Given the impact of the COVID-19 outbreak on businesses and their financials, the sale and purchase agreement (SPA) has become more crucial than ever. Patrick O’Brien explains the key points for those who are either in the process of or have recently completed a deal.
This is a tricky time for buyers and sellers, whether they have already completed deals before the COVID-19 pandemic and need to reconsider the financial and accounting elements of the SPA, or are looking to complete deals while contending with this uncertain landscape. In both of these scenarios, the financial terms of the SPA will become more important than ever in ensuring that parties achieve their commercial objectives, while minimising the risk of disagreements arising from the impact of COVID-19 on the subject business.
For deals that have completed but elements of price are yet to be calculated, the SPA may provide some guidance, but may not contain sufficient clarity. Areas that may be affected include:
Based on Financial Reporting Council (FRC) guidance in relation to statements up to 31 December 2019, it is expected that - under UK generally accepted accounting principles (GAAP) - any COVID-19 impacts would be considered a non-adjusting, post-balance sheet event and should not impact completion accounts up to that point. Where completion accounts are drawn up beyond that point, it will be more nuanced, and will be driven by the extent to which it can be demonstrated that COVID-19 had begun to impact the business before the completion date.
Deferred consideration and earn outs
Where deferred consideration and earn-outs are calculated by reference to a financial measure, such as revenue or EBITDA, SPAs may have specific policies in relation to the removal of exceptional, abnormal or one-off costs from the calculation. However, there will be many cases of SPAs signed prior to COVID-19 that do not contain drafting to take into account the effect of the outbreak, such as revenue adjustments or one-off contract provisioning.
Where COVID-19 has impacted a business to the extent that it is clear or highly likely that existing targets for earn-out or other contingent deferred consideration payments will not be achieved, sellers may lose their incentive to continue to act in the best interests of the business or buyer. To re-align objectives, parties could seek to renegotiate the terms. For example, by:
adjusting the target levels
clarifying the treatment of revenues and costs impacted
extending the reference period
delaying the start of the reference period
Ongoing deals, yet to complete
Where the deal is not yet completed or is being deferred directly or indirectly due to COVID-19, the parties will be seeking to reconsider the changing risks in an uncertain environment. This will inevitably lead to increased tension, as each party seeks to shift the balance of risk in its own favour. Issues that may arise include:
Where maintainable earnings projections are less certain and the trading environment is riskier, it may well have an impact on headline pricing.
Consideration payment profile
Buyers may seek to mitigate the risks of increased uncertainty by deferring part of the consideration to a future point, contingent on performance.
Parties may have agreed to an earn-out driven by future financial or non-financial metrics. They will need to consider how COVID-19 affects the business’ performance and the viability of the proposed earn-out.
Specific accounting policies should be drafted to reflect any change in market conditions arising from COVID-19, for example bad debt provisions. Methods of calculating accounting estimates or judgments should also be agreed on in the SPA.
Parties may be more hesitant to use a locked-box mechanism instead preferring completion accounts to provide a more up-to-date position on the assets and liabilities at completion for price-adjustment purposes. If a locked-box is still used, close attention should be paid to the value accrual from the locked-box date to completion, given that it typically includes a forecast element of trading that may now not be achieved.
Agreeing on an appropriate ‘normal’ working capital target may be challenging if businesses’ working capital requirements change due to COVID-19 and parties seek to anticipate what the ‘new normal’ might look like. Buyers should also pay more attention to cash flow in the short and medium term from completion and consider funding implications
Warranties and indemnities
Buyers may wish to include stricter or more-specific warranties, but sellers may be hesitant to commit to them in light of current economic uncertainties. Greater attention may also be paid to the material adverse change clause. Sellers should also give more careful thought to disclosure against warranties. For example, if management accounts do not factor in COVID-19 impacts.
Keeping these issues in mind, you should be able to adjust your deal to get you through the current situation and return to business-as-usual once the outbreak has passed.