After a period of record M&A activity over the past decade, business engaged in M&A activity now face unprecedented disruption. Some acquisitions are still being completed in sectors unaffected, or at least less affected, by the pandemic but the majority have been either been placed on hold whilst the full extent of the pandemic fallout is assessed and related valuation and financing issues are reviewed or cancelled all together.
Despite unprecedented social and economic paralysis, the uncertain market will for some present an opportunity. A recent survey by EY Capital found that 56% of executives are opting to transform their business through transactions and plan an acquisition in the next 12 months.
Company Commercial Partner, Tom Webb discusses some of the likely structural changes to those transactions that do proceed during these uncertain times.
How will the deal structure change?
It goes without saying that both buyers and sellers will be looking for greater deal protection mechanisms for transactions moving forward. We expect pricing structures to change, and multiples often used in certain sectors being reduced, in an attempt to offset uncertainty and encourage buyer and sellers to share risk. A lot, as always will depend on whether buyer and seller expectations and risk appetite align.
Use of locked box reducing
The ‘locked box’ concept involves a purchase price payable on the transaction’s closing date being agreed and fixed at the date of signature with no option of price adjustment. The principal objective in doing this is to give certainty on the cash consideration at the point the deal is signed, and to eliminate the distraction and resource commitment of a lengthy completion accounts process.
Where deals were planned to have locked box mechanisms, we are now seeing buyers wanting to move to a completion account mechanism and push back the valuation date of the business, allowing for the uncertainties and fluctuations around performance and receivables to be taken into account.
A seller, unwilling to agree to a pure completion account mechanism, may be willing to consider a hybrid structure where the price is still set by reference to a locked-box account date, but certain items such as cash and working capital are tested at completion. There can then be a pound for pound price adjustment against expected levels.
Use of Earn-outs increasing
An earn-out structure is a contractual provision that enables the seller to obtain additional compensation in the future if the business achieves certain financial goals. This type of price protection was commonly used pre Covid-19 but will be particularly relevant now when parties may not be confident of the market post-Covid-19.
A seller may however, be reluctant to accept such pricing mechanism as they will have very limited control over the business after completion. If an earn-out is agreed, the parties will need to consider whether this pandemic is a factor that can be taken into account or will be ignored when calculating the earn-out targets set.
Retention of minority stake of ordinary shares
Rather than buying or selling 100 per cent of a company, parties may decide to share the risk on valuation and agree that the seller retains some value in the company so that the buyer does not take on the entire valuation risk. This would not usually be a preferred option with buyers wanting 100% control from the date of purchase but could be structured to allow the buyer to obtain full control of the business in due course and the seller to fully exit, with the price of the final tranche of shares being valued at a the point of purchase in the future which may be beneficial to both parties.
Preference or Convertible Shares
A possible alternative to acquiring a minority stake of ordinary shares would be to structure the transaction using a different capital instrument, such as a preference share or convertible share.
This may allow a more flexible agreement to be reached on valuation, allowing for the current turbulent market. For example, the buyer could acquire convertible preference shares with the conversion date set for a time when the market is likely to be more stable. The conversion ratio could be set at a level that matches the buyer’s current view of the investment value, but if the seller is able to deliver additional value by the conversion date, the actual conversion would result in the buyer receiving a lower percentage stake.
If you are considering buying or selling a business and are worried about the current uncertainty please speak to us on 01225 750 000 or email email@example.com. There are many options available to you that can help manage any associated risk due to Covid-19, we can discuss these with you enabling you to make an informed decision about the future.