In this second alert in our series discussing M&A in the COVID-19 era, we will address potential acquirers in the marketplace. As we posited in our last release, the COVID-19 pandemic will most certainly create opportunities for buyers poised to act fast to seize good deals when they arise. In fact, a number of our buy-side clients have already contacted us about potential acquisitions and other transactions in the coming months as founders of potential target companies struggle to sustain operations, notwithstanding their otherwise strong business models.
So how can you, as a potential acquirer, prepare to move quickly and decisively when an opportunity presents itself? First, you should prepare and upgrade your standard deal documents (e.g., preferred forms of a mutual nondisclosure agreement, due diligence request list, and letter of intent) so they’re ready for immediate delivery to a potential target. Having these documents ready and waiting will help you accelerate the negotiation process, understanding that deal-specific tweaks will need to be made to these documents before you send them to your prospective target.
Of course, the definitive purchase agreement is the document that really counts. There is no reason to draft that document before addressing certain key considerations (e.g., will the acquisition be completed via a purchase of assets or equity of the target, or as a merger); but buyers would be wise to anticipate and consider how to address certain key issues and negotiation points that the parties will have to tackle in order to seal the deal. For example:
Purchase price: More now than in recent years, buyers and sellers are likely to have inconsistent views about the value of the seller’s business. Historical financials may support the seller’s view of valuation, while the recent and perhaps prospective impact of the COVID-19 downturn will color the buyer’s competing view. Buyers should be prepared to consider creative ways to bridge any gap with the seller on price, including by making a portion of the purchase price contingent on performance of the target business after closing (an “earnout”) or potentially paying a portion of the purchase price in equity of the buyer (which would enable the seller to participate in future value created after the acquisition).
Working Capital Adjustment: The working capital adjustment in a transaction (e.., increasing or decreasing the purchase price based on how much working capital the target has at closing relative to an agreed-upon target) can often be the subject of significant negotiation prior to the deal closing and stinging disagreements after closing. Given the current downturn and its impact on cash flows, buyers will need to pay particular attention to how the working capital target is calculated as sellers seek to minimize the risk of failing to meet the target and the resulting purchase price reduction. While the seller will point to the business’s pre-downturn working capital needs to support a particular target for this purpose, the buyer will need to reassess working capital needs in light of financial strains on the business created by the pandemic. If nothing else, buyers should reevaluate what constitutes normalized working capital in the downturn and should also push for a longer post-closing purchase price adjustment period to allow more time to assess the pandemic’s impact on the target’s business. Buyers should also consider pushing for increased working capital escrow amounts to help minimize risk.
Representations and Warranties: Every purchase agreement requires the seller to make representations and warranties about the business and operations of the business, and then stand behind those representations after closing if any of the representations or warranties are incorrect and buyer suffers a financial loss. Buyers should upgrade and expand the customary representations and warranties contained in their current form purchase agreements in order to ferret out operational, contractual, and financial challenges caused by the pandemic. For example, consider asking the seller to provide representations concerning (i) compliance with SBA regulations and the terms of any CARES Act loans the seller may have obtained, and (ii) the impact of those loans on the terms of any preexisting indebtedness. Consider also strengthening seller representations concerning accounts receivable and payable, deviations from GAAP in financial statement preparation, the absence of material changes since the last financial statement date, and the status of key customer and supply agreements.
Pre-Closing Operating Covenants: For transactions where there will be an interim period between the signing of the purchase agreement and closing, buyers should anticipate and plan for how to address seller requests for increased latitude in operating the business prior to closing in light of the challenges of the current downturn, while still giving the buyer approval rights over certain significant actions by the target. Will the buyer want more rather than less oversight and consent rights over seller’s pre-closing operations in light of current conditions? If yes, and understanding that most sellers will resist buyer’s involvement in operations, consider what specific areas cause particular concern and be prepared to provide a principled argument for greater-than-normal buyer oversight. Examples of potentially sensitive areas include expansion of sick-leave policies, changes in supply arrangements, amendments to material contracts, and operational shutdowns.
Closing Conditions: Given the unpredictable impact of the COVID-19 crisis on the economy and your seller’s business, buyers should revisit the closing conditions section of the purchase agreement and reconsider what circumstances, if they arrive, should give the buyer the right to walk away from the deal and terminate the transaction. For example, if an unforeseen government shutdown order prevents the seller from operating in the ordinary course, should the buyer have the ability to terminate the deal, or just postpone closing? In this regard, give some thought to the proposed “drop dead date” (or “end date”) and consider if providing for a longer than normal runway to closing might make sense in light of broader market uncertainty and other factors like slower regulatory review. Consider also including a financing out to give the buyer the right to walk away from the deal if bank financing does not materialize because of downturns in the credit market.
Insurance: Given the increased affordability of representation and warranty insurance, buyers should explore whether they can obtain insurance for their deal at an attractive price, and ask the seller to share in the cost of the policy (e.g., cost of the premium or any deductible that the buyer must meet before recovering under the policy). If the buyer does purchase coverage, they will need to review the policy carefully and potentially negotiate with the insurer to minimize coverage exclusions for COVID-19 or to tailor them as narrowly as possible.
Be on the lookout for our next alert where we’ll address what sellers can and should do to be prepared for a transaction in this pandemic-induced downturn. Until then, be safe and take care.
The contents of this Alert are for informational purposes only and do not constitute legal advice. If you have any questions about this Alert, please contact the Shulman Rogers attorney with whom you regularly work or feel free to contact a member of the Mergers and Acquisitions Team.
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