demonstrate to buyers how the company intends to return to pre-COVID-19 operations.

If you have questions regarding this article or need further information related to the purchase or sale of a business in light of COVID-19, reach out to your Davis|Kuelthau attorney, the authors linked above, or the related practice group chair linked here.

We will continue to monitor the impact of COVID-19 and provide information businesses need today to prepare for a continually changing tomorrow via our Navigating Disruption: Business Resilience Resources hub.

Davis|Kuelthau has created an Essential Business Toolkit for clients navigating various business restriction orders in Wisconsin and throughout the United States. The Toolkit includes template authorization forms to declare Essential Business status, and a declaration to distribute to staff members for use in confirming approval to travel in the event they are stopped by the authorities. Clients who are interested in these resources should contact their respective Davis|Kuelthau attorney for details.