Managing M&A valuation issues in the era of COVID-19

The COVID-19 pandemic has had a profound impact on businesses, both immediate and in terms of their long-term outlook. Whilst hospitality, retail and travel businesses have suffered obvious and acute impacts, there are hidden complexities in the valuation of longer-term assets in the infrastructure, property and agribusiness sectors. Tech-focused company valuations have risen sharply, as illustrated by the NASDAQ Composite Index’s sudden return to pre-COVID-19 levels.

Given the uncertainty of revenue, expense impacts and timing in the current environment, can valuation issues be successfully managed in mergers and acquisitions? Some buyers have taken a conservative approach and suspended their acquisition programs, but experience suggests that stronger players will emerge to take advantage of opportunistic acquisitions. Domestic acquirers may also have a period of competitive advantage under the current ‘zero threshold’ FIRB regime (see our previous publications). From a seller’s viewpoint, certainty around the purchase price and de-risking completion are key.    

So what are some of the tools that buyers and sellers need to consider to manage valuation issues and deal risk?

Terms Sheet – often terms sheets or letters of intent (LOI) are cursory. It is in the interests of both buyers and sellers to have a common understanding of the purchase price and key valuation drivers on which a deal can be consummated.

Due diligence – additional focus is required on key liabilities and risks arising from COVID-19, including employment, insurance and key contracts (including any force majeure triggers). It is vital for accounting and legal advisers to work collaboratively to inform the due diligence exercise and identify any potential valuation impacts.

Conditions precedent – conditions precedent allow the benefitting party to walk away from the transaction if certain events do not occur prior to completion.  In the current environment, focus needs to be given to the specific wording of conditions regarding ‘material adverse change’ (also known as a ‘MAC’ clause), assignment of contracts and key regulatory issues, such as FIRB.

Payment mechanisms – there are a range of adjustment and deferred payment mechanisms which may suit particular transactions. In a COVID-19 environment, these may include:

• Earn-outs – these form part of the purchase price but only become payable if the target company achieves one or more defined goals. Whilst often in the form of general financial targets, such as achieving a particular EBIT, earn-outs can be tailored towards key valuation drivers such as retention of particular client volumes or contracts. Importantly, the timing of the earn-out can be matched or paid in tranches to reflect the key valuation drivers, especially where the valuation involves a forward financial year forecast.

• Retention amount – this is a portion of the purchase price that is retained until a fixed point in time (such as delivery of audited financial results or the warranty expiry period) or upon the occurrence of a specific event. The retention amount may be a ‘pool’ or may involve specific retention amounts for issues of concern (such as customer claims, employee liabilities or tax matters).

Innovative deal structures – value may be captured using innovative scrip consideration structures. For example, a mechanism like price-protected shares (as used in the Wesfarmers-Coles transaction) or contingent value rights provides the parties with some comfort with known ‘caps’ and ‘floors’ on price. 

The above tools can provide certainty for buyers and sellers, assist in breaking pricing deadlocks, and minimise execution risk.

Many thanks to Michael Macanochie for his assistance in putting this article together.

This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.