Diligence with 20/20 vision
Nothing in recent history has changed the business landscape as drastically or as quickly as the COVID-19 pandemic, which presents a real challenge for mergers or acquisitions. Market multiples, past cash flow generation, and other measures based on performance formed the foundation of due diligence. But what good are historical measurements when the future may no longer reflect history?
Like the rest of the world, transactions have slowed down dramatically. Borders are closed, travel is restricted, and face-to-face meetings are no longer an option. Management is consumed with weathering the immediate crisis while trillions of committed capital wait for the dust to settle. But deals will resume. In fact, the pandemic may create a wave of new deals as troubled companies look for exit strategies and investors look for a market correction. In some industries, companies may exit the pandemic healthier, attracting a new round of interested sellers. Given these M&A opportunities, how can buyers and sellers accurately gauge value and risk going forward?
Treading this new terrain, buyers will be more diligent in their approach, while sellers will need to prepare for increased scrutiny. Historical business information may be less useful and will be carefully scrutinized as an accurate predictor of future performance. There will also be increased focus on forward-looking information, including, forecasts, budgets, backlogs, and pipelines, along with qualitative factors regarding changes in business practices.
Due diligence for the COVID-19 era
In a post-pandemic world, buyers must understand not only the direct impact of COVID-19 on the target but also management's response to the crisis and the pandemic's effects on near- and long-term operations. These steps will provide increased visibility to achieve maximum returns on investment. Below are five areas of supplemental due diligence that buyers and sellers should consider.
- Expanded EBITDA Benchmarks: Consider a pro forma adjustment to reflect 2020 financials under normal operations. The months directly affected by the pandemic are likely not representative of historical financial performance nor indicative of future results. While COVID-19 will adversely impact most companies, some businesses may experience a temporary or permanent benefit so consider the specific fact pattern. There is no one size fits all approach. The key focus here is to understand the "new normal" of the company. Following are some methods for quantifying the pro forma impact:
- Compare EBITDA trends for the quarter before COVID-19 (on a seasonally adjusted basis) to impacted months and management's near-term forecasts.
- If momentum for financial performance appears to be stabilizing for a series of months, the annualization of EBITDA for the most recent quarter(s), adjusted for seasonality, may help determine the impact of COVID-19. Shorter reference periods will likely be less reliable than a quarter or half-year approach.
- Benchmark EBITDA trends of the company relative to industry peers.
- Benchmark performance against growth rates from prior years and future year projections.
- With uncertainty clouding the immediate future, understanding operating leverage and breakeven points become more important to model how a change in revenue impacts EBITDA and a time horizon to achieve stability.
- Top-line impact: In addition to looking at profitability metrics (e.g., EBITDA margin), it is important to understand the short- and long-term COVID-19 revenue impact.
- Analyze sales trends before, during, and after the pandemic by customer, product, end-market, and channel. This will provide a structure for assessing which key market trends will most impact the top-line performance. Further, it will help identify risks in sectors expected to have extended recovery periods.
- Consider the company's position in the value chain and potential for lagged pandemic impacts. While businesses with global supply chains were affected early on, certain verticals and sectors may experience lagged effects not yet reflected in historical financials.
- Focus on forecasts in addition to historical results and carefully review budgets, backlogs, and pipelines. Evaluate the likelihood of achieving these forecasted results by assessing historical win rates, budget vs. actuals, and post COVID cancellation rates.
- Some companies may alter standard practices with increased acceptance of returns and discounting in response to changes in aggregate demand. Other companies may find limited supply provides opportunities to increase pricing.
- Vendors and supply chains: Understand the timing and resulting changes in the company's supply chain recovery. Consider the company's suppliers and key sourced materials (particularly for sole-sourced materials). Determine if there will be permanent changes resulting from the adaptation process.
- Does the company have reliable sources for the timely delivery of the quality materials, and will those relationships survive the pandemic?
- What will be the ongoing impact on vendors and product pricing?
- Does the company have vendor agreements with purchase commitments? With supply chain disruption and changing purchase volumes, consider whether purchase commitments can be met, and penalties for not meeting these obligations.
- Is the company considering diversifying supply risk to multiple vendors or alternative countries? If so, what are the impacts on margin, order fulfillment and quality?
- Employees and contractors: Payroll is commonly a company’s most significant expense. Many businesses have been forced to make difficult personnel-related decisions. From March 15 to May 2, 2020, a record 33.5 million people filed for unemployment benefits, approaching 20% of the American workforce. Understand any financial or operational ramifications of the company’s personnel decisions.
- Pay attention to headcount fluctuations during the crisis. Will the company be able to rehire the workers needed to resume operations as the crisis recedes—especially skilled and experienced team members?
- Understand whether the target temporarily deferred compensation to employees or reduced employee salaries. Further, has the company delayed payout of severance, deferred salaries, payroll taxes, bonuses, or discretionary 401k contributions? Consider whether funds should be left behind at close for settling these deferred obligations.
- Working capital and additional debt-like items: Given the upheaval of COVID-19, historical accounting methodologies may not reflect all risks on the balance sheet. Additionally, historical working capital may not accurately reflect working capital needs going forward. With the disruption affecting all levels of business, a fresh look at accounting methodology is warranted.
- Consider the trends and potential deterioration of the target's accounts receivable portfolio. Has the company updated its allowance for bad debts to reflect the risk of these assets and to offset inflated AR levels?
- Has a drop in demand resulted in extended aging of inventories? Consider the need for additional inventory reserves for spoilage, slow-moving, excess and obsolete inventory. This consideration will avoid inflated inventory balances from skewing net working capital.
- How is the company accounting for regulatory action and stimulus funds? Is the company accruing for deferred payroll taxes?
- Analyze accounts payable trends of your target and whether extended payables should be considered indebtedness in closing agreements.
- Look for rent concessions granted and consider treatment as debt in closing agreements.
Purchase agreement implications
It is essential the risk areas identified during diligence are reflected within the purchase agreement, even more so when COVID-19 creates further pitfalls and nuances that can lead to post-closing disputes. Here are eight areas to consider prior to signing your next agreement:
- Subsequent events and accounting estimates --Many transactions require net working capital or earn-out calculations be calculated in accordance with GAAP, which includes evaluation of subsequent events occurring after the closing date that provide evidence of conditions that existed at that time. However, the way subsequent events are interpreted is often not further defined in a purchase agreement. So how should your post-closing calculations consider the effects of COVID-19 that could cause post-closing debtor liquidations, supply chain impacts and inventory impairments?
- Negotiating specific accounting principles to account for changing market conditions--Parties often agree to calculate net working capital in accordance with "GAAP, consistently applied." But how can parties prepare accounts on a consistent basis when circumstances have shifted so dramatically and there is no historical practice to compare against? This could be a particular concern for those subjective accounting areas noted above.
- Earn-out provisions and the calculation of financial metrics--Earn-out targets are commonly based on EBITDA or similar financial metrics, such as revenue or net income. Purchase agreements already signed have likely not factored in the impact of market changes due to COVID-19. Parties may want to work together to consider revisions. For those yet to be signed, metrics may need to be reconsidered to account for any impaired future performance based upon diligenced projections.
- Material Adverse Change or Force Majeure clauses -- Many purchase agreement provisions may now contemplate COVID-19 within the language of the agreement itself. Buyers should consider whether these could impact or potentially override earn-out provisions and the calculation of financial metrics.
- Target net working capital--Parties often struggle to agree on what normal working capital is. Agreement can be even more difficult when they aren't sure what normal business will look over the coming months. The target set should be based upon diligenced financial information and projections.
- Paycheck Protection Loans— Many business may have received a Small Business Administration Paycheck Protection Loan (PPP loan) through the recently passed CARES Act and will have a corresponding liability to factor into the definition of Indebtedness. Subject to certain conditions, many PPP loans may ultimately be forgiven. Parties will need to consider the likelihood of loan forgiveness, and to whose account any such forgiveness should be credited, then factor this into the agreement prior to signing to avoid post-closing disputes.
- NOLs –Buyers and sellers will need to be more aware of what tax assets are being included in the transaction. As a result of the CARES Act, sellers are back in control of retaining actual and negotiating value from NOLs. The purchase agreement should be overly clear on tax return procedure including any tax elections with respect to pre-closing NOLs.
- Representations and warranties--Sellers provide buyers with representations and warranties regarding the current state of the target business. In general, these representations and warranties do not consider specific events such as COVID-19. Buyers and sellers should therefore contemplate whether specific amendments need to be made to the purchase agreement to appropriately consider the breadth and extent of the promises being made.
Tax implications for post-pandemic deals
Tax considerations will also need special attention in light of COVID-19. The Families First Coronavirus Response Act and the Coronavirus Aid, Relief, and Economic Security Act, known as the CARES Act, afforded all taxpayers a wide variety of cash generating incentives. However, as may be expected with legislation that is passed through the legislative channels in short order, the CARES Act left taxpayers and tax professionals with many unanswered questions.
The CARES Act included changes that not only increase the availability of NOLs for many companies, but also increase the actual liquidity and trading value of NOLs in deals. As taxpayers look to monetize NOLs, Buyers and sellers will have to understand the impact tax accounting method changes and other tax planning strategies will have on current and future tax obligations. As taxpayers have monetary incentives to enhance NOLs available for carryback, Buyers should pay particular attention to any aggressive tax positions that may have been taken and ensure they are adequately protected should any position be challenged.
Additionally, Section 165(i) permits taxpayers to treat certain losses arising from a presidentially declared disaster as having occurred in the prior tax year. As such, losses attributable to COVID-19 events in 2020 may be claimed on 2019 returns, potentially adding to pre-closing NOLs. Finally, given the elimination of NOL carrybacks in the 2017 tax reform legislation, many purchase agreements no longer contemplate which party would be entitled to a refund in the event of a carryback to a pre-closing tax period—now they may have to.
COVID-19 and the CARES Act also raises a variety of other potential tax considerations:
- AMT credits—AMT can be immediately monetized, so purchase agreements will need to address who benefits.
- Qualified improvement property (QIP)—QIP is now eligible for 100% bonus depreciation as if enacted originally in the 2017 tax reform act, so companies have the option of amending prior returns to claim the benefit or to take the benefit on their next return with an accounting method change. Buyers will need to understand if any material changes to tax basis or taxable income will result based on this retroactive application. Sellers taking advantage of QIP may increase pre-closing NOLs available for carryback or increase the amount of NOLs a buyer will receive in the transaction. What if an S Corporation seller takes advantage of QIP pre-sale and a buyer is on the hook for making a seller whole for any incremental taxes above and beyond a straight stock sale? Buyers will need to be thoughtful of managing a seller’s pre-closing tax returns to ensure they understand what they are receiving, or not receiving.
- Net business interest deduction—The limit for the deduction of net business interest is increased from 30% to 50% of net taxable income for tax years beginning in 2019 and 2020. This could potentially generate NOLs in 2019 and 2020 that could be carried back to prior years, adding to the NOL considerations addressed above.
- Restrucuring debt obligation—Many companies are looking at restructuring their debt obligations, including modifying terms on existing debt instruments. Buyers will need to understand the tax implications of any debt workouts undertaken by a target company, including the amount of cancellation of debt income and effects on the target’s tax attributes.
- Employee retention credit—Eligible employers can take advantage of an employee retention credit of up to $5,000 per employee. If your target company has claimed the credit, ensure they have complied with credit requirements to avoid being stuck with unexpected tax and penalty liabilities.
- Paycheck Protection Program (PPP loans)—Small business may have received PPP loans. Ensure eligibility requirements are met, check interaction with other CARES act benefits such as the employee retention credit, and determine whether the loan is eligible for partial or complete forgiveness. If eligible for forgiveness be sure to consider the tax implications, as the IRS recently issued guidance suggesting that deductions associated with PPP loan forgiveness may be disallowed, though this topic is currently being debated.
- CARES Act compliance—Buyers should confirm the target company’s compliance with regulations concerning any or other stimulus relief, whether or not tax related. Relief legislation has been enacted swiftly and regulations are still being issued in many cases. Given the dollar amounts involved, regulatory failures on the part of a target company could end up creating significant liabilities for a buyer.
- State conformity rules—Conformity rules will affect how CARES Act changes impact your state tax situation. States with rolling conformity should enact applicable IRS rules, but states with static conformity may not. Check with your tax advisor.
- Foreign tax issues—Several foreign countries have also passed laws providing companies certain tax incentives. Check with your tax advisor.
Here is a more complete overview of tax changes in the CARES Act.
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