By: Scott Van Vooren
Merger and acquisition activity has significantly decreased since the outbreak of the COVID-19 pandemic. As uncertainty exists, buyers and sellers have put many transactions on pause to see what might develop. For those transactions that occur during the pandemic and for those that are jump started thereafter, the purchase agreement should be drafted taking into consideration the effect that COVID-19 will have on the target. Below sets forth some of the COVID-19 matters that buyers and sellers should consider:
1. Valuation of a target can be challenging. Revenues are off and expenses have increased from pre-pandemic levels. Sellers will propose addbacks in an attempt to normalize EBITDA. The buyer will be concerned whether there will be a rebound upward of the target’s revenues and downward of its expenses to pre-pandemic levels. The seller will want certainty on price claiming COVID-19 is a short-term event. Buyer will want to value the target on what has occurred as opposed to what could be in the future. Expect earn-out discussions to bridge the gap. In order for an earn-out to work, the seller and the buyer will have to be aligned on whether the business can earn itself out of the disruption resulting from COVID-19. Earn-outs issues include how the business will be run post-closing to obtain the rebound to pre-pandemic levels. Seller will want sufficient allocation by buyer of resources with an understanding as to how the business will be operated post-closing. Buyer will want maximum leeway to operate the business. Earn-outs in practice are an appealing concept but are ripe for conflict post-closing.
2. The vast majority of transactions factor into the purchase price a component of working capital based upon a normalized amount of working capital that the target has at the closing of the transaction. From that normalized amount there is a purchase price adjustment up or down depending on whether the working capital at closing is above or below the normalized working capital amount. The working capital normalized amount and the subsequent working capital calculation in connection with the purchase price adjustment must be carefully reviewed in light of COVID-19 and a determination should be made whether an adjustment be made to reflect COVID-19 factors such as an influx of cash resulting from the Payroll Protection Plan, increased mitigation expenses, or other adjustments expected in the target’s financial operations. Consider whether a separate escrow should be provided for to account for variability during the operating time while COVID-19 applies to account for a potential downward purchase price adjustment.
3. There are several concepts to consider when drafting seller’s representations and warranties.
(a) The target may have supply agreements and purchase orders that it is having difficulty meeting because of supply chain disruption. Special care during the due diligence period should be taken to have those adequately disclosed. In many cases, the target may be required to incur mitigation expenses in order to comply with agreements signed pre-COVID-19 which expenses were not contemplated prior to the pandemic. Determine whether the target has received or given any force majeure notices to excuse or delay obligations under contracts.
(b) Pay attention to the target’s accounts receivable. Many companies up and down the supply chain are experiencing stress. It is reasonable to expect that the higher percentage of accounts receivable due to the pandemic will be uncollectible resulting in write-offs. In addition, check the aging for target’s accounts payable as those may be deferred.
(c) Due to supply chain disruption, levels of inventory may be insufficient or may be more difficult or costly to obtain.
(d) Consideration should be given to family leave laws, OSHA, overtime, discrimination, and employment law provisions arising out of the Family First Coronavirus Response Act. If reductions in force were taken, make sure they were done in compliance with state and federal WARN Acts. Determine whether the target received a claim by any employee that its work environment is unsafe, that the target’s employees are working remotely under policies in compliance with the Center for Disease Control and State Department of Health, and whether the target has a significant number of employees under quarantine.
(e) In connection with the target’s financial statements, determine whether any accounting principles have changed or altered and whether there are any material deviations from GAAP.
(f) The CARES Act recently passed makes several changes to tax laws. For example, businesses are permitted to defer for 2020 the employer’s portion of Social Security taxes. If the transaction is a stock purchase, that unpaid liability is that of the target. Therefore, a representation by the buyer should be obtained regarding no deferral of payroll taxes and if there is such a deferral, the amount of the deferral which the buyer will want to be factored into the purchase price.
(g) The target may be subject to state emergency orders covering shutdowns unless it is an essential business. Any pandemic-related orders should be included in the disclosure schedules and considered by the buyer.
(h) A close look at the IT of the target should be done to determine that the infrastructure is able to handle heavy telecommuting and whether such is done in compliance with licenses and data security requirements. Buyer should also obtain representations about data privacy compliance. With workers working remotely, there is greater susceptibility to data breaches. Check to see if the target has instituted third-party testing to check vulnerabilities. Also check to see if the target has implemented employee education in an attempt to bring awareness regarding phishing, malware, cyber hygiene and potential data breaches.
(i) There should be a representation and warranty regarding the absence of changes since the balance sheet date. In addition to the ones typically requested, obtain others about change of line of business (a local business pivoted from a distillery to manufacturing hand sanitizer while others have recently manufactured face masks and other PPE for health care concerns). Others include any accounting changes, governmental shutdown or other orders, accounts receivable write-offs or accounts payable deferrals, any reduction in force, material changes in suppliers or customers.
4. If the transaction is contemplated to be signed and closed at a later date, there will need to be covenants so that the buyer will be certain that the target will be operated from signing to closing in the ordinary course of business consistent with past practices. The seller understandably will want some type of leeway for business disruption due to the pandemic such as operational shutdowns due to supply chain issues or governmental stop orders and increased expenditures to mitigate potential issues regarding delivery under contracts if the supply chain is disrupted, and the like.
5. Consider closing conditions, particularly if the buyer will be financing the transaction and the likelihood that loan approvals and documentation will take longer during the pandemic period. If Hart-Scott-Rodino filings must be made, make sure there is plenty of time and understand for now the Federal Trade Commission and the Department of Justice are not giving early terminations.
6. You can expect that indemnification provisions will lean the buyer’s way, including limitations of liability such as baskets caps, types of damages, and the like. Material adverse effect clauses will likely add pandemic or epidemic to their definition.
7. During the pandemic, virtual due diligence will be key. Virtual data rooms may be set up and populated with buyer’s due diligence requests. Virtual due diligence could become an issue if the target is less sophisticated. Site visits may be challenging.
8. Representation and warranty insurers are reacting to COVID-19 and have adopted their underwriting standards to consider risks associated therewith such as excluding the COVID-19 exposure from coverage.
During the COVID-19 pandemic, transactions will occur. It is important to thoughtfully consider potential COVID-19 effects on your transaction and negotiate and document your deal accordingly.
Scott is a senior partner in Lane & Waterman’s Mergers & Acquisitions practice group, helping clients with transactional and business matters including mergers and acquisitions, joint ventures, corporate and limited liability company formation and governance, commercial real estate transactions, and general corporate and contractual matters.