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.
3. Suppliers and procurement
Determining whether there is a dependence on certain suppliers or whether some important suppliers are located in the same region and are therefore likely to be affected at the same time if measures are put in place at the local level is crucial.
Investigate going concern risks
The going concern risks of certain suppliers must be investigated in order to assess the various contingency options.
The effects on cost prices must be assessed.
4. Working capital
One of the complex components in a transaction is determining a target working capital.
- What time period should be used?
- Should projections be considered?
- Are there any items that should be excluded and included instead in the net debt calculation, such as taxes and customer deposits?
These items are often discussed during negotiations between the parties.
The pandemic is certainly complicating matters. The following additional points should be considered in determining target and closing working capital.
Adjust various items
The various items affected by COVID-19, such as accounts receivable, inventory, and accounts payable and accrued liabilities, must be adjusted. The goal is to recalculate the “normal” level of these items during the months affected by COVID-19.
For example, a historical collection time rate could be considered for accounts receivable or a standard turnaround time for inventory. This avoids penalizing the vendor by using temporarily high working capital items in the calculation.
Do not include potential losses in the target calculation
Be careful not to consider potential losses in the target calculation. For example, if inventory has to be sold below cost, the target should not be changed.
However, when determining working capital at the transaction closing, these items will have to be taken into consideration.
On the closing date, pay special attention to some items
Here are items that require special attention for the buyer/investor on the closing date:
- Recoverability of accounts receivable without a provision;
- Sufficient allowance for inventory obsolescence;
- Occurrence of prepaid expenses;
- Percentage of completion and appropriate evaluation of work in process.
If there are any doubts about these items, specific clauses should be included in the purchase contract, for example:
- Adjustment clause after a certain period (normally 120 days) for accounts receivable without a provision at the balance sheet date that are still not collected after the period specified;
- Clause stating that if inventories likely to be sold at a loss after the balance sheet date are in fact sold at a loss, the purchase price will be adjusted downwards.
It is always advisable to have a balance of sale that specifically protects the buyer against potential price adjustments.
An adequate target working capital that supports attainment of EBITDA for purchase price purposes should be determined. Any temporary impact of COVID-19 should be excluded from this calculation. This ensures that the seller is not penalized with a target working capital that would otherwise be overstated.
In addition to validating the target working capital adjustments, the buyer/investor must ensure that the various working capital items are properly valued at the closing date. If there are any doubts, clauses in the purchase contract should be considered.
5. Other considerations
Guard against insufficient capital investment
In an uncertain environment, an entity may be inclined to reduce capital expenditures or required to suspend them.
Whether it is a question of maintenance or capital expenditures, the buyer/investor must ensure that it properly assesses the consequences on the EBITDA determination or on future cash requirements to address the delay.
One way to guard against insufficient capital investments is to include fixed assets in the working capital calculation (target and closing).
Analyze management’s reaction to the pandemic
It is very worthwhile for a buyer/investor to analyze the management team’s reaction to COVID-19.
- What plan was put in place?
- How was staff supported and how were they mobilized?
- Were difficult decisions made? How quickly?
Consider review or audit engagement options
It is not always possible, for several reasons, to require audited financial statements at the balance sheet date. Given the risk associated with COVID-19, other options should be considered to protect the buyer/investor:
- Review engagement;
- Application of specific audit procedures by an independent auditor. Such procedures would focus on risk items, such as:
- Confirmation of accounts receivable;
- Physical inventory count tests;
- Inventory price tests;
- Sales and purchases cut-off tests.
Consider adding clauses
The buyer/investor should include several items in the purchase contract as a safeguard, especially in uncertain times. Here is a partial list of items to consider in addition to the usual clauses:
- Be careful of the usual clause stating that the closing financial statements must be prepared on the same basis as the historical financial statements. With COVID-19, this may no longer be possible;
- Adjustment clauses for the recoverability of certain assets included in working capital;
- Sufficient balance of sale to cover certain purchase price adjustments;
- Specific representation on the risk of having to reimburse the CEWS following a government audit;
- Important changes and cases of force majeure. The standard clause must include specific wording related to COVID-19.
Our team of financial advisory professionals has extensive experience in providing guidance in uncertain times. They also have in-depth corporate financing expertise and privileged access to capital market stakeholders.
Don’t hesitate to contact us today. We will respond promptly so we can work with you to achieve your objectives.
15 Oct 2020 | Written by :