Insights / 27-07-2020

The current climate has made the valuation of target companies very difficult for buyers, ultimately impacting M&A deal flow globally.   Whilst deal flow is unlikely to resume the pace it took in 2019 it appears that buyers and sellers alike are feeling more comfortable with exploring deals they may not have considered 2 months ago.  However the M&A landscape is now very different.  These days it is less of a sellers’ market and parties are having to consider more flexible and creative ways to structure a deal to allow for the fair allocation  of the valuation and financial risks associated with the transaction.

What line of questioning can the management team of a target company expect from the buyer in a post COVID-19 world?

Aside from pandemic related due diligence checks sellers have come to expect to receive (see our article COVID-19: Transactional due diligence in a post COVID-19 world), particular questions are also being impressed upon the target’s management to allow buyers to better assess the risks, capabilities and operations of the business of the target and consider impact on the value of the business.  Questions being asked of management include:

• What decisions did you make to manage the impact of the pandemic and why? Did these decisions impact your employees and suppliers? How?
• Has your supply chain been effected by the pandemic?  How?  What steps did you take to cope with any vulnerability in the supply chain?  Have any changes that have been made long-term?
• Have you encountered any increase in operating costs?  Will these continue in the post-COVID-19 world?
• Have you revised your business plan?  Have any steps been taken to plan for a second wave of the pandemic?

A buyer wants to ascertain the seller's pre-COVID-19 financial performance and how the seller will manage through the disruptions caused by the pandemic.  Sellers appear to be preparing their management teams to address such queries making the process as transparent and as informative as possible for the potential buyer.  Undoubtedly, the buyer will find a prepared seller far more attractive.

How do you value a company after COVID-19 when you cannot predict with any certainty how a company will perform over the next 12 to 18 months?

Due to the uncertainty caused by COVID-19 the historical earnings of a target company are no longer a reliable measure of the future performance of its business.  Agreeing a fixed price (locked box) for the shares of the target company before the acquisition is signed based on a set of accounts (be they audited year-end accounts or recently available management accounts) is therefore unlikely to be agreed by either the buyer or the seller. 

In the current climate more creative pricing structures are being considered to allocate the risk relating to this financial uncertainty.  Structures which allow the parties to potentially bridge the gap between what the buyer is willing to pay and what the seller is willing to accept. Whilst such structures have been used before they have not always been the popular choice due to their complexity and the additional negotiation required by the parties to implement such structures.  Such structures are usually implemented where a particular risk regarding value has been identified which makes them an option to consider for parties where the underlying value of the business of the target company has been impacted (or is likely to be impacted) by COVID-19.

The following are pricing structures that may be considered either alone or in combination as a potential solution to bridging the valuation gap:

• Completion accounts:
  The purchase price is calculated after completion of the transaction has taken place by reference to the accounts relating to the target company, or business, which are drawn up to the date of completion. This mechanism allows the buyer to test, and adjust its valuation by reference to the actual balance sheet that is delivered by the seller.
   
• Earn Out:
  An earn-out structure, which involves an element of the purchase price being calculated by reference to the target's post-completion performance, thereby ensuring that future earnings and valuation risk is shared between buyer and seller.  The parties will have to carefully consider the metrics for such earn-out and the earn-out period (likely in the post COVID-19 world to be longer than the usually expect 2 years) and the impact of a second wave of the pandemic on the benchmarks set for the earn out, to avoid disputes down the line.
   
• Deferred Consideration: 
  Typically, this will involve the buyer paying part of the price on completion, with the balance being paid in one or more instalments after completion. This could be structured in any number of ways including the use of convertible loan notes.
   
• Part Acquisition:
  Where the parties agree to an equity purchase in tranches.  The remaining equity tranches can purchased on a pre agreed formula linked to the financial performance of the company during a future time period.  This provides an upside to the seller where the financial performance improves over time (e.g. revenue recovery in the post COVID-19 world) whilst also protecting the buyer in the event that financial performance deteriorates and fails to return to pre COVID-19 levels.  This structure could be further finessed to include a put and call option structure so each party can compel the other to complete the subsequent purchase of remaining tranches where the pre agreed formula metrics are met.
   
• Non Cash Consideration: 
  Non cash consideration would usually take the form of consideration being settled by the issue of shares in the buyer to the seller. 

If we cannot agree on valuation, are there any other structures we might consider which allow the parties to share risk?

Yes.  You could consider a joint venture (full function or contractual), collaboration or strategic partnership.  Each of these structures will allow the parties to share financial risk and responsibility.

This Q&A does not constitute legal advice.  Should you have any queries, or youwould like our assistance in considering the issues raised in this Q&A then please do not hesitate to contact the author of this article or your usual contact at Ince. Our team stands ready to assist.

Related Content:

COVID-19: Potential impact on M&A transactions

COVID-19: Transactional due diligence in a post COVID-19 world