In a climate where there are so many unknown factors challenging valuation methodologies, we explore a number of mechanisms that European dealmakers may consider during the Coronavirus (COVID-19) pandemic in order to bridge the valuation gap, provide greater pricing certainty, and allow transactions to proceed with seller and buyer sharing both the risk and the potential rewards from driving deals through now.
The recent instability and disruption to business caused by the Coronavirus (COVID-19) has generally led to a disconnect between sellers’ and bidders’ valuations of the businesses that are coming to market. Parties may have differing views on the impact of government restrictions and consumer appetite, the likely speed and extent of the target’s (or indeed the market’s) recovery, and how a business can adapt to the “new normal”. These discrepancies are factored in the respective business plan assumptions of both the bidders and the sellers, and ultimately drive the size of the “COVID chip” that the bidder wants to factor into the purchase price.
Price Protection: Deferred Payments and Their Increase in Popularity During COVID-19
Sellers are invariably nervous that changes in the trajectory of the pandemic can lead to last minute price chips. As a result, bidders wanting to set themselves apart and drive the process may choose to propose creative structures to try to mitigate the uncertainties caused by COVID-19.
Structures that reduce the initial cash consideration payment made at completion, such as earn-outs, true-ups, and deferred consideration, have become a prominent feature of M&A transactions during periods of economic uncertainty.
Earn-outs and True-ups
These structures require the seller to accept a lower (initial) purchase price with the potential for an uplift in the event of better than expected financial performance by the target business, as measured in sales; revenue; earnings before interest, taxes, depreciation, and amortisation (EBITDA); or any other appropriate metric.
This is considered intrinsically fair, because it gives the seller the opportunity to “prove” the projections it has provided to the buyer. These structures have traditionally been used primarily to incentivise sellers who are also management being retained within the business as they will then have greater influence on the business’ trajectory. They have, however, historically created significant tension between buyer and seller as parties worry about the metrics being manipulated or skewed by how the business is run post-closing.
The COVID-19 crisis presents further difficulties with the negotiation of earn-out structures, including
Determining the metrics for the earn-out and the duration of the earn out-period.
Determining the scope of restrictions on the target business’ and/or buyer’s ability to take certain actions that might have a negative impact on whether or not earn-out targets are achieved, when businesses may need to act quickly in the face of lockdowns and to capitalise on relaxations of government restrictions.
Factoring in the impact of a second or third wave of the pandemic on the benchmarks set for the earn-out, and allocating risk accordingly.
During periods of market uncertainty, buyers are more likely to want to defer all or some of the purchase price, even if there are no substantive conditions attached to payment other than the passage of time. The buyer may, however, attach a number of conditions precedent to the distribution of the deferred payment, for example, a target internal rate of return (IRR) or, in the current environment, volumes of sales or other key metrics falling within agreed tolerances when compared with equivalent periods in prior years.
Equally, the seller might want to seek some kind of security for the buyer’s payment obligations by obtaining a parent company or bank guarantee, or a charge over the buyer’s assets. The seller may also consider requiring the buyer to pay cash into a closed escrow account and to consider the extent to which such funds can be used to settle any warranty or indemnity claims that could arise.
Where such structures involve an element of the purchase price being calculated by reference to the target’s post-completion performance, the valuation risk is shared between buyer and seller. However, a crucial challenge in any such arrangement is determining how to ensure that the relevant performance metrics are not unfairly manipulated.
One key area of focus will be the restrictions that are imposed on what buyers can do. For example, does the business need to be ring-fenced to restrict the sale of part of the business or prohibit bolt-on transactions? And how will additional capital expenditure injections be reflected? For sellers and buyers alike, the following factors should be considered:
Lessons from previous downturns are being applied to such arrangements, with the triggers, thresholds, and ratchets often being based on neutral criteria.
The macro influences on sector performance support arguments for moving towards price adjustment arrangements, calculated by reference to the performance of the specific industry sector in which the target business operates as a whole, for example, by reference to data on rental prices or changes in volumes of sales across the sector.
There is an increased focus on trying to ensure that such mechanisms operate based on “normalised” performance. More than ever, sellers want to ensure that they will not lose out under the adjustment because a purchaser invests in equipment upgrades or advertising spend that limits profitability, or focuses on promotional offers that build market share at the expense of margin in an earn-out year while allowing them to reap the rewards in the years thereafter.
Other Options to Help Bridge the Valuation Gap
In addition to delaying payment or adjusting the amount of consideration, in the current climate parties are increasingly calling on other creative deal structures, forms of consideration, and other transaction mechanics as means of addressing the disparity between the amount the buyer is willing to pay and what the seller is willing to accept.
For corporate strategic buyers, there may be benefit in some or all of the purchase price being satisfied with non-cash consideration in the form of shares or convertible loan notes issued by the buyer to the seller. The initial valuation of such shares may still create challenges, but if both parties operate in the same sector, any swing in the performance of the target business as the pandemic unfolds, or during its aftermath, is likely to affect the buyer’s business, and hence the valuation of the “consideration shares”, similarly.
To the extent that a transaction is structured in this way, there will be the added workstream of the seller needing to carry out its own due diligence on the buyer. In addition, vendor loan notes and vendor financing can be particularly useful in a market where it can be challenging to obtain acquisition financing. These tools will, however, also raise issues such as how such financing ranks and whether such arrangements should be secured.
The pandemic is also triggering an increase in venture capital style partial investments, which are often coupled with put/call options to give the purchaser a route to control or sole ownership.
Under such structures, the seller is left with a (usually minority) equity stake, typically with the parties each having the benefit of an option to require the sale of that stake to the buyer at a later date and at a price usually based on a metric such as multiple of earnings or revenue at the time of exercise.
This structure is beneficial to a seller where the financial performance is likely to improve over time, e.g., when revenues recover post-COVID-19. It also protects a buyer in the event that financial performance deteriorates and fails to return to pre-COVID-19 levels. This type of investment may be preferred in sectors such as technology, pharmaceuticals, and personal protective equipment, which may have seen a spike in revenue and profitability as a result of the COVID-19 crisis, but a buyer may nevertheless have serious reservations regarding the sustainability of that position in the mid- to long-term.
From the seller’s perspective, the risk of mispricing a disposal and selling too cheaply can be mitigated to some degree by incorporating anti-embarrassment provisions into the share purchase agreement. Frequently used in distressed situations, they may now become more mainstream owing to the prevalence of valuation challenges.
Anti-embarrassment clauses require the purchase price to be recalculated and subject to an upwards adjustment if the buyer goes on to sell the shares, or certain other assets, at a higher price within a specified period following completion of the original transaction.
Price certainty provides even greater comfort when businesses are still struggling with the effects of the pandemic and experiencing a period of severe reduction or volatility in earnings.
In a more seller-friendly M&A market, prior to the outbreak of COVID-19, it was common practice for auction processes to include a locked-box (fixed price) valuation. This remains the case for hotly contested prime assets that are coming to market in auction processes. However, in less competitive processes, bidders are more reluctant to accept that the economic risk of the target’s performance will pass to the buyer at the balance sheet date, particularly where any negative business performance, i.e., owing to the pandemic, in the intervening period may not be reflected in the accounts.
Since the outbreak of the pandemic it has been harder for sellers to resist completion accounts mechanisms, but we expect the locked-box mechanic to regain popularity again as economic stability returns, as it did in the aftermath of the 2008 financial crisis.
Warranty and Indemnity Insurance
Warranty and indemnity insurance, which was already increasing in popularity before the pandemic, is likely to become an important component of M&A deals, particularly with insurers now showing more flexibility around COVID-19-related risks and a willingness to provide cover in distressed situations.
It is likely, however, that the process for obtaining cover may take longer owing to more robust due diligence requirements demanded by insurers, and premiums may be higher than before the start of the outbreak. Policies may now also be subject to COVID-19-specific exclusions, but their scope will often be negotiable depending on the nature of the business.
While the uncertain environment presents various obstacles for parties to overcome, it also presents significant opportunities. There will undoubtedly be situations where a change of ownership will present new funding and promote new drive within a business, and completing a transaction now will provide a springboard for growth as the macro-economic conditions improve.
By appreciating the importance of sharing the risk and potential growth, and taking advantage of the methods discussed above, innovative dealmakers will unlock value for both buyers and sellers.