As the world begins to emerge belatedly from the COVID-19 crisis, potential buyers are lining up to forge ahead with existing expansion plans that were delayed due to the pandemic or take advantage of the opportunities that the post-COVID-19 economic landscape may present. Both buyers and sellers will naturally need to pay very careful attention to the interpretation and negotiation of sale and purchase agreements. However, in an environment of increased uncertainty around the impact of the pandemic and the target business’s development, how should sale and purchase agreements address these uncertainties? How can this uncertainty be catered for in the context of an M&A deal?
In this second of four blog posts, Global Transactions partner Jochen Ellrott looks at the type of valuation and consideration provisions that buyers and sellers might utilise to minimise the risk of mis-pricing deals in a market where traditional financial barometers have been undermined.
Valuation and purchase price mechanics
In most cases, it will be difficult for quite some time to predict the impact of the pandemic on a target business’s revenue, profitability and, accordingly, its valuation. For that reason, many buyers will not rush to execute deals, but will rather want to review a minimum of two quarters of “COVID-19 financials”, i.e. the financial results of two quarters after the pandemic took effect on the business. In most cases, this will mean that financials for at least the first two, if not three quarters of 2020 will need to be available.
It is safe to assume that even the availability of COVID-19 financials will not eliminate uncertainty around valuation completely. How can that be addressed in the context of a sale and purchase agreement? Buyers are likely to drive a return to the use of completion accounts, whereas in many markets fixed price arrangements – mostly in their locked box manifestation – have previously been the norm. It is paramount to note, however, that closing accounts typically only capture a cash drain or working capital erosion between signing and closing; they do not capture long-term revenue or profitability loss and are thus an imperfect tool to address the valuation dilemma.
It is therefore worth considering a purchase price adjustment for revenue or EBITDA loss between signing (or the last balance sheet date) and a defined future point in time. If the anticipated time between signing and closing of a deal is sufficiently long and therefore likely to register most of the impact of the pandemic, closing accounts – in a broader sense as they would capture more than net debt and working capital movements – are the obvious choice to adjust the purchase price. If the impact is likely to show or increase meaningfully after closing, earn-outs or earn-ins may be the better option to bridge the gap and more closely align the valuation with the ongoing performance of the acquired business.
Earn-outs / earn-ins
Earn-outs provide for an increase of a (lower) initial purchase price in case of better-than-expected financial performance of the target business as measured in sales, revenue, EBITDA, free cash flow, average revenue per user or any other appropriate metric. “Earn-ins” are the seller-friendlier inverse to earn-outs and require the seller to repay a portion of the (higher) initial purchase price at a future point in time based on a decline in the defined metrics.
In both cases, parties can agree a limit to the adjustment to establish a floor on what the seller will receive or a cap on what the buyer must pay, as applicable. For obvious reasons, earn-outs are favoured by buyers as they will only be required to use liquidity if and when the higher purchase price has become definitive, whereas sellers naturally prefer earn-ins.
Whatever form of price adjustment is employed, the parties will need to work hard to agree and define the metrics of the adjustments, the process for agreeing them and, in the case of contingent consideration, the permitted operating parameters within which the target must operate to achieve its targets. Parties should keep in mind that even if the metrics and calculation methods are clearly defined and properly drafted, disputes are still likely. Parties may therefore want to consider binary mechanics where a specified event (e.g. a further lock-down of a minimum length in a second wave of infections; legislation impacting the target’s supply chain in a defined manner; or the imposition of specific import or trade restrictions) or development (e.g. a shrinking of the relevant economy by a certain percentage of GDP; or a drop in average revenue or EBITDA in the relevant in sector) will trigger a fixed change to the purchase price. However, parties will likely shy away from such, rather simplistic automatisms and prefer to rely on more elaborate, yet more complicated (and dispute-prone) solutions.
Payor covenant strength
In the case of an earn-out / earn-in, the party entitled to receive the adjustment payment will want comfort that the counterparty is good for the money if a payment obligation does indeed arise. When considering ways of creating that comfort, parties should consider the relative commercial terms for different payment support mechanisms. For example, bank guarantees may be costly but are typically favoured over escrow mechanics, where the entire amount at stake is parked somewhere secure without earning meaningful interest. In the current economic climate, however, the cost of capital of bank guarantees and escrow payments will not be too dissimilar.
A parent company guarantee will undoubtedly be the least costly option, though this provides imperfect protection if the parent itself is not immune to financial distress. (It is also worth noting that the parent’s financing arrangements may limit the ability to provide collateral to a third party making this an unfeasible solution).
Earn-outs will be less attractive to distressed or insolvent sellers as there will be an inherent requirement for the seller to realise the full sale proceeds and, in the case of insolvency, distributed to creditors quickly. Insolvency administrators, receivers and similar officeholder are notorious for rejecting any purchase price adjustment whatsoever. It is nonetheless fair to assume that earn-outs will become a much more common feature of M&A transactions as deals terms become more buyer-friendly, and buyers focus more on ensuring valuations match the ongoing viability and operational health of target businesses. Annual earn-out tests or milestone payments providing for earlier, yet staggered cash inflow to sellers may make the approach more palatable to them.
Payment in kind
Another way of addressing valuation uncertainty is paying a portion or all of the purchase price with buyer stock, at least in cases where the purchaser is a strategic buyer from the same industry. This obviously assumes that the axiom “cash is king” does not apply in the transaction where such payment in kind is considered, which will be the exception. If both parties are players in the same sector, there is a fair argument that in the current climate, any swing in the performance of the target business caused by the pandemic or its aftermath is likely going to affect the buyer’s business and hence its stock price similarly. The purchase price will therefore be subject to some degree of automatic indirect adjustment and, while such adjustment will not be a dollar-for-dollar reflection of the target’s performance, a stock deal can help level out some of the volatility of valuations.
If share consideration is to be considered, a number of factors will need to be explored beyond simply the commercial merits, including:
- the extent to which the seller will be able to conduct due diligence on the buyer giving the share consideration (this may depend on the buyer’s willingness to allow diligence but also whether the seller is in a position to devote resources to this);
- depending on the relative size of the buyer and the seller, whether certain listing requirement issues could be triggered by the new shares; and
- the extent to which anti-trust rules will apply if the buyer and the seller operate in the same markets.
From the seller’s side, the risk of mis-pricing a disposal and becoming subject to subsequent accusations of having sold too cheaply as a knee-jerk response to a global market shock, can be mitigated to some degree by the use of anti-embarrassment (or “anti-flip”) clauses which may see a comeback. These clauses provide for a top-up of the purchase price if and to the extent that the buyer on-sells the target business to a third party within a certain period of time (typically one to three years) at a significant premium to the price the buyer paid to the original seller. Such top-up may not be permitted on public M&A deals, however.
As deal-terms potentially shift in favour of buyers, achieving certainty of execution will be paramount in the minds of sellers in return for potentially having to acquiesce to other buyer-friendly mechanics. As we continue our blog series, we will look at what parties might expect in terms of conditionality on M&A deals and how parties might seek to strike the balance between providing for certainty of execution, and addressing the desire of buyers to walk away where significant changes to the business or operations of the target, or to the wider macro-economic environment, make a transaction unpalatable.
(For those who wish to continue reading, the consolidated version of all four blog posts is available in the attached/linked PDF.)