The myriad and rapidly evolving impacts of COVID-19, the disease caused by the novel coronavirus, are being felt across society—in the healthcare system, employment, politics and the economy. Those involved in corporate transactions should take note of the direct business and legal implications of this major human and economic event.
The Transactional Environment
- Historically, business and capital market uncertainty have led buyers to scale back their strategic plans. In an environment where mid- and possibly long-term economic performance and projections are uncertain, establishing a reasonable, reliable business model for a transaction, the foundation of any deal, may be difficult, if not impossible. Accordingly, we would expect many acquirer boards to adopt a wait-and-see approach to potential significant transactions.
- That said, the long bull market now ending had created an environment in which many strategic acquirers had become uncomfortable with target valuation expectations. For buyers with substantial cash on hand, the market disruption may lead to targets significantly lowering their sights regarding a take-out price, leading to possible value convergence if the strategic value of a deal is clear and certain enough to the buyer despite the environmental disruption. In addition, the “dual track” threat of a near-term IPO for late-stage private companies, an oft-encountered feature of the recent deal landscape, has likely receded.
- In addition, the significant and sudden decline in market values may lead some companies to consider sales, including as a result of opportunistic shareholder activism and financial pressures. In the recessions of 2001-02 and 2008-09, particularly in the technology industries, there was a clear trend that “the strong got stronger,” in some cases through confident and well-executed acquisition strategies. Conversely, vulnerable companies should prepare for possible activism by reviewing their takeover defenses, assembling a team of experienced advisors, and staying close to key shareholders.
- For transactions involving private company targets, the uncertain business outlook may lead parties to consider earnout structures where the risks of future performance are shared between buyers and sellers. Earnouts, of course, come with their own host of issues, from negotiation complexities to high potential for disputes over whether milestones were, and were able to be, achieved.
Assessing Target Companies/Increased Due Diligence Focus Areas
- In this uncertain environment, the need to conduct thoughtful, comprehensive diligence becomes paramount. Buyers should focus on the impact of coronavirus on a company’s workforce and its ability to function remotely, supply chain, go-to-market strategy, capital expenditures, financial condition, ability to service debt and other fixed obligations, the strength and financial condition of customers, ability to control operating costs, the location and condition of facilities, the terms of key contracts including the termination rights of each party, regulatory and legal compliance exposure and other key company-specific risk factors. It will be particularly difficult in the near term to assess “worst-case” scenarios.
- For buyers utilizing third-party financing, there may be significant challenges coming to terms with lenders given an evolving landscape as to market terms, “flex” provisions, financial covenants and closing conditions. Lenders will have similar diligence concerns as buyers regarding the target but will likely be more risk averse and may increase their diligence on the buyer-borrower as well. In addition, raising broadly syndicated debt could be particularly challenging during this period of uncertainty. Buyers will be well advised to ensure MAE closing conditions in their financing papers are absolutely “back-to-back” with their acquisition agreements. Careful thought should also be applied to the “outside date” on financing papers—in a high-risk environment, extended financing commitments will likely come with a hefty price.
MAE and Other Transaction Terms
- As buyers and sellers seek to allocate the risks associated with the effects of the novel coronavirus on the target company and more broadly the general industry and markets, deal terms in acquisition agreements will need to be carefully considered.
- In negotiating the definition of Material Adverse Effect (MAE), which is the basis for a common closing condition allowing buyers to terminate a deal if the target company suffers an MAE, targets may seek to include “disease outbreaks,” “pandemics,” “epidemics,” “international calamities” and/or “public health events” as exceptions or carveouts to the definition of MAE. Buyers should be mindful that accepting such exceptions have the effect of allocating the risks of the coronavirus to the buyer as it would be forced to consummate the deal even if the target company’s business has materially deteriorated since the signing of the deal. While it will likely be difficult for buyers to negotiate for a complete walkaway right relating to coronavirus, buyers should consider limiting any such exception for situations where harm to the target company is not disproportionate to others in comparable industries, or given the nature of the pandemic, in the same geography.
- Even if buyers don’t seek to add or change closing conditions in view of coronavirus concerns, they may seek to reallocate some of the risks back to sellers by seeking special indemnity provisions. Buyers will be in a better position to negotiate for such special indemnity if they are able to identify and articulate specific potential costs or liabilities that a target company may face based on thorough diligence focused on potential coronavirus impacts, such as potential liabilities arising from workforce accommodation costs, supply chain disruptions or contract terminations.
- Parties negotiating deals that involve regulatory approval may also take into account potential delays, which could be significant, as governmental agencies may face temporary shutdowns or limited operations as a result of the coronavirus. Parties should consider whether the “outside date” for a transaction should be extended in the event that the governmental agencies responsible for the deal approvals may not be able to function on normal timelines.
- For any deal that is currently pending, target companies should be particularly mindful that they continue to be subject to interim operating covenants in the deal documents, which often restrict a target company’s ability to operate outside of the ordinary course of business and include specific restrictions against workforce reductions, material changes to personnel policies, changes in compensation or benefits and similar actions, in each case without the buyer’s consent. While there is typically an exception for actions taken in compliance with applicable laws, sellers should review the covenants with their counsel to ensure that it is seeking buyer consent where necessary before taking actions in response to public health guidance or otherwise.