Due diligence is an essential step in the process of purchasing a business and there are a number of pandemic-related considerations.
Never in recent history has a global event had such a significant and rapid impact on the M&A landscape.
All established transactional paradigms, such as market-recognized valuation multiples, historical profitability and all other performance measures, need to be reviewed.
Can we continue to evaluate a business on the basis of its financial projections and past profitability when it is hard hit by the turmoil of the COVID-19 pandemic?
- How will upcoming transactions be structured?
- Will a larger portion of the purchase price be payable at some future date based on the attainment of certain profitability criteria?
- Will the use of financial instruments convertible into shares based on certain factors be more frequent?
In any event, the M&A world will, at least in the short and medium term, have to adjust to this highly uncertain environment.
Business opportunities for some buyers
At the same time, this pandemic will also provide opportunities that strategic acquirers and investment funds have been looking forward to.
Such transactions will have to be based on a thorough due diligence review adapted to the current situation.
- How should due diligence be adjusted for issues such as the ability to meet with management in person, visiting the site and seeing the target company’s operations?
- What role should seller or buyer/investor due diligence play in determining recurring profitability in the context of a global pandemic?
The “new normal” must be determined. Here are five additional considerations for the buyer/investor or seller.
1. Determination of EBITDA (earnings before interest, taxes, depreciation and amortization)
It’s important to consider pro forma adjustments in order to highlight the business’s recurring profitability and exclude any temporary COVID-19-related impact. In some cases, COVID-19 was advantageous and resulted in increased sales and EBITDA. The seller will have to demonstrate that this is a recurring increase and the buyer will have to ensure that this is the case.
There is no standard formula. Here are some methods for quantifying pro forma adjustments.
Compare the evolution of EBITDA
It is important to compare how EBITDA evolved (considering seasonality) from pre-COVID-19 periods to the COVID-19 era. Performing this analysis by business unit, by product and even by customer will provide greater comfort to the acquirer. Some business units may be more affected by COVID-19 than others. It would therefore be advantageous to isolate these units from the rest of the entity’s activities.
Compare with financial projections
The pro forma adjustment can also be quantified by comparison with the financial projections. Obviously, the buyer/investor will need to ensure that the projections are established carefully and that, in the past, the company’s results have been fairly close to the forecasts made.
Adjust subsidies received
Adjusting the various subsidies provided by different levels of government to support businesses during this period is also useful, including the Canada Emergency Wage Subsidy (CEWS).
Adjust the salary expenditure
The salary expenditure must be adjusted and restored to a standard recurring level. Many companies have made cuts in salaries or laid off employees (temporary adjustment).
Consider ongoing savings related to a reorganization
Ongoing cost savings associated with a reorganization during the pandemic should be taken into consideration. Several companies reacted quickly and put a restructuring plan in place to deal with the situation. In some cases, these restructuring plans have resulted in permanent savings. The pro forma adjustment will therefore have to take this into account.
Obviously, it will be more difficult to justify such an adjustment if the restructuring plan exists on paper only and has not yet been implemented (layoffs, closure of business units historically at a loss, review of the manufacturing process, etc.).
Consider the gross margin loss
The gross margin loss related to the decline in sales should also be noted (see the following section on sales). It is important to properly validate the margin percentage used. The greater the degree of precision, i.e., determined by business unit or by product, the lower the need to question the adjustment.
Assess future supply costs
Future supply costs and their effect on EBITDA must be evaluated (see the section below on suppliers and procurement).
As was the case for EBITDA, it is important to understand the impact of COVID-19 on sales and its effect over time.
Analyze the trend in monthly sales
It is important to analyze the trend in monthly sales prior to COVID-19 by geographic area, business unit and even by customer, and to compare it with sales during the COVID-19 period.
Determine the entity’s position in the supply chain
Knowing where the organization is located in the supply chain can help determine if the impact is still to come.
Analyze the most important customers
Analyzing the most important customers and assessing how COVID-19 impacted them is essential.
Analyze financial projections
Financial projections should be analyzed with an emphasis on the backlog and pipeline and by considering the historical achievement of projections and the success rate of potential sales.
Assess collection issues
Any collection issues must be evaluated, as well as the future impact on sales to the customers in question.