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04.03.2020 | Legal Advisory

This is the first installment of a two-part series highlighting M&A transaction issues for buyers and sellers to consider in light of COVID-19.

1. Letter of Intent

In many instances, COVID-19 will cause both buyers and sellers to hesitate prior to signing a letter of intent to enter into an M&A transaction because of the following potential issues: 

• Supply chain interruptions, reduced consumer demand, and fear of recession will contribute to weakened revenues, earnings, and other financial metrics of sellers.
• Reconciling financial projections will make it challenging for buyers to formulate post-closing business models with which buyers will be comfortable.
• Lower valuations should be expected after a cycle of seller favorable valuations.

However, essential industries such as food and beverage, education, and health care are positioned well, due to pre-packaged foods, online educational tools, and medical supplies, to support higher valuations.

2. Valuation; Risk Allocation; Deferred Consideration

It’s likely that capitalized buyers will attempt to exploit lower valuations and sellers will attempt to postpone a deal until conditions stabilize. Alternatively, creative solutions to bridge the valuation gap may be utilized, which are discussed below.

• Earn-Outs
  • Metrics to calculate earn-out milestones should be carefully considered.
  • Sellers should attempt to negotiate earn-out provisions that allow for earn out payments even if milestones are not achieved as a result of COVID-19.
  • Broad COVID-19 exclusions will be rejected by buyers but limited, enumerated, logical exclusions may be deemed more amenable.
• Seller Notes, Escrows, and RWI
  • To mitigate risk, buyers may use a seller note as deferred deal consideration, which will be (i) subordinate to senior credit facilities, (ii) subject to restricted repayment terms, and (iii) for a term of at least three to five years.
  • Escrows may be increased beyond the typical 10% of deal value and for longer periods of time, which historically were 12 to 18 months.
  • Terms, conditions, and cost of Representation & Warranty Insurance (RWI) will change such that COVID-19 exclusions will be prevalent if not universal.

3. Third Party Debt

Despite reductions in lending rates, lenders may be more risk-averse, causing an increase in the level of their due diligence efforts of targets and buyers, which will reduce the number of consummated M&A transactions. Buyers dependent upon third party debt may need to reassess a target’s valuation based on the terms, conditions, and cost of securing such third party debt. 

4. Considerations for Buyers

• Seek to minimize cash paid at closing through (i) earn-outs, (ii) seller notes, and/or (iii) escrows, each over an extended period of time, to address COVID-19 concerns.
• Propose an earn-out to address valuation gaps caused by a disagreement on the expected effect of COVID-19 on the target’s business.
• Require secured third party financing as a condition to closing and termination rights for any material adverse change caused by COVID-19.

5. Considerations for Sellers

• Minimize deal risk by using an escrow or RWI over a seller note.
• Propose very specific milestones, and seek more flexible achievement terms, to address any expected effect of COVID-19 on your business.
• Require a specifically drafted Material Adverse Effect clause that limits the ability of a buyer to walk away from a deal under COVID-19 related events.
• Determine if you actually need to sell now. If not, waiting may lead to a more favorable outcome once the current uncertainty subsides.

This advisory was prepared by Shannon Zollo in Nutter’s Mergers and Acquisitions practice group. For more information, please contact Shannon or your Nutter attorney at 617.439.2000.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.