The novel coronavirus (“COVID-19”) triggered unprecedented disruptions in business operations, supply chains, and distribution networks. With such disruptions come considerable challenges to existing and future merger and acquisition (“M&A”) transactions.
We created a series of alerts to educate buyers and sellers about the ways in which COVID-19 may impact the transaction process and the terms of the purchase agreement. This alert (Part II) focuses on the impact of COVID-19 on valuation and due diligence. A previous alert (Part I) focused on the impact of COVID-19 on representations and warranties, pre-closing covenants, and MAC clauses.
The impact of COVID-19 makes valuation more difficult for buyers and sellers. A seller’s historical financial performance is usually a key factor to determine valuation and purchase price. For many businesses, however, historical financial information may not necessarily predict the future performance of a company due to the current and future impact of COVID-19. The impact of COVID-19 is wide ranging for many businesses, including disrupted supply chains, reduced business operations, and impaired future revenue.
To account for this new uncertainty, an M&A buyer may include one or more protections designed to shift a portion of the valuation risk onto the seller. One protection is a purchase price adjustment based on the revenue or EBITDA of the seller’s business. This purchase price adjustment is similar in structure to the more common working capital adjustment. Actual revenue or EBITDA immediately prior to closing is measured against metrics set by the parties earlier in the M&A process.
While a purchase price adjustment based on pre-closing revenue or EBITDA is intended to help protect a buyer against drops in pre-closing financial performance, the full impact of COVID-19 may not necessarily be known until some period of time post-closing. Due to the potential medium-term and long-term impact of COVID-19 on many businesses, buyers will likely increase the use of earnouts. With an earnout, a portion of the purchase price is paid once the seller’s business hitting specific revenue or EBITDA metrics during a post-closing measurement period. While parties often avoid earnouts due to their complexity and high likelihood for creating post-closing disputes, earnouts serve to shift a portion of the valuation risk onto the seller.
The impact of COVID-19 also extends to the due diligence that a buyer will conduct during the M&A transaction. Due diligence allows a buyer to review information about the seller and its finances, operations and other key areas.
Similar to our discussion in Part I related to representations and warranties, sellers should expect buyers to include COVID-19-specific diligence questions in due diligence request lists. The example diligence requests listed below represent a mix of new requests that are COVID-19-specific as well as common due diligence requests that will have an increased emphasis.
- Operational changes since COVID-19 restrictions were enacted, including impact of social distancing restrictions on operations
- Impact of COVID-19 laws or regulations on seller, its customers or vendors
- Supply chain risks, including confirmation of supply chain business continuity and existence of changes in shipments and key terms
- Distribution chain risks, including ability to ship products and existence of disruptions to distribution networks
- Workforce, health and safety policies and procedures, including accommodations the seller has made for employees
- Receipt of complaints related to failure to provide safe working environment
- Adequacy of insurance coverage and existence of COVID-19-related claims
- IT systems, including response to remote workforce and customer communications impact on cybersecurity measures and exposure
- Impact of travel restrictions on customer and vendor relationships
- Termination rights and force majeure provisions in key customer and vendor contracts
Additionally, the new COVID-19 virtual environment creates challenges for due diligence with continuing restrictions on travel and business operations. One of the major issues include the inability to conduct on-site visits and management meetings which are a critical part of comprehensive due diligence. With the proliferation of video conferencing, buyers are adapting their inspections to digital platforms, while asking sellers to include representations and warranties that certify digital findings. Sellers also should keep in mind that health data of employees or contractors (such as COVID-19 diagnosis) may constitute “personal information” and that the disclosure of any such personal information is subject to applicable law and the seller’s privacy policies.
Buyers and sellers are modifying their approach to M&A transactions in light of the significant impact to date and the uncertain future impact of the COVID-19 pandemic. Some of these changes include structural changes due to disagreement over valuation and conducting additional and COVID-19-specific diligence.