In recognition that businesses are adjusting to their “new normal” and some companies are exploring acquisitions or divestitures as opportunities to strengthen their bottom line, we will be publishing a series of blogs aimed at highlighting some of the considerations and key drafting areas in a purchase and sale agreement that parties to Canadian private M&A transactions should consider in light of the COVID-19 pandemic.
The impact of COVID-19 creates a lot of challenges in determining the valuation of a target – which ultimately, helps the parties determine the price of the shares or assets being sold/purchased. For example, it is challenging to align valuation expectations between buyers and sellers including what should and should not be excluded as unusual or nonrecurring transactions in preparing the pro forma forecast or deciding what assumptions should be included when building financial projections of the target.
Purchase Price Adjustments
Due to economic volatility and to bridge valuation gap expectations, we expect the majority of buyers to favour post-closing purchase price adjustment mechanisms over the locked box mechanism that previously gained traction and popularity due to its ability to generate greater deal certainty for the parties.
There are a number of different ways the purchase price can be determined and adjusted. Common mechanisms include working capital adjustments and earn-outs, both of which we’ve previously discussed in Deal Law Wire.
Businesses affected by COVID-19 may be seeing significant reductions in accounts receivable, abnormal inventories and may be deferring payments to manage liquidity, which could distort working capital compared with historic norms. Both parties will need to give careful consideration to how the pandemic has affected and will affect the target’s working capital and whether and what adjustments are appropriate, including but not limited to:
- considering whether a significant reduction in revenue and accounts receivable for the target is attributable to COVID-19;
- considering how to characterize all funds received from government subsidy wage programs implemented for the specific purpose of addressing COVID-19, including whether to include such funds in the definition of EBITDA and/or claw backs and liabilities; and
- considering the treatment of any deferrals of accounts receivable and accounts payable (such as debt payments or rent) as a result of COVID-19.
In drafting the post-closing adjustment provisions, the parties should specify what accounting principles governing the preparation of the financial statements (or some part thereof) will apply, as the information therein would inform the working capital statement used to calculate the adjustments. The parties should also determine whether such accounting principles should be consistent with GAAP/IFRS or accounting principles consistent with the target’s previously audited statements.
To bridge valuation gap expectations and/or to satisfy a buyer’s necessity or desire to use alternative forms of consideration, the parties can consider (i) structuring a portion of the purchase price in the form of an earn-out that is contingent on achievement of certain financial metrics, milestone events and/or targets during a specified period after closing; (ii) deferring payment of a portion of the purchase price until a later date or the occurrence of a future event (i.e. 12 months after the majority of the shopping centers in which the target conducts business are reopened to the public following mandatory closings in connection to COVID-19); (iii) putting a cap on the purchase price adjustments by establishing a “ceiling” (an upper limit to any purchase price increase paid by a buyer to a seller) and/or a “floor” (a lower limit to any purchase price decrease paid by a seller to a buyer); and/or (iv) paying a portion of the purchase price in the form of buyer’s equity.
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