Part Three: Reducing Your Risks
And now, an important update from the world of M&A transactions: Buyers are still buying and sellers are … checks notes … still selling. Businesses are pushing through the uncertainties of COVID-19 to get deals done, and they are succeeding with heightened vigilance and good old-fashioned attention to detail.
Welcome to the third part of our series on due diligence best practices in the age of COVID-19. Our first post focused on the IT environment, the wave of new risks linked to a prevalently remote workforce and the importance of identifying all vulnerabilities.
Our second post was all about money—the pandemic’s impact on financial due diligence and how COVID-related expenses and losses impact business valuation.
In this insight, we’re covering some of the less obvious, but no less important, due diligence considerations to keep on your radar.
Insurance against risk
Pandemic or no pandemic, the M&A world is fraught with risk—so protection is paramount. That includes insurance contracts, which can help guard against uncertainty during precarious times.
Representations and warranties (R&W) insurance, for example, protects buyers from inaccurate or misstated seller financials, employee issues or legal entanglements not disclosed at the outset of the transaction. Sellers, meanwhile, use R&W insurance to insulate themselves from liabilities related to misrepresentations, accidental or otherwise. R&W insurance also helps sellers keep more money out of escrow to maximize initial proceeds for shareholders at closing.
Given the circumstances, buyers should ask if a target company carries business interruption insurance and, if so, whether that coverage includes damages related to viral outbreaks. Similarly, buyers should closely examine general liability insurance policies for coverage in case the target company is eventually sued for lack of proper preparation related to employee, customer or vendor safety.
Target companies that received Paycheck Protection Program (PPP) loans from the Small Business Administration (SBA) might find it beneficial to seek PPP insurance. This novel product protects against the SBA deeming the borrower ineligible for the loan upon review of its forgiveness application.
Speaking of PPP loans, any government funding received during the pandemic could have significant tax implications. Buyers need confirmation that a target company complied with the rules established for use of said funding; however, regardless of a change in ownership, the seller or borrower of the PPP loan would remain responsible for the loan. If not, as with the PPP loan stipulations mentioned above, the funding may not be forgiven, and stiff penalties could follow.
In most cases, sellers need to notify the PPP lender of any M&A transaction. Sellers can circumvent SBA approval by applying for PPP fund forgiveness before the transaction and establishing an escrow with funds equal to the PPP loan.
Doing the deal
Pandemic-era due diligence means weighing different deal structure options, including the use of earnouts. Like insurance, earnouts offer a degree of protection in an uncertain world. Cautious buyers may be more willing to base a target company’s purchase price on future performance.
We’ve seen many earnout arrangements recently that benefit all parties. One notable example involved a private equity group who incentivized the target company’s management team with bonuses for hitting their earnout target. If the team fell short, the group committed to reinvesting the bonus money to pay down senior debt. For any earnout arrangement, sellers and buyers need to clearly delineate parameters and agree on value calculations. Transparency makes all the difference.
Sellers interested in closing a deal quickly may want to consider providing financing to buyers in the form of seller notes. This allows buyers to defer a portion of the transaction price until a later date, while the sellers receive continuous future payments along with interest.
A quick note about timing
The late Tom Petty was 100% right: Waiting really is the hardest part. But it’s become a fact of life, and you’d be wise to prepare for any transaction to take longer than it would under more normal circumstances.
What’s causing the delays? For starters, it’s harder for buyers to secure financing. Amid such turmoil, banks aren’t eager to lend (thus the emerging popularity of alternative financing like seller notes.) This lack of eagerness to lend from traditional financing has changed the structure of deals, which can lead to longer closing periods.
As we pointed out throughout this series, the entire due diligence process is, by necessity, more involved during COVID-19. Obtaining a good assessment of a company’s culture, for instance, takes more time and effort when much of the workforce is virtual.
Steer clear of DIY
The depth and breadth of M&A due diligence considerations in these muddled times makes one fact abundantly clear: You don’t want to attempt this on your own. With so much at stake, you need trusted advisors by your side capable of minimizing your guesswork and maximizing your advantages.
The due diligence specialists at Sikich bring to light all the facts, figures and considerations that allow buyers and sellers to make smart decisions. Get in touch to find out what we can find out for you.