What to Consider in Private M&A Transactions During COVID-19
As the United Sates looks to move forward in reopening the economy, it has become clear that there may be a new “normal” for a period of time. For individuals looking to sell or purchase a business prior to this pandemic, the question now becomes how exactly this new normal will affect the M&A transaction landscape.
Current Marketplace
Surprisingly, right now may be an ideal time to purchase or sell a business. While the legislation from the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was focused on the Paycheck Protection Program, there was a key provision relating to existing SBA Loans. In short, the SBA will automatically pay all principal, interest and fees owed for a period of six months for any current 7(a), 504 or microloans loans as well as any new 7(a), 504 or microloans issued prior to September 27, 2020. In other words, an individual who wishes to purchase a business and borrows from an SBA lender prior to September 27, 2020, will have six months of any costs of the loan automatically paid by the SBA. This could make purchasing a business incredibly attractive to some purchasers.
On the other side, as negative economic impacts are affecting so many businesses across the country, many business owners may be looking for ways to exit. With some owners having difficulty obtaining PPP loans or EIDL’s, or certain owners or businesses being disqualified from such assistance, a lot of businesses are still experiencing major cash flow issues. At some point, listing their business for sale may become a viable alternative to supplement owner’s income. Additionally, as discussed below, business owners who were looking to sell prior to COVID-19 should not be deterred from selling as there are ways to protect the value of the business.
Due Diligence
It is especially important for any purchaser 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? Are these vendors experiencing shortages? What do the contracts say regarding non-performance? 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?
Customer Analysis – Are customers of this business still purchasing the product or service? Are local or state government orders forcing this 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?
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 value in April 2020. Purchasers are likely to push for a discounted price due to COVID-19. Sellers will be reluctant to agree to such 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 met at the end of 2019. Purchaser’s 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. This ongoing back and forth could result in a failure to reach an agreement which is acceptable by both sides.
Agreements can be drafted in a way to make both sides content in this regard. One thing that could potentially become more prevalent in private M&A transactions is the concept of an “earnout”. 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. Adding an earnout to an agreement is likely to give both sides more comfort in the transaction. Purchaser may like this as amounts paid at closing may be at a discount with additional payments required only if the business attains profitability, and Seller’s will be content and will still be protected in ensuring they receive fair value for the their business once the economy returns to levels seen pre-COVID-19. 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. COVID-19 is likely to have significant impacts on these provisions. Sellers will want to 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. Seller’s 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 more narrow carveout, excluding any event caused due to a “pandemic”. Click here if you have already entered into a M&A transaction agreement and are considering whether to invoke an MAE clause.
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.
Tax Provisions
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 allows 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 defer 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. Click here for more information regarding employer payroll tax deferrals.
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 who are operating at a loss more attractive as it provides options to utilize existing net operating losses. Click here for more information regarding the modification of net operating loss rules.
Summary
While COVID-19 has impacted how M&A transactions will proceed going forward, the agreements can provide for mechanisms to help make buying or selling a business during this pandemic attractive.
Check out the Crow Legal COVID-19 Resource Page for new developments regarding COVID-19.