- June 9, 2020
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
How to close M&A deals successfully in the Post-COVID environment
COVID-19 has generated a rare dilemma for almost all businesses since companies cannot prognosticate when and how companies and consumers will return buying their goods and services. This unpredictability has made it more diﬃcult for dealmakers to apply historical earnings to predict a company’s future profits. Consequently, their valuation has rigorously reduced the number of M&A transactions at present. This post explains how to close M&A deals successfully in the post-COVID environment. Further, this article reviews diﬀerent ways deals can be structured to earmark the risks between buyers and sellers in a post-COVID world.
Why would acquirers and sellers need to close M&A deals successfully in the Post-COVID environment?
Buyers with accessible funds may ﬁnd that the prevailing circumstances render opportunities that would not have subsisted before the pandemic. In particular, strategic buyers with extensive industry expertise will scan for deals that will enable them to supplement a new product, service, or obtain new technology or a faction of skillful employees. Private equity buyers have a lot of free funds to invest and will need to marshal capital, particularly if they perceive it as a buyer’s market. One of the pandemic’s principle eﬀects for M&A transactions has been to weaken seller valuation expectations, urging sellers to be more ﬂexible than they were only a few short months ago. As a consequence, valuation expectations are substantially lower for sellers, making it more straightforward to structure a transaction that makes sense.
Several budding start-ups and technology companies may need suﬃcient cash resources to overcome the storm and incapable to ﬁnd further funding soon enough. This crisis may enhance the attractiveness of a more significant strategic buyer proficient in giving security and combined resources that the seller and its employees badly require. Sellers may have additional reasons to explore a sale, including the death or divorce of a founder, needing to get some necessary liquidity for some diversiﬁcation for the owners, or a management team that has attained its limits for driving the company forward. Such sellers may have been striving to ﬁnd an acquirer before COVID-19, and do not have the leisure of pausing a year or longer for a more positive selling environment.
How has the due diligence approach evolved in the post-COVID situation?
Acquisitions are typically the commencement of a long-term relationship between the seller’s management team and the buyer, the progress of which depends massively on the seller’s key employees. For buyers, face-to-face encounters with the seller’s management team remain a crucial component of deal-making and due diligence, and few buyers will be amenable to close a transaction without any opportunities to socialize in person with the management team. Most deals closing today got initiated before the pandemic, so the buyer previously had allocated time with the seller’s management organization. For new deals where the buyer has no previous relationship with the seller, video conferences will enable the sale process to get commenced between motivated parties. For now, though, buyers will likely request on meeting the management team before they are ready to close the deal.
The inability to engage with the seller’s management in person is one reason to stretch the due diligence period. A prolonged due diligence phase provides the buyer more time to evaluate COVID-19’s bearing on the seller accurately and to ﬁnd any needed ﬁnancing for the transaction. Consequently, watch for the exclusivity period in letters of intent to be lengthened from the standard duration of 60 days pre-COVID to 90 or 120 days, if not higher.
The quality of due diligence will heavily depend on whether the significant assets of the seller are intellectual property (software business) or whether the principal assets are physical, such as inventory. The more the critical assets are tangible, the more likely the buyer will need physical inspections. Some physical assets, such as a factory or distribution facility, will need more rigorous due diligence on new health and safety measures to shield workers at the plant.
The pandemic presents new lines of questions to question the management team to better estimate their abilities and the services of the target company.
- What resolutions did you initiate to cope with the pandemic, and why? How did they roll out? How did you handle your employees and vendors? What did you discover, and what would you do diﬀerently?
- What is the seller’s supply chain vulnerability, particularly to China and other abroad sources? What strategies does management have to adjust the supply chain in a post-COVID world?
- What are the supplementary operating costs needed to work in a post-COVID environment?
- What ideas do executives have if the pandemic re-emerges in the Fall?
Due to the change from a seller’s business to a buyer’s market, sellers will need to ﬁnd methods to differentiate themselves. One way to do that is to conduct due diligence more open and transparent. In this new situation, sellers should make the up-front investment in pre-sale due diligence. These expenses will include spending in a more thorough quality of earnings (Q of E) reviews before beginning the sale process. This procedure will give the buyer with greater clarity into the seller’s pre-COVID performance and how they will handle the pandemic’s disturbances. Sellers will also need to develop “stress test” analyses for their business under diﬀerent likely scenarios in a post-COVID world. Buyers will ﬁnd sellers with more transparent ﬁnancial data, and a strategy for an indeterminate future, to be much more attractive. These types of “stress test” analyses are crucial to generating more imaginative deal structures needed under the current environment.
What are the steps to bridge the valuation gap, given the ambiguity in the seller’s expected ﬁnancial performance?
Three popular ways to value target companies are:
- Trailing 12 months EBITDA multiple, employed for companies with earnings. This method is the most common valuation methodology.
- Revenue multiples used for software and other technology companies which have been able to build signiﬁcant sales but are not profitable
- A “build versus “buys analysis, in which the buyer evaluates the cost to replicate the seller’s product or technology’s functionality from scratch, versus the price to purchase the seller and its employee organization. This standard used for early-stage software and other technology companies before them having signiﬁcant sales revenues. Acquisitions of these types of companies are particularly attractive if they have an experienced set of employees who can jump-start the buyer’s eﬀorts to append a new product or service, or technology. This valuation methodology usually leads to more depressed valuations, but not always depending on the buyer’s immediate needs.
A seller’s historical earnings are no longer an expected measure of future performance due to the dilemma created by a coronavirus. Ere the pandemic, in a seller’s business, the multiples of EBITDA and revenue applied to value sellers were at all-time highs, with auctions drawing a considerable amount of likely buyers. Employing trailing 12 months (TTM) of EBITDA or TTM of revenues was the right way for buyers to prognosticate future ﬁnancial achievement. COVID-19, though, has upended these metrics as a means to value businesses.
How do you evaluate a company after COVID-19 when you cannot foretell how a company will operate across the subsequent 18 months? For the “build versus buy” valuation review, the modified environment probably will not substantially change the buyer’s analysis. Still, it has considerably altered the seller’s expectations, making them more responsive to an acquisition.
One significant diﬀerence between the prevailing environment and past recessions, such as 2008-09, is that sellers have quickly understood the obscurity produced by the pandemic. In earlier recessions, it led 12-18 months for sellers to recognize the new reality completely. Today, sellers’ expectations have re-set almost instantly. Sellers with the waiting power and resources to wait may be happy to pause it out until conditions develop. Sellers who have other obligations may be more motivated to sell, notwithstanding the current ambiguity, and ready to share the risks with the buyer. From the buyer’s perspective, and particularly for strategic buyers, if a target company is a strategic ﬁt that renders a new product or service or new technology or a skilled group of employees, this may still be an exceptional time to acquire. If the buyer and seller are motivated and are willing to be more ﬂexible than before the pandemic, then deals can, however, occur.
Valuation Tools to close M&A deals successfully in the post-COVID environment
1. Subdued Total Purchase Price and Discounted Cash at Closing
Companies estimated as a multiple of earnings or revenues are not deserving as much now as they did in January 2020 in the pre-COVID environment. Especially attractive companies that were in auction processes in January 2020 with many bidders may have earned bids of 10X of 2019 EBITDA, with 90%+ of the purchase price given in cash at closing. In the prevailing environment, though, a more pragmatic multiple might be 8X or 9X of 2019 EBITDA, with hardly 50% to 60% of the purchase price paid in cash at closing. The residual portion of the purchase price will be contingent, deferred, or subject to an equity rollover.
Earn-outs are a means applied by both private equity and strategic buyers. For transactions with earn-outs, the metrics employed were revenues, EBITDA, or sometimes aggregates of these metrics, depending on the business and the growth stage of the target company.
In the pre-COVID business, both buyers and sellers were cautious in exercising earn-outs. Earn-outs are often “litigation lodestones” since conflicts regarding whether the earn-out has got achieved have become popular. A few of the causes for the disputes are due to obscure metrics for deciding whether the earn-out get met, variations in the buyer’s operations post-closing, the allocation of expenses, and the diﬃculty induced by varying circumstances, especially when the earn-out period is prolonged (more than two years). Consequently, in the pre-COVID world, earn-outs were flawed tools used only when needed to bridge the valuation gap between buyer and seller.
However, in the post-COVID world, earn-outs will become more prevalent to earmark added risk to the seller for the risk of expected performance. As a consequence, these are expected changes for earn-outs:
- Earn-outs will get employed in a more significant percentage of transactions, from the current 18% to perhaps 30% to 40% of deals.
- The period for earn-outs will rise from the current median of 24 months to more lengthened time frames. Given the dilemma with how long it will take for companies to recover from COVID-19, most companies have no visibility of their results for 2020, and even into 2021. Therefore, earn-out periods may stretch into 2022 and 2023, and more lengthened, give the seller more possibility to earn an earn-out.
Equity rollovers are a medium utilized almost exclusively by private equity buyers in platform acquisitions, and seldom for tuck-in acquisitions. Equity rollover transactions typically entail rollover participants taking between 10% and 40% of the purchase price in the form of equity in the purchaser. Equity rollovers usually restricted to founders and other members of the seller’s management team who are joining the buyer post-closing. This structure gives founders and management with a significant equity stake in the buyer to adjust their respective interests to expand and sell the target company. Usually, current equity holders in the seller who are not founders are omitted from the equity rollover because they have no continuing role with the buyer post-closing and would instead exit the seller’s investment. Private equity buyers like equity rollovers as they serve as a kind of seller ﬁnancing, which decreases the buyer’s up-front cash payments at closing.
Equity rollovers were previously very popular before the COVID-19 pandemic. In the future, they get employed as a tool to earmark more risk to the seller to deal with the unpredictability of post-COVID ﬁnancial performance.
The following are some of the changes expected to observe.
- The equity rollover percentage is possible to increase. Before the pandemic, a private equity buyer might have been amenable to just a 10% or 20% rollover by the founders. In the post-COVID environment, the equity rollover percentage will increase to 30% or 40%, shifting more risk to the seller and reducing the requirement for outside ﬁnancing.
- The seller participants in the equity rollover expect to extend to cover more of the equity holders in extension to the founders and management team. The buyer may emphasize holding venture capital, private equity, or angel investors involved in the equity rollover. It may not be perfect for those investors who may have desired to exit their investment entirely, but they may have no alternative in the current environment. For the buyer, this turns the post-COVID risk to more of the seller’s equity holders and increases seller ﬁnancing.
The private equity buyer may assert on having a liquidation preference for its equity, which will get compensated out before the seller participants get the equity rollover. In the pre-COVID world, it was common for the seller participants to get rollover equity with the equivalent economic rights and preferences as the private equity buyer. The buyer will explain that the seller participants have now cashed out a signiﬁcant part of their investment so that it is entirely appropriate for the buyer to get shielded if the seller’s post-COVID performance is signiﬁcantly more detrimental than anticipated.
Targeted Incentive Bonus Scheme for the Target Business
Strategic buyers usually will not employ equity rollovers. The reasons include that the strategic buyer will have no timeline to sell the target organization. Other reasons could be that the strategic purchaser may be privately-owned by a group and have no desire to have any minority equity holders.
Strategic buyers may not desire to employ earn-outs if the management team joining the buyer has a little equity stake in the seller. Consequently, an earn-out may raise the purchase price for the other equity holders of the seller, but the management team will not gain much of the earn-out due to its little equity holdings. Consequently, the management team will not have the required incentives to assist the buyer in realizing the solicited results post-closing. It is mostly needed when the buyer is acquiring to obtain new software or other technology, as well as the experienced group of employees engaged for developing the technology (i.e., a so-called “acqui-hire”).
This condition, particularly in a post-COVID world, needs the strategic buyer to devise a structured incentive bonus plan for the management team. Also, in a post-COVID world of higher unemployment, skilled technology employees may yet be capable to ﬁnd additional attractive jobs or may be driven to begin a new company. Consequently, the buyer needs to devise targeted incentive bonus plans that may be outside the model for the buyer and speciﬁcally tailored to incentivize the management team to deliver speciﬁc buyer goals for the transaction. Following are some ideas for what a targeted incentive bonus plan might involve:
- Speciﬁc milestones could consist of the development of innovative software, or upgrading existing software or other products to satisfy market needs, in both cases applying the buyer’s broader resources. These milestones may be a portion of a long-term project that may need two to ﬁve years to accomplish, so therefore, the incentive plan will need to have a longer-term horizon that equals the achievement of speciﬁc milestones.
- Speciﬁc milestones could cover sales or other ﬁnancial targets for the software or other technology products acquired in the acquisition to attach the management team to the sales eﬀorts for their products.
Acquire less than 100% of the Target Company’s Equity (with deferred purchase options for the remainder).
In the standard rollover structure, the rollover participants cannot sell their rollover equity until the private equity fund sells the whole company. As explained above, strategic buyers are unlikely to accept rollover equity. Nevertheless, a hybrid rollover structure that can be employed by strategic buyers is to:
- Buy less than 100% of the Target Company’s stake in the closing (typically higher than 50% of the stake, but less than 80% (to bypass consolidation for tax purposes)); and
- Obtain the remainder of the equity at the following date, maybe two to three years following the closing, on a pre-set ratio to ascertain the purchase price based upon anticipated performance.
This structure provides the seller’s equity holders to sell a portion of their equity at the initial closing, and give some liquidity for their purchase. In the post-COVID conditions, the pricing multiple for the part of the ownership obtained at the deal closing may reﬂect some of the uncertainty for how swiftly the target company’s operations will get back to pre-COVID levels.
The second-step acquisition of the residual equity can utilize a pre-set formula to ascertain the purchase price, which will get based on the ﬁnancial performance of the target company through a later time. This structure presents a likely upside to the seller if the ﬁnancial performance gains within a reasonable period, while at the same time giving downside protection to the buyer if the ﬁnancial performance is forever impaired or takes an extended period to get back to pre-COVID levels.
For instance, consider that buyer buys 70% of seller’s equity at the initial closing at a 9X multiple of EBITDA (which might have been an 11X or 12X multiple in January 2020). The purchase agreement would render that the buyer will acquire the outstanding 40% of seller’s equity based on a 9X multiple of 2021 or 2022 EBITDA, maybe with some minimum price to give some downside protection to the seller’s equity holders. This arrangement earmarks the downside risk to the seller of a slow or extended recovery while giving upside incentives to the seller if the target company’s ﬁnancial performance progresses more speedily. This structure can be particularly beneficial for a smaller target company with limited sales acquired by a more prominent company with more extensive sales and distribution channels.
Final thoughts to Close M&A deals successfully in the Post-COVID environment
M&A partners have to deal with an exceptional amount of obscurity as a consequence of the COVID-19 pandemic. Therefore, due diligence eﬀorts and transaction structures shall shift from a highly pro-seller situation to one in which buyers and sellers want to be more ﬂexible and original for earmarking the valuation and ﬁnancing risks among them. If a seller can pause for more desirable conditions, then they will do so. But many sellers still want to strive to get a transaction closed. Furthermore, private equity buyers have multiple funds to invest and will want to deploy capital at some point, particularly those with funds that have investment periods coming to an end. Cash-rich strategic buyers, and particularly those seeing for businesses with new products and technology, may ﬁnd this an attractive opportunity to acquire firms that are a strategic ﬁt. This situation may offer strategic buyers who are previously familiar with the industry and the target business with numerous possibilities, mainly if they are ready to proceed swiftly and are keen to be more inventive with their deal structures.