Our M&A Master Class Series has been thoughtfully designed to highlight critical topics and legal implications throughout the life cycle of a transaction. We look forward to continuing this important dialogue through events and other communications in 2021.

Today’s mergers and acquisitions environment has grown significantly more complex based on the influence of novel events in 2020, most notably, the Coronavirus (COVID-19) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). As a result, the process and substance of business transactions will continue transforming into 2021.

When considering selling or acquiring a business (whether its equity interests or its assets), or making or receiving a significant investment in a company, a number of key considerations should be made in evaluating a transaction in this changing environment. In the next two weeks, we will issue a multi-part series to assist in identifying potential challenges and factors in anticipation of a sale or acquisition. The series is designed to draw attention to the specific impact of COVID-19 and the CARES Act, rather than serve as a start-to-finish guide or detailed analysis of how/where these concepts fit into business overall.

Part 1: Market Opportunism, Valuation and Risk Allocation

Today’s mergers and acquisitions environment has grown significantly more complex based on the influence of novel events in 2020, most notably, the Coronavirus (COVID-19) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). We look forward to sharing key considerations with you over the next couple of weeks as part of our three-part series. This first installment will discuss the current landscape as it relates to market opportunism, as well as the impact on valuation and risk allocation in a somewhat volatile environment.

Market Opportunism:

From the perspective of a buyer who has capital to deploy, the current landscape could ripen the opportunity for both strategic and add-on acquisitions of target businesses lacking sufficient cash or resources to weather the economic downturn. While this fertile landscape creates an attractive scenario for buyers, bringing everyone to the deal table is merely the beginning.

Valuation and Risk Allocation:

In the pre-COVID-19 era, historical earnings were a useful tool to value a business. However, valuation tools predicated on historical earnings may not offer a buyer an acceptable level of comfort and predictability for a business’ future performance. A core issue precipitated by unpredictability of future performance is which party, the buyer or the seller, should bear the risk of an underperforming business post-closing? Parties should consider the following when assessing current and future performance of a target business:

• Post-Closing Adjustments and Paycheck Protection Program (PPP) Loans:If a target business received a PPP loan offered under the CARES Act, but has not yet applied for loan forgiveness, the parties should consider where this risk is best addressed. Depending on the deal’s timeline and closing, the parties could address this risk in post-closing adjustments (short-term period for resolution), or in a seller’s indemnification obligations (long-term period for resolution). Sellers should also consider appropriate covenants regarding a buyer’s post-closing operations that may impact forgiveness, as well as procedures for making the forgiveness application. In the event a PPP loan deducted from the purchase price is later forgiven, the parties should memorialize how that forgiveness will be treated – for example, as a debt adjustement, or as a post-closing payout to the seller from the buyer (or from escrow). The parties should also account for procedures and risks relating to any remaining audit period for the PPP loan. Alternatively, the parties could completely exclude the PPP loan from initial purchase price adjustments and negotiate for any amounts failing to be forgiven in a separate escrow or as leverage in other areas of the overall transaction.
• Net Operating Losses (NOLs):The CARES Act allows businesses to carryback NOLs up to five years from taxable years 2018, 2019 and 2020. Parties should consider whether a buyer is required (or incentivized) to amend prior tax returns, and to what extent the parties will allocate the benefit derived from the pre-closing time period.
• Earn-outs: Despite earn-outs’ troubled reputation as a source of post-closing disputes, they may become more attractive in the current environment because they enable parties to exercise control today over events occurring in the future (i.e., the method and manner of earn-out payments). A buyer can reduce the risk of overpaying for a target business impacted by COVID-19, while simultaneously presenting the seller an immediate opportunity to exit during a turbulent economic environment with the potential for more gain in the future. Pre-COVID-19, it would be normal to see an earn-out period range from 12 to 24 months; however, given the uncertainty of COVID-19 and its far-reaching economic effects, parties may consider extending earn-out periods to 36 or even 48 months. With an increase of duration, however, buyers may be less willing to agree on post-closing management covenants (e.g., restrictions on daily operations, separate accounting requirements and fundamental governance of the business), which could further prompt a buyer to require an option to buy out the earn-out (or a seller to require various acceleration triggers). Additionally, if the target business received a PPP loan, the parties should consider how the loan forgiveness, or lack thereof, will be accounted for in the overall earn-out scheme. Typically, an earn-out would be based upon operating earnings, such that the parties might exclude any income generated by forgiveness of a PPP loan.
• Equity Rollovers:  This risk allocation tool is most often employed by private equity firms. It is possible, however, that we’ll see the use of equity rollovers outside of the private equity space if a seller impacted by COVID-19 is not looking for an immediate exit or payout from the target business and buyers are receptive to sharing control of a newly purchased entity or retaining passive sellers as investors post-closing. An allowance for passive sellers as investors could be justified by the buyer’s short-term benefit from the reduction of cash paid at closing. Pre-COVID-19, it was common for the equity rollover percentage to range from 10% to 20% of the purchase price, but if the parties are motivated to complete the deal with the use of an equity rollover, the percentage could increase significantly pending a buyer’s inability to access capital or the desire for additional operating capital in the business amidst COVID-19 concerns.
• Cash/Equity fluidity: For deals that closed pre-COVID-19 or during COVID-19 with parties currently operating under an earn-out scheme coupled with related buyer obligations or operating restrictions, a lose-lose scenario may result if the pre-COVID-19 method of operating the business is proving no longer to be viable. In a lose-lose scenario, buyers with post-closing obligations and operating restrictions should not immediately disregard new profit-driven developments just because the developments could run afoul of such obligations or operating restrictions. If the seller is willing to agree with the buyer’s vision to develop the business in a new manner, the parties could swap-out the buyer’s cash payment (or lack thereof) under the earn-out with equity back to the seller. With this arrangement, both parties share the risk of deviating from the current business model and the potential benefit from the buyer’s new business developments.

Stay tuned for additional communication on timely M&A topics from Armstrong Teasdale:

Part 2 – Coming Nov. 19
Due Diligence

Part 3 – Coming Nov. 23
Purchase Agreement Negotiations, General Carve-outs and Limitations

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.