M&A transactions in times of COVID-19
Effects of COVID-19 on a due diligence review
In times of COVID-19, the audit should focus on whether the target company is sufficiently protected against the negative effects of COVID-19, e.g.: Can employees work from home? Can certain activities be outsourced? Can supply chains be maintained? Do contractual partners have unilateral rights of termination or withdrawal due to force majeure caused by COVID-19? If risks arise from this, it must be considered whether the transaction should be canceled or initially postponed or whether the risk may lead to a reduction in the purchase price. Consideration can also be given to a possible indemnification by the seller with regard to the identified risk. However, it is unlikely that a seller will agree to an exemption due to a risk caused by COVID-19.
Issues relevant to the purchase agreement due to COVID-19
Possible risks for the transaction due to COVID-19 can also be reflected in the purchase agreement. Material adverse change (MAC) clauses are one way of reflecting changes due to COVID-19. Such a clause can be used to compensate for a COVID-19-related change in the target company between signing and closing by giving the parties the option of withdrawing from the contract or refraining from closing if there has been a substantial economic change in the target company (due to COVID-19) between signing and closing. This gives the acquirer the opportunity to enforce a reduction in the purchase price and, in the event of failure, to refrain from the acquisition altogether. However, as this clause is clearly in the interests of the acquirer and shifts the transaction risk very heavily to the seller, it will often be difficult to enforce such a clause. Such MAC clauses have been agreed less and less frequently in recent years, as the M&A market has been a seller's market in recent years. However, it is possible that COVID-19 will give the MAC clause a new lease of life, as COVID-19 shows how quickly a company's economic situation can change for the worse.
Long-term effects of COVID-19 on a target company, e.g. due to the loss of supply chains and the resulting production losses, can possibly be offset by purchase price adjustment clauses. Such purchase price adjustment clauses provide for interim financial statements to be prepared for the closing/completion of the transaction. In a purchase price adjustment model, the company's cash is remunerated at closing/completion. The net financial liabilities are deducted from this. If the net working capital exceeds or falls below a previously agreed target figure, this is offset. This means that, for example, in the event of a significant reduction in inventories due to COVID-19, e.g. due to a supply chain failure, this will be reflected accordingly in the net working capital and will lead to a corresponding adjustment of the purchase price, unlike in the case of an agreed fixed purchase price. In times of COVID-19, an acquirer should therefore have a great interest in working towards such a purchase price adjustment clause. However, since such a clause is naturally disadvantageous for the seller, the seller will try to avoid such a clause or at least negotiate out COVID-19-related special effects. However, as the tense economic situation continues, this will become increasingly difficult for the seller.
Another way to counter COVID-19-related risks and reflect them in the purchase price is to agree an earn-out clause. If the seller and buyer cannot agree on a specific purchase price, an earn-out clause is often used. A lower base purchase price is agreed and part of the total purchase price is structured as a variable purchase price, which increases the purchase price and depends on the achievement of certain target figures within a certain period (e.g. turnover, EBITDA, EBIT, etc.). If there are fears that COVID-19 will affect the turnover of the target company, this risk can be partially shifted to the seller by agreeing a corresponding earn-out clause. For the seller, however, there is the further risk that after closing/execution it is solely in the hands/control of the acquirer whether certain target figures are achieved or not, so that there is room for manipulation by the acquirer regardless of COVID-19. If the seller nevertheless agrees to a corresponding earn-out clause, he should try to counter possible manipulation by the acquirer by means of appropriate control mechanisms (e.g. continuing to be part of the management for the period of the earn-out clause).
Practical tips for the implementation of the transaction
Finally, a few practical tips regarding the execution of transactions in the current travel situation: In most cases, meetings/notarizations and trips can no longer be carried out due to the increasing government restrictions. In particular, the government entry and exit restrictions must be observed. If transactions are still in the negotiation phase, telephone and video conferences should increasingly be used. However, the current travel situation should also be constantly monitored for national transactions, as it may no longer be possible to attend notarization appointments in Germany at short notice if curfews are still in place.
Conclusion
Even in the current difficult times and the uncertainty caused by COVID-19, there are ways to counter these risks in the context of transactions. The parties should discuss these risks in detail during contract negotiations and try to achieve a balanced distribution of risk by agreeing MAC clauses, rights of withdrawal or purchase price adjustment clauses.
Status: 18.03.2020