As the impact of COVID-19 on financial markets continues to play out, so does its effect on M&A transactions. Many deals have been cancelled or are on hold as parties struggle with valuation, availability of financing, and uncertainty with respect to business models. But M&A has not halted altogether; in light of diminished valuations, buyers with strong capital positions may actually see increased activity. There is no doubt, however, the terms of purchase agreements will evolve due to the pandemic.
Many of these issues can lead to post-closing disputes as uncertainties from COVID-19 continue to evolve and variances between a seller’s pre-closing working capital estimate and a buyer’s final post-closing working capital are analyzed.
Final working capital is based on current assets and current liabilities that existed at the closing date and were known as of the working capital true-up date. Most purchase agreements provide for a working capital true-up mechanism where the purchase price is adjusted to reflect the difference between the company’s agreed-upon “target” working capital and working capital as of the closing date. As such, it is critical to understand when certain COVID-19-related events began to impact the target company, and if such events impact final working capital.
CALCULATING FINAL WORKING CAPITAL
The impacts of the pandemic may make it difficult for final net working capital to be calculated along the typical practice of “GAAP [Generally Accepted Accounting Principles], consistently applied”; businesses may have been affected operationally and/or financially by COVID-19 such that historical practices are not a viable point of comparison. In such cases, buyers and sellers may want to reconsider the accounting methodologies used for such calculations.
- Have days sales outstanding (DSO) increased as a result of an increase in aging of the company’s accounts receivable? Is there a need to increase the allowance for bad debts?
- Has a decline in sales resulted in an increase in aged inventory? Is the inventory saleable? Is there a need to provide for reduced inventory values via increased inventory reserves?
- Consideration needs to be given to inventory held at restaurant concepts that may have been shut down due to the pandemic. Is the inventory subject to spoilage?
- Is the company properly recording concessions agreed to by the company and its vendors, as well as promotions/discounts agreed to by the company and its customers? Are they properly calculated in working capital?
- The widespread payment deferrals we are seeing amid COVID-19 are fairly out of the norm as compared to companies’ historical operations. Companies may not have mechanisms and processes in place for properly accruing expenses when there have been agreements with vendors as to extended payment terms. Be mindful that deferrals in rent, marketing expenses, payroll taxes, and more are indeed deferrals, not forgiveness – they will need to be paid eventually, and included in working capital accordingly.
- Consider, also, whether these concessions should be considered in working capital or elsewhere. Should extended payment terms, aged accounts payable, or rent deferrals be considered as debt-like items?
- Has the company received any COVID-19-related funding, such as Paycheck Protection Program (PPP) loans or Economic Injury Disaster Loans (EIDLs) or Advances? How do those funds (and, if applicable, their forgiveness) affect working capital? Keep in mind that PPP loan recipients have months to apply for forgiveness, and that forgiveness decisions can be appealed, so calculations involving these funds might not be possible to finalize for some time.
It is important to understand and agree on the timing of when COVID-19 hit a specific geographic area, and the impact that it may have on the final working capital adjustments, as any difference in judgments of these factors between buyers and sellers can result in disputes. Keep in mind, too, that the locations of the company’s customers and vendors may need to be considered – for example, a EU retailer that began its own shutdown in March might have felt the effects of COVID-19 earlier if it was unable to get merchandise from a China-based vendor that shut down in January.
Earnout provisions are often included as part of the purchase price to bridge the difference between the buyer’s and seller’s positions regarding the value of the target company. Earnout provisions in a purchase agreement are often considered to be an attorney’s dream or a “litigation magnet” as the high stakes involved mean that disputes are likely and often nasty. However, with increased uncertainty, buyers are finding contingent considerations to be an attractive approach to negotiating the purchase price. Because of COVID-19, a buyer will likely be less confident in a target’s ability to return to pre-pandemic EBITDA levels. With the increase in the number of earnout provisions included in purchase agreements comes the likelihood of earnout disputes related to the earnout calculation.
Earnout provisions in a purchase agreement can cause concerns in the operations of the business – especially in situations where the seller continues to be involved in the day-to-day operations of the business. The seller may focus on short-term results in order to maximize the earnout, while the buyer may have longer-term goals in mind, and, as an example, may want to incur certain expenditures today – e.g. hiring of key sales persons – that may help increase sales in the long term.
The earnout period historically ranged from one to two years. Due to post-pandemic uncertainty, it will likely increase to time frames greater than 24 months. Common earnout performance metrics include gross revenue, gross margin, net income, or EBITDA. While these accounting terms used in defining the earnout calculation are typically routine, buyers and sellers sometimes interpret them differently based on the specific objectives of each of the parties.
The definitions agreed upon in the purchase agreement may appear to be abundantly clear to the parties prior to closing, but as the parties calculate the earnout calculation, the definitions may become muddy and subject to interpretation, resulting in post-closing earnout disputes. Additionally, as the parties are bound by the terms of the executed agreement, the pandemic has been a “lesson learned” for attorneys, private equity funds, and others on the importance of expecting the unexpected in their agreements, and laying out expectations for the characterization of expenses related to future disasters.
Example: A buyer purchased a manufacturer on July 31, 2019, that sells its products primarily to non-essential retailers. The purchase agreement provides for an earnout calculation for the period ending July 31, 2020. Due to COVID-19-related mandates, many of the company’s customers were shut down for a period of time in 2020. The company incurred additional storage costs as it was unable to sell a substantial portion of its inventory during the shutdown period. Upon reopening of its customer base, the company offered its customers special one-time promotions to sell inventory already on hand, and incurred higher freight costs as it needed to airfreight its products to keep up with the newly created customer demand. Accordingly, the EBITDA calculation for the period ending July 31, 2020, included increased storage and freight expenses, as well as lower sales as compared to prior years.
The additional storage and freight expenses, as well as the reduced sales levels, resulted in the company missing the earnout target amount. The buyer included these additional expenses in its calculation of EBITDA as it believed they were necessary expenses to operate the business. The seller objected to such, and characterized the additional expenses as a permitted addback in its calculation of EBITDA as it argued that these costs were non-recurring.
To reduce the likelihood of purchase price disputes, buyers and sellers should negotiate to include the following in the purchase agreement:
- Sellers should negotiate the right to request support for amounts in the company’s books and records that may impact post-closing purchase price adjustments.
- Accounting terms used in the definitions of working capital and earnout amounts – such as current assets, current liabilities, operating income, gross profit, and the components of each – should be defined. In light of COVID-19, definitions should also consider future uncertainties: Establish how any income and expenses related to future disasters and other major unpredictable developments will be characterized.
- Working capital and earnouts are typically calculated on the basis of U.S. GAAP, using historical practices. However, in certain situations, it is possible that historical practices may not be GAAP. Accordingly, the purchase agreement should clearly spell out whether GAAP or consistency prevails should such a conflict arise.
In the wake of the pandemic’s widespread impact, companies and their vendors, customers, lenders, and others within their business ecosystem have been flexible with one another. We have seen some of that flexibility extended to final purchase price negotiations, and believe this will continue for future pandemic-disrupted deals. Everyone is in uncharted waters, making consistency in working capital and earnout calculations difficult; negotiations and compromise are key.
As earnout provisions for new deals rise in prevalence amid these conditions – buyers may not be fully confident in the acquired companies’ go-forward results, but are still willing to pay fair value for the businesses if they perform – we recommend continued caution in the negotiation of earnout provisions, as more times than not they become contentious.
The full impact of COVID-19 on the final purchase price is still evolving, as many of these calculations and related disputes will be negotiated in the months and years to come. There are and will continue to be lessons to be learned here for future deals. But for the purchase agreements already executed, all buyers and sellers can do is be mindful of how the pandemic has impacted the company’s results of operations and its impact on the final working capital and earnout calculations, and come with up negotiated terms that reflect the complexity of this new business world.