The process of conducting mergers and acquisitions (M&A) transactions has not remained unaffected by the economic consequences of the Covid-19 crisis; many transactions have been postponed. However, the crisis has also offered opportunities: After almost a decade of economic upswing, during which the M&A market has developed in an extremely seller-friendly way, interesting negotiating opportunities now open up for prospective buyers when drafting contracts, and private equity investors could explore new opportunities for their buy-and-build strategy.
A sale can also be interesting on the seller side in times of crisis. Some family-run, medium-sized companies may be looking for a financially strong investor with sufficient funds to guide the company safely through these challenging times.
In the following, the essential interests of the parties against the background of the Covid-19 crisis shall be pointed out first, and then the relevant safeguarding mechanisms and their benefits for the M&A practice shall be explained.
2. Interests of the Parties
The fundamental interests of the parties remain unchanged even in times of the Covid-19 crisis. The seller is interested in achieving the highest possible sales price for the company, securing the payment by the buyer and at the same time reducing its own liability. To the buyer it is important to not overpay on purchase price and to be able to take recourse to the seller for risks, which could realise after the purchase, or to adjust the purchase price afterwards.
Particularly in economically uncertain times, two further interests come to the fore. For the seller, the interest in transaction security gains increased importance. The seller wants to avoid frustrated expenses, because in case a prospective buyer jumps off, there may not be as many alternative buyers available as in economically stable times. On the other hand, it is a matter of concern for the buyer to be able to withdraw from the purchase agreement as late as possible or to make (subsequent) purchase price adjustments if a deteriorated economic situation has a negative impact on the business operations and thus the value of the target company.
3. What Instruments are available to implement and safeguard the Interests of the Parties
a) Purchase price mechanisms
i) Closing accounts and locked box mechanism
The purchase price in M&A transactions is determined by the enterprise value and its bridge to the equity value. Therefore, the question arises how to deal with the uncertainty of the equity value development between the date of the last annual financial statement, which usually provides the last reliable basis for determining the enterprise value, and the closing of the transaction. This problem is intensified if an economic crisis could cause a significant negative change in the business operations of the target company. Two major purchase price concepts have been established in practice: closing accounts mechanism and locked box mechanism.
With the closing accounts mechanism, the purchase price is determined based on a balance sheet, which is drawn up after the closing. At closing, the buyer first pays a preliminary purchase price, which is then subsequently adjusted. Since this procedure is often subject to disputes due to the purchase price relevance, the purchase agreement stipulates in detail the procedure for determining the final purchase price.
With the locked box mechanism, no post-closing purchase price adjustment takes place. Instead, the net assets determined on the basis of the last balance sheet are “locked in” by prohibiting the leakage of funds (e.g., in the form of dividends) to the seller or its affiliated companies or related parties. Changes in assets due to business operations between the balance sheet date and closing are estimated based on projected figures; this is often done on a simplified basis by paying interest on the purchase price. This results in a fixed purchase price, which is paid at closing.
In recent years, the locked box mechanism has become established in the majority of M&A transactions in Europe. This could change because of the Covid-19 crisis if it is difficult to project the development of the business operations or if the development of the earnings situation gives cause for concerns about a rapid decline in the net asset value of the target company between the balance sheet date and closing.
ii) Due date of the purchase price/earn-outs
In order to take account of the uncertainties regarding the development of the target company even after closing, it may be advisable to include an earn-out clause in the purchase agreement, according to which part of the purchase price (additional purchase price) will be paid at a later date, provided that agreed performance targets are achieved.
This shifts the full transfer of economic opportunities and risks to the buyer to a later point in time, so that the seller still participates in the economic success or failure of the target company even after closing. While an earn-out clause is often included in favor of the seller, in the event of an economic crisis it could also work in favor of the buyer, who would only have to bear part of a future economic failure (Fig. 1).
Source: Own illustration
The purchase agreement has to define the performance targets which trigger the earn-out payment. In most cases, standard performance figures (e.g., earnings before interest, taxes, depreciation and amortisation, or EBITDA) are chosen for this purpose, which are determined based on a future annual financial statement. Alternatively, other parameters can also be agreed (sales volume, extension of an important customer contract, etc.). It should be ensured that possible manipulations by the seller after closing are prohibited by strong information and participation clauses (Fig. 2).
Source: Own illustration
A look at the period since the last major financial and economic crisis in 2008/2009 shows that the proportion of sales contracts with earn-out clauses has increased significantly (Fig. 3):
Source: CMS M&A study 2020
Since an earn-out is also often subject of disputes, a settlement procedure similar to that for a closing account mechanism should be agreed.
iii) Financing of the purchase price
Frequently, the financing of M&A transactions is partly based on bank loans. Especially in times of crisis, this can become problematic. Banks may not want to provide financing due to the high burden in times of crisis, or companies may no longer be able to meet the conditions for payment.
In addition, many bank loan agreements contain obligations of companies to adhere to agreed financial covenants during the term of the loan, e.g., certain leverage or equity ratio. Due to the Covid-19 crisis, some companies might not be able to meet these standards anymore. As a result, interest rates may rise and banks may demand the provision of further collateral or be entitled to extraordinary termination or free transfer of the contract, e.g., to hedge funds.
It may therefore be advisable to consider alternatives to traditional bank financing. Various options are available. On the one hand, a vendor loan can be agreed through which the seller participates in financing the acquisition of the target company. A part of the purchase price is deferred by the seller granting the buyer a loan in this amount. A further possibility can be a reinvestment of the management or the seller, who could be granted a part of the purchase price not in cash but in the form of shares in the target company or the acquisition company.
Debt funds are another alternative to bank financing. They collect money from various investors and invest specifically in company transactions. In addition to greater flexibility and faster approval decisions, funds specialising in specific sectors or technologies often have in-depth knowledge of the industry and an extensive network, which the buyer can make use of in the transaction.
b) Other provisions of the purchase agreement
In addition to the major issues of the general purchase price mechanism, the due date of the purchase price and the financing of the purchase price, further provisions can be included in the purchase agreement to protect the special interests of the parties and reduce the risks associated with the Covid-19 crisis.
(i) Net debt/net cash definitions
Frequently, the purchase price and any subsequent purchase price adjustment are based on a debt-free/cash-free valuation. This is because the liquid assets and liabilities of the target company are constantly changing. It is therefore important to determine the exact basis of the company valuation. Throughout the Covid-19 crisis, the company’s field of activity, dependence on suppliers from risk areas, the location of local production facilities, the location of the main customers or dependence on certain production materials, etc., must be taken into account.
ii) Working capital adjustments
The purchase price is often subject to an adjustment based on changes in the net working capital of the target company, the amount of which fluctuates during the course of the financial year. If the working capital is lower than the working capital assumed by the buyer at the time of closing of the transaction, the buyer would have to pay the difference. Here, a precise provision can pay off, especially in times of crisis, as it clarifies the financing obligations of the parties.
iii) EBITDA adjustments
Only in rare cases the EBITDA derived from the annual financial statements is the actual reference value for the company valuation. In principle, one-time circumstances that have occurred in the financial year must be adjusted. Other special factors must also be adjusted, such as severance payments, insurance compensation or deliberately accepted loss-making contracts with a new customer in order to gain market share. These EBITDA adjustments are often subjects of discussion in negotiations. In the Covid-19 crisis, the EBITDA adjustments and the structure of the adjustment calculations will become increasingly important.
iv) Protection of the valuation basis
In order to secure the valuation basis for the target company, an extended due diligence process should be considered in light of the Covid-19 crisis. In particular, sectors directly affected, but also indirectly affected sectors whose production facilities are temporarily shut down or whose supply chains or customers are located in risk areas, must be investigated and the resulting risks economically assessed.
Besides the purchase price mechanism, an adjusted catalogue of guarantees can be used to distribute risks fairly. This can be done, for example, by excluding certain production facilities from the guarantee catalogue or by providing guarantees with regard to customer relations. On the seller’s side, one should refrain even more than in any case from guarantees directed towards the future, e.g., with regard to business development forecasts or business plans, as the economic consequences of the Covid-19 crisis are still not foreseeable.
v) Material adverse change (MAC) clauses and force majeure
The parties may protect themselves against unforeseeable events by means of special safeguard clauses. The buyer can protect themselves against the risk of a deterioration of the condition of the target company between signing and closing by including a MAC clause, which, for example, enables the buyer to exercise a contractual right of rescission or to make the payment of the purchase price subject to a condition precedent or subsequent. MAC clauses could include, for example, closures of business premises or the interruption of supply chains due to the Covid-19 crisis.
Force majeure clauses provide protection if a contracting party is prevented (at least temporarily) from fulfilling its contractual obligations because of force majeure. The term force majeure typically includes unforeseeable events such as wars, riots or natural disasters. Here, however, cases could also be explicitly included that are connected with the Covid-19 crisis.
While the Covid-19 crisis has led to a shift in M&A activities, it also opens up opportunities. In any case, the legal instruments to draft contracts that take adequate account of the current uncertainties and at the same time sufficiently safeguard the interests of the parties are available.
In the end, even in the most dramatic situation, those who focus on two factors cope best with the circumstances: experience and the assessment of what is feasible according to the well-known sentence, usually attributed to the poet Dante:
“One waits for the times to change, the other grabs them and acts.”