M&A in times of Corona
By Friederike Henke and Paul A. Josephus Jitta
Given the tremendous impact that the virus has on doing business in general and on companies’ businesses in particular, mergers and acquisitions activity is dropping tremendously. Companies fac-ing a heavily affected work force, wiped-out demand or disrupted supply chain have to struggle for survival. Nobody can tell how long this insecure and threatening situation will continue. It is clear though that doing business has become difficult now, due to national and international travel bans, closed-down public life and the limitations to meeting people. COVID-19 does not only demonstrate our human vulnerability, but also that of our globally integrated societies, economies and businesses. The upside is that we live in modern times and the state of our science and technology should allow governments to take the required measures to slow down the virus and find solutions to stop it. How-ever, this might take more time than we would like. In times of decreasing M&A, M&A specialists are to focus on the effects of the virus on pending deals, done deals and future deals.
Pending deals: to terminate or not to terminate?
Most pending deals will not come to a close soon, as both the seller and the buyer shall want to shel-ter against the current storm. Sellers will fear that they will not obtain the agreed purchase price or shall have to grant far-fetching representations and warranties to the buyer, as buyers shall want to shift to the seller part of the existing risk on the target’s uncertain future business outlook. Buyers shall want to see how the Corona-crisis is affecting the target’s business and the agreed purchase price. Quite commonly a multiplier on the target’s pre-Corona EBIT(DA) (earnings before interest and tax (and depreciation and amortization) shall have been used. Post-Corona EBIT(DA) might seriously deviate from that. There have been jokes on twitter referring to EBITDAC where the “C” stands for “Coronavirus”. Changing deal perspectives are also likely to affect any external financing of transac-tions.
Pursuant to Dutch law it depends on the actual status of the negotiations and the letter of intent, term sheet or memorandum of understanding, if any, whether or not parties are still free to terminate the negotiations or whether they are required to reimburse costs or damages to the other party. Having said that, nobody can deny that the current crisis is unparalleled and terminating negotiations facing such a perfect storm shall very likely be justifiable in most occasions.
If a pending deal is already signed it is now in an interim phase awaiting closing. In this interim phase certain conditions precedent / pre-closing covenants shall have to be met, such as governmental ap-proval, third-party involvement or financing. If parties agreed on a material adverse change/effect clause (MAC/MAE), usually both parties can terminate the transaction without further consummating it and without incurring costs or damages to the other party, provided the conditions of such MAC-clause are met. If the respective MAC-clause covers pandemic situations, termination rights are se-cured. In most cases Corona will likely have material adverse effects on the target’s business. If par-ties did not agree on a MAC-clause, usually the purchase agreement contains a termination right for the seller, the buyer or for both parties in the event it is likely that one or more of the conditions prec-edent are not or will not be met.
Most SPAs also contain interim period operative covenants for the seller to run the target’s business in the ordinary course. For any business decisions outside of the ordinary course the seller requires the prior written approval of the buyer. In these times sellers are likely to take unconventional measures in order for the target’s business to survive. If such measures are outside of the ordinary course of business, parties (usually the buyer) might have the right to terminate the purchase agree-ment. Whether or not the seller is required to reimburse the buyer for all costs made shall depend on the contents of the purchase agreement. Well-balanced drafting should protect sellers against claims from buyers.
Another aspect to be considered for deals that are between signing and closing is that most SPAs require the seller to provide the buyer with extensive representations and warranties, both at signing and at closing. Even if the Corona-crisis has not hit a business in such a way that it leads to a MAC or to the business running outside the ordinary course of business, sellers will need to carefully check whether each of the representations and warranties provided at signing is still accurate at closing.
Done deals: likelihood of purchase price adjustments
Transactions already consummated prior to the outbreak of the Corona-crisis are likely to be affected if a purchase price adjustment mechanism, such as an earn-out, was agreed upon. Buyers shall want to shift the burden of decreasing target’s results to sellers by lowering earn-out payments. If the earn-out payment is to be determined on the target’s turnover, lower earn-out payments are likely. If such earn-out is based upon the EBIT(DA), it is even more important how successful the target can be in temporary cost reduction. Higher costs will clearly reduce EBIT(DA) and therefore the anticipated earn-out. Again, the importance of a purchase agreement well-balancing both the interest of the seller and the buyer is of the essence. Did parties for example agree upon leaving aside once-only effects, such as temporary costs influencing the relevant earn-out EBIT(DA)? If not, the buyer will profit and might even further influence EBIT(DA) in this respect. In a decreasing economy usually inter-company litigation activity increases. We therefore expect to face an increasing number of earn-out disputes.
Future deals: Corona effects all-over
In future transactions the effects of Corona on the target’s business can be expected to be every-where. Was the target’s corporate decision-making affected due to violated convening, (digital) at-tendance or quorum requirements? If so, was this healed appropriately? Did the target make use of emergency funding and is it compliant with the terms and conditions thereof? Were any of the target’s material agreements violated? Can damages be claimed or, to the opposite, expected to be incurred? Do these agreements contain price adjustments / renegotiation mechanisms? Do the insurance poli-cies of the target provide for any coverage of Corona driven losses? Have any filing deadlines been missed, for example regarding IP Rights or permits? Are there any licensing and data privacy implica-tions as a result of remote working arrangements? What is the status of pending litigation proceed-ings and what is the likelihood of new proceedings, for example on breached contracts? Were the pension contributions fully paid during the crisis? Did the target make use of the possibility to delay tax payments?
Sellers should be prepared for buyers being highly sensitive to these issues and show them infor-mation on the impact of the Coronavirus outbreak on the target’s business and what they did to miti-gate this. Buyers should thoroughly investigate the same during due diligence.
In the contract negotiation phase we expect COVID-19 to lead to specific stipulations.
Locked box, the most used mechanism for determining the purchase price in a shares transaction, can be expected to be replaced by the more traditional closing accounts mechanism, with a tradition-al working capital adjustment provision to limit risks in declining working capital for buyers. Are there any Corona-related adjustments to be incorporated into the net working capital calculation (e.g., a-typical collection of accounts receivable or payment of accounts payable, non-recurring penalty pay-ments)? Debate can be anticipated around the appropriate target working capital level, in particular whether adjustments need to be made to historical average working capital levels to reflect short/intermediate-term Corona impacts.
Earn-out mechanisms can be expected to become increasingly popular for bridging post-Corona pricing gaps. However, the terms and conditions thereof should be carefully negotiated with due con-sideration of the “uncertainty” factor, as no one is able to predict the extent and duration to which Corona will impact the financial performance of the target’s business.
Obtaining regulatory approvals might take more time than before and realistic long-stop dates might be planned further into the future.
Sellers should disclose as much as possible about the (potential) impact of the Coronavirus on the target’s business and its (potential) effects to ensure adequate defenses in the event of a claim. Buy-ers should on their turn pay in-depth attention to these aspects in the Q&A and consider seeking addi-tional representations and warranties relating to the target business’s emergency protocols, contin-gency planning, business continuity processes, undisclosed liabilities relating to the virus, the status of material contracts and performance thereunder, the adequacy of supply chain and inventory, col-lectability of accounts receivable, ability to pay accounts payable and other adverse impacts of the virus.
All these examples lead to the safe conclusion that the effects of the Corona-crisis shall reiterate long time after the virus shall have been beat.
“Closing”
In his in 1985 published novel “Love in times of cholera” Colombian Nobel price winning author Gabriel García Márquez was not referring to M&A activity in pandemic times. Nevertheless, M&A will over-come Corona-times as well. The effects of the virus outbreak will be all-over targets’ businesses. Not only pending transactions shall be affected but also done deals and future deals. For successful future sales and purchases these effects will have to be assessed timely and to be addressed ap-propriately in the transaction documentation. Both sellers and purchasers better prepare for that to make new transactions Corona-proof.
By Friederike Henke and Paul A. Josephus Jitta, lawyers at Buren N.V.
