COVID-19 has significantly reduced M&A activity during the first and second quarters of 2020 and it is unclear when deal activity will get back to pre-pandemic rates. What is clear, however, is that the impact of COVID-19 will be a prevalent topic in most transactions that take place over the next couple of years.
While the extent varies, COVID-19 has influenced all industries. On one end of the spectrum, the travel industry has screeched to a halt, and retail and consumer products have not fared much better. Conversely, industries like e-commerce and home entertainment have thrived. Even operations for less-affected industries, like software, have felt the effects of mobilizing a workforce to work from home and managing cash flows as customer payments slow.
A mutual understanding between a buyer and seller of the assumptions that drive a seller's financial model is key to a successful transaction process. Sellers who are best able to articulate the impact of the pandemic on their businesses, support the narrative with data, and bridge the results to budgets are much more likely to achieve a successful exit.
Similarly, buyers will have to develop a thorough understanding of how COVID-19 fits into their investment theses in order to convince lenders and transaction insurance providers of the influence. As a result, COVID-19 EBITDA analyses are quickly becoming appropriate, if not imperative.
Keys to addressing the impact of COVID-19
Sellers have first-hand experience of how COVID-19 has affected their businesses and they hold the information necessary to assess and support the impact. Meanwhile, buyers are on the outside looking in, with the unenviable task of getting comfortable with the pandemic’s implications on earnings to date and the business’s future earnings. Given the imbalance in power created by this dynamic, a buyer's burden of proof may be higher than that of a seller.
By leveraging the following framework, a seller can facilitate an environment that would allow a transaction to be completed amid COVID-19.
Establish the narrative: Assessment of the severity and anticipated duration of the impact is a key first step to managing the process. Nearly all businesses have experienced the short-term effects of COVID-19, from the mobilization of at-home workforces to temporary operational closures. Many businesses will feel the medium-term effects resulting from the economic disruption caused by the pandemic, from reduced cash flow to furloughs and lost customers.
For some businesses, COVID-19 may represent a complete course change for industry operations and economics. Understanding the short-, medium- and long-term effects is crucial to assessing the "new normal" and establishing a narrative conducive to a well-run and efficient process that is equitable for the buyer and seller.
Track and support the short- to medium-term impact: The more quantitative and qualitative information a seller retains to support the narrative, the more likely a buyer will become comfortable. For example, businesses that have lost customers due to COVID-19-related financial constraints would be wise to track customer attrition rates by reason and compare them to pre-COVID-19 rates as well as rates that underlie the assumptions in financial models.
Corroborating the rates with third-party support, such as emails from customers indicating the reason for attrition, will enhance a seller’s ability to support the narrative. Conversely, a grocery store chain should track revenue per square foot and consider the impact and support any associated increases in expenses, such as overtime wages. Sellers will need to continuously update this information as transaction processes have inevitably taken longer in the COVID-19 deal environment.
Ensure a balanced view: COVID-19 is likely to affect businesses that could simultaneously have positive and negative implications to EBITDA. For example, a business experiencing a decrease in sales may also experience a slightly offsetting reduction in commission expenses. A balanced view of adjustments is important to illustrate a holistic, well thought out and well-intentioned position. Without a holistic approach, a seller risks an inefficient process fueled by buyer skepticism and dissenting views on valuation.
Construct a bridge to budgets: Given the disruption to markets, buyers and lenders will have a heightened focus on budget-to-actual performance. In particular, sellers will have to show how EBITDA that has been adjusted for the effects of COVID-19 bridges to revised year-to-go budgets developed by management.
Sellers should continue to monitor budget-to-actual results and update the quality of earnings analyses throughout the process to ensure alignment or identify the need for further revised budgets. Without a clear bridge, the integrity of both the adjusted historical financial statements and the revised budget will be questioned and may affect a buyer’s ability to finance the transaction.
Compare to industry trends: Well-positioned businesses that outpaced the industry should highlight comparative metrics that illustrate market share and channel gains. Conversely, businesses that fell short of the industry should be prepared to explain the shortfall.
Throughout the process described above, but especially as the analyses become more finalized, a seller should ensure the narrative established at the onset is intact and consistent with adjustments to EBITDA, year-to-go budgets, and financial models. Without alignment of these analyses, buyers may lose faith.
Purchase agreement considerations
While deal volume has significantly declined, transactions are still occurring. For those deals that remain active, buyers and sellers will need to agree on some key purchase agreement considerations, including the following:
Earnout provisions: Buyers and sellers may not see eye to eye on the achievability of budgets and projections. As a result, the use of earnout provisions may increase, with a portion of the deal value held back and subject to achieving post-close targets. Buyers and sellers alike should take additional care to define adjustments that may be applied to post-close results for purposes of assessing earnouts.
Working the capital impact of COVID-19: Any deals that close in the next 12 months, and possibly longer, are likely to experience a COVID-19 impact on closing working capital that is not fully reflected in a trailing 12-month average. As a result, setting a working capital target may require more creativity to normalize the effects, which could include recasting historical working capital balances, using a more recent average, or projecting balances. Whether buying or selling a business, it is important to assess the working capital impact caused by COVID-19.
Indebtedness considerations: Buyers will heighten focus on COVID-19-related indebtedness, including severance, extended payables, deferred bonuses, and other liabilities arising from the pandemic. In addition, sellers will need to be cognizant of any Paycheck Protection Program (PPP) funding and understand which portions may be forgiven and which may require repayment.
Today’s deal environment is significantly different than that of pre-COVID-19. Organizations with well-run processes with properly vetted analyses to support the effects from COVID-19 are more likely to achieve their desired outcome.