Across sectors, COVID-19 has had a significant impact on the way we work, and the M&A market is no exception. Sam King and James Pitts look at what the future holds.
As we start to see the number of deals pick-up again, this is leading to some interesting questions for businesses contemplating acquisitions in an environment that has been significantly impacted by coronavirus.
How to value a business?
The standard way to value a business is to multiply the historical earnings (typically EBITDA) by a multiple, with this multiple dependent upon various factors such as; the growth prospects of the business, the sector in which it operates, competitive pressure to win the deal, as well the prospect of post-deal synergies.
However, with historical earnings now being skewed by trading through coronavirus, and multiples now reflecting very different market conditions, valuations are more subjective than ever.
We're seeing clients approach this challenge in several different ways, including using forecasts as the basis for valuation or adjusting the historical EBITDA for the impact of coronavirus. Each approach poses different challenges and the most suitable option will depend upon a variety of factors such as, the quality of the forecast numbers, the level of risk in achieving these forecast numbers and the extent to which the EBITDA impact of coronavirus can be determined. Additionally, it will be dependent on whether coronavirus will have long-term structural impact on the sector or is only expected to have a short-term effect on the business.
Ultimately whatever metrics are used, as ever, pricing comes down to finding a balance between the vendor’s price expectations and the amount a buyer is comfortable paying based on their perception of the risk and potential return.
How to deal with the known unknown?
Acquirers are now facing a very different risk profile than 12 months ago, with the threat of a second wave or recession posing a significant threat to deal-making.
One common method to reduce the risk for an acquirer is increasing the element of consideration that is either deferred or based on an earn-out mechanism. This has the benefit of reducing the risk for the buyer, can help bridge the gap between a buyer and a seller’s price expectation and can also give the seller the chance to benefit from any upside. A successful earn-out is dependent upon trust between the buyer and the seller, simplicity and transparency in the earn-out mechanism, and for this to be documented with clarity in the SPA.
We are also seeing the increased use of completion accounts as a closing mechanism in place of the locked-box mechanism. Completion accounts give the buyer the benefit of a later information cut-off, to determine the final price (helpful in flagging up doubtful debts for example). It also avoids the need to pay for forecast profits in the period between the locked box date and completion (which a buyer may be hesitant to do given the current uncertain economic environment).
However, for some acquirers, the simplicity of a locked-box mechanism may suit the deal, especially for those making a strategic acquisition and where time is at a premium.
What should you watch out for?
Coronavirus has also presented additional considerations, which a buyer (or seller) should be aware of, to ensure that they are protecting value and managing their risk. These include:
Working capital targets
Make sure you are not losing value in the bridge between enterprise and equity value through a working capital target that does not match the valuation you are giving to the business.
Have specific coronavirus schemes been dealt with appropriately? For instance, have any tax deferrals been removed from working capital and treated as a debt-like item.
Consider the warranties and indemnities included within the sale and purchase agreement. 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.
We'll be holding a series of small round table discussions for local acquisitive businesses to discuss the challenges posed by coronavirus on M&A, covering the topics discussed above.
Get in contact with Sam King or James Pitts if you would like to join one of these discussions.