Mergers and Acquisitions after Covid19 - Deferred consideration and warranties

October 2020 update: When we first published this article, we speculated that there would be changes in behaviour, including cautious drafting of warranties and more deferred considerations. We're seeing this happen and predict it will continue into 2021 but, whilst certain purchasers/investors have stepped back, the current conditions have also created great opportunities for ambitious investors with available cash resources.

What is your experience, or do you have questions on this issue?  Please get in touch with jason.milkins@roxburghmilkins.com to let us know. 

One of the issues raised was that factors caused by Covid-19 may cause buyers to push for more favourable deal terms. There is a great deal of uncertainty around how the economy will be brought back to life and how businesses will perform in that new environment. For example, some observers are talking about ‘every business being a start-up now’ due to the upheavals and changes to business operation caused by Covid-19. Some buyers will therefore be looking for deal terms that will give them some protection against this uncertainty whilst others may simply be opportunistic.

In this article we’ll look in more detail at some of these terms.

Buyer’s concerns

It is fair to say that Buyers will justifiably give greater consideration to variables/risks that didn’t seem so relevant before the outbreak of Covid-19, for example:

• how resilient will the target be to further virus outbreaks and government measures to control its spread
• will the target need to factor increased costs into its forecasts/working capital requirements to allow for such things as:
  • the need to introduce rapid changes to working practices
  • breaks in supply chains (maybe an increased cost to supplies) and the fallout from that
  • changes to its T&Cs with customers
  • increased contingency /business continuity planning i.e. increased insurance costs going forwards
• will the Buyer face increased challenges to:
  • freeing its own cash resources for M&A activity; or
  • raising debt finance on commercially acceptable terms; or
  • simply satisfying their own investors that they have achieved the best terms possible in the current M&A market.

These concerns will cause buyers to look harder at how they may protect themselves from perceived risks.

Split exchange and completion

Buyers may ask for split exchange and completion with the inclusion of a Material Adverse Change (MAC) clause. A MAC clause will allow the buyer to withdraw from the transaction or renegotiate on price prior to completion if there has been a material adverse change affecting the business.

MAC clauses generally exclude macroeconomic events which affect the market generally so would normally not apply to risks such as Covid-19. However, buyers may now be pushing for clauses which cover further outbreaks or other specific events.

MACs should generally be resisted by sellers. If buyers are insistent, the MAC’s scope should be narrowed - covering further virus outbreaks should, for example, be resisted. This would be on the basis that it is reasonably foreseeable that a further outbreak may occur and that it has already been factored into the business’s operation (via well executed disaster recovery plans) and also factored into the pricing and/or deal structure.

Reduced/deferred consideration and warranties 

The buyer may try and renegotiate the purchase price and/or not pay all consideration up-front. Deferred consideration and earn-out clauses allow a buyer to pay elements of the purchase price after completion and such payments may be tied to actual performance of the business.

Deferred consideration will reduce the buyer's immediate need for cash to finance the deal and give the buyer an opportunity to withhold money owed to the Seller in connection with any potential warranty or indemnity claims. Even where such claims are somewhat less than clear the ability to withhold payment gives a greater likelihood of a negotiated settlement and a saving for the buyer. Risks and difficulties faced when trying to recover monies from sellers for breach of warranty or indemnity are much reduced. The Sellers should therefore:

• ensure the drafting of warranties is as precise as it can be
• ensure the drafting of indemnities is limited to the perceived risks only
• include appropriate limitations on liability and/or conduct of claims provisions
• ensure that any set-off provisions are carefully drafted to limit set off to specific circumstances only and include a clear process to be followed before any sums may be withheld or set -off from future payments
• consider whether interest should accrue on deferred payment before as well as after such payment falls due
• consider whether warranty and indemnity insurance may be used as an alternative to deferred consideration.

Earn-out provisions

These are future payments of consideration that are only payable if the business performs to specific requirements agreed by the buyer and seller. The following issues should be taken into account when negotiating such clauses:

• agree appropriate targets and ensure that the basis of calculating future profitability is clearly documented - a missed or badly drafted specific accounting policy could be a very costly mistake
• include appropriate seller protections to ensure that any changes to the target’s business, personnel, cost base, accounting policies are appropriately limited (i.e. ensure that the buyer can’t make changes which would be deliberately detrimental to the earn out calculation) and that the apportionment of any risks associated with Covid19 are as balanced as they can be
• ensure that the earn out mechanism allows for increased payments should the economic fallout be less damaging than feared - resist a cap on payments - a dramatic change in fortunes could go either way and if the buyer is protected against the downside the seller might argue for an ability to benefit from an upturn in fortunes.

Due diligence and other things to consider

Sellers should ensure that you are as ready for a transaction as you can be, undertake your vendor due diligence exercise well in advance to give yourself the best chance to pre-empt any concerns a buyer may have and provide solutions. In the current environment, have your ‘Covid-19 story’ ready - how have you dealt with the crisis, how have you adapted, how are you planning for the future - evidence of how you have dealt with the situation may allay a buyer’s fears. Good preparation is key to heading off awkward negotiations and/or limiting the justification for less attractive payment terms.

Sellers should also consider the financial credibility of the buyer and its vulnerabilities to a further virus outbreak - a deferred payment is a payment at risk and so sellers should consider whether security or a guarantee can be given or whether funds can be placed in escrow.

Buyers should rightly look to protect themselves from specific and genuine concerns - opportunistic or very general coverage should be resisted.

If you would like more advice on this topic, please email Jason.milkins@roxburghmilkins.com.