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.