Deal Issues Post Covid-19Download PDF version
We expect a number of potential accountancy and litigation issues to come the fore as business returns to ‘normal’ post Covid-19 with deals agreed and signed prior to the pandemic now looking more unattractive. Looking forward, we also explore what Covid-19 is likely to mean for future deal structures.
For deals which are close to signing…
The recent economic challenges will have resulted in many deals going on hold, with the parties revising their views on pricing and other key deal terms. For the potential losers in such renegotiations, one viable option is to argue a point which has already been agreed.
The familiar debate of whether heads of terms or other discussions represent an actual agreement will no doubt be revisited, and the wording of emails and other documents reviewed to support these views, if only as leverage against price chips.
Furthermore, a party that does seek to walk away from heads of terms may still find that certain terms are legally binding (e.g. relating to confidentiality, exclusivity or lock-out undertakings) and may even be required to cover the other party’s costs if negotiations break down.
Deals between exchange and completion…
Buyers may be concerned that a deal struck pre-Covid doesn’t now reflect the Target’s revised projections and any price adjustment mechanisms negotiated into the Sale Purchase Agreement may not adequately account for these unprecedented market conditions.
As a first step, Buyers may turn to material adverse change (MAC) or material adverse effect (MAE) clauses to delay completion and push the price down. MAC clauses triggered by reference to specific events (e.g. a specified drop in revenue over a specified time period) will be easier to invoke than generic MAC clauses (e.g. matters affecting the Target’s business or liabilities). In addition to known or disclosed events, MAC clauses may well carve-out natural disasters/force majeure risks or macro-economic/industry wide events.
Buyers will face a high hurdle trying to invoke a ‘financial condition’ MAC and will need to demonstrate that a matter will have a material and long term (i.e. years) impact on the Target. There is little guidance on materiality but, as a rule of thumb, Buyers will likely need to show a reduction in the Target’s net asset value of approximately 20% (based on the only significant case, which is from 1977). In relation to public takeovers, The Takeover Panel’s guidance states that meeting the materiality test requires “an adverse change of very considerable significance striking at the heart of the purpose of the transaction” but, unhelpfully, do not provide specifics.
Alternatively, Buyers may seek to rely on other clauses – as Sycamore Partners argues in its attempt to pull out of its deal to buy Victoria’s Secret’s business from L Brands. Whilst in this scenario the MAC clauses do not apply, the transaction arrangements require Victoria’s Secret to be run “in the ordinary course consistent with past practice”.
Is the acquisition funding available as expected?
Even if there is still an agreed deal with your counterparty, the funding the purchaser had planned to rely may not still be available. Borrowers may be forced to renegotiate financial covenants and may not be able to meet the resulting cost of funding. Furthermore, will lenders seek to renegotiate terms and will the investors in funds be in a position and prepared to meet capital calls as and when they are made?
Where the deal has been done what does Covid-19 mean for completion accounts and earn-out calculations?
When deals have been completed, there are points that need to be considered particularly where the parties are still in the process of agreeing completion accounts, or there are future earn outs to consider.
Many agreements only require that the completion accounts follow UK Generally Accepted Accounting Principles (“GAAP”) and in particular the detailed accounting approaches adopted in the historic audited accounts. There is often little, if any, specific guidance on the treatment of unusual one-off issues, such as the pandemic related matters we have encountered in the last few months, beyond the reference to UK GAAP.
The Financial Reporting Council has confirmed that in relation to accounts prepared for periods up to and including 31 December 2019 under UK Generally Accepted Accounting Principles, any Covid-19 impacts are treated as non-adjusting post balance sheet events. As such. Accounts including completion accounts, for periods up to 31 December 2019 should not in general require restating unless there are specific provisions to that effect in the deal documents.
However, the treatment of Covid-19 related issues in completion accounts for deals which completed during 2020 is not clear. Disputes around the detailed contents of these accounts, particularly where the business has been adversely impacted by pandemic related issues can be expected. In order to resolve these issues it’s important to have input from both lawyers around the drafting of the relevant agreements but also from accountants around the accounting treatments adopted and what, if any, scope there is for debate around the correct interpretation of UK GAAP and other relevant accounting issues in these areas.
This is also a similar problem for earn outs where measures such as earnings before interest depreciation and amortisation (“EBITDA”) need to be calculated for future periods and compared against targets to determine if further payments of consideration are due. Again the language typically included in the agreements on how these figures are calculated tends to be focused on giving consistency with prior years, not dealing with granular but potentially material issues such as how one-off costs related to Covid-19 should be treated in those calculations.
Typically, post-closing disputes revolve around completion account adjustments or earn-out adjustments and are caused by (i) the choice of accounting rules to apply, including any industry specific practices and guidance; (ii) the discretion permitted under the relevant rules and how that is exercised by the (new) management of the acquired company; and (iii) changes between the Seller’s historical practices and the Buyer’s own accounting methodologies.
The relevant transaction document will likely set out the method of resolving disputes, including which balance sheet items can be disputed, how long each party has to bring a dispute, and whether disputes will be resolved by an independent expert (either as a final determination or as a non-binding step to try settle the dispute without the need to resort to the Court/arbitration).
How about the tax man?
The starting point for UK capital gains tax is that it falls due on all ascertainable consideration, even if contingent or deferred and this is payable in full on the 31 January following the end of the tax year in which the deal occurred.
A vendor can however approach HMRC to arrange a tax repayment in circumstances where contingent consideration is no longer expected to be paid and also obtain some level of tax deferral where part of the consideration is only paid after the 31 January tax due date. We have considerable experience in assisting clients in making such claims and are happy to discuss this further.
What about the banks?
Where the deal has included debt funding it may well be the covenants in the debt are no longer achievable and the target company rapidly falls into a technical default around its acquisition debt which then needs to be addressed to avoid an acceleration of the loan.
What does this all mean for deals going forward?
In structuring deals in the next 6-12 months there are a number of challenges:
- Historic comparables, such as earnings multiplies used in other deals in the same or related sectors, are arguably no longer valid, particularly in sectors where future profitability is likely to be very different to historic profitability. This is an issue because historic comparables are often key pieces of evidence in order to marry up the price expectations of buyers and seller.
- Much more focus will be on whether forecasts remain valid now and going forward. As such recent trading performance is key rather than a focus on historic trading performance.
- Issues such as customer concentration, cash collection and working capital management are likely to be much more closely examined.
- Negotiations and purchase prices will account for Covid-19 and its impact on the market and the Target’s business, whether explicitly stated or not.
For many sectors it is likely the net effect of the above will be to depress prices and widen the gap in price expectations between buyers and sellers. Vendors will also be keen to be quickly paid in cash to maximise their certainty as to the outcome. Against this, buyers will favour earns outs to offset the risks of poorer than expected future performance and issues such as failures of key customers and suppliers.
Locked box deal structures will become less popular than completion account-based deals
The perceived strength that a locked box deal can be based on a fully audited set of historic accounts becomes its weakness. That long period of time from the locked box account date, on which the deal is priced, to completion means that the target business has a considerable period to underperform if trading and/or cash management performance deteriorates.
As such there will be far more focus on reviewing the businesses trading and working capital performance in that locked box period. In many ways the simplest way to capture these risks is to move to a completion account structure where the price reflects the target businesses assets and liabilities (and hence trading performance) right up to completion.
We suspect it will take longer for deals to complete as people get used to the new normal both in terms of pricing metrics, deal structure and availability of funding.
The importance of value protection
Value protection will become more important in deals so there will be an increased focus on warranties and indemnities (and the level and detail of disclosure made against them). Where businesses appear to have survived Covid-19 there may subsequently be increased levels of litigation and claims from disgruntled customers, suppliers and employees.
As such we expect the numbers of warranties and indemnities requested by buyers and the level of detail for which comfort is requested will increase materially going forward. At the same time responding to these requests appropriately will become an increasingly onerous job for sellers. Having good legal advice as to what warranties and indemnities are appropriate to accept on both sides will be key to getting the deal done.
Other parts of the deal process which have also often been taken for granted such as certainty of funding and the wording of clauses allowing parties to pull out of, or renegotiate a deal will also be more focused upon going forward.
How can we help?
There are lots of ways we can help you develop and execute your M&A strategy. For example:
- We can review heads of terms and other documents to determine if they could be legally binding. We can also discuss how to manage your negotiations in an effective way if you or the other party to a deal have decided to try and pull out.
- We can help you update your deal documents and underlying strategy to ensure it addresses the new issues emerging from the pandemic. This would typically include advice on additional wording and protections to build into your agreements, advice on deal structures (ie: consider moving to completion accounts or if you must go with a locked box approach what extra protections to bake into the agreements and related advice on issues such as what extra detail the completion accounts and earn outs schedules should include to ensure pandemic related issues are dealt with appropriately in any key accounting numbers).
- We can review proposed warranties and/or the planned disclosure against them.
- We can advise on actual or potential disputes on existing deals, addressing both the legal and accounting issues.
- We can help you get tax repayments from HMRC where contingent consideration is no longer expected.
Our dedicated tax team and legal team have extensive experience in assisting individuals, entrepreneurs, family offices and private businesses. If you would like to benefit from our services and discuss suitable options that work for you, please contact our Tax Partner, Paul Cooper: email@example.com or our Litigation Partner, Rob Stewart: firstname.lastname@example.org
This post is intended to be a brief note for clients and other interested parties. The information is believed to be correct at the date of publication but should not be relied upon as a substitute for professional advice.