Controlling COVID-19 risks in purchase agreements

COVID-19 is adding significant complexity to deals for both buyers and sellers— including how to document the accounting implications of COVID-19 when negotiating and drafting purchase agreements. If these risks aren’t addressed, you risk post-closing disputes and lost value. Following are five areas you should consider when negotiating a deal now.

1. Accounting estimates and subsequent events

Many transactions require net working capital or earn-out calculations be calculated in accordance with GAAP, which includes evaluation of subsequent events occurring after the closing date that provide evidence of conditions that existed at that time. However, the way subsequent events are interpreted is often not further defined in a purchase agreement. So how should your agreement define consideration of the effects of a major disruption, such as COVID-19?

For transactions that have recently closed, or will close during the COVID-19 crisis, buyers preparing closing statements or earn-out calculations must consider how they will adjust any accounting estimates and judgments for the pandemic. These post-closing accounts may not need to be submitted for weeks or months, by which time business conditions could have shifted significantly. For example, a significant drop in sales after the closing date may call into question the valuation of inventory that is perishable or subject to expiration as of the closing date.

Given the level of uncertainty, parties may wish to agree to specific provisions governing the treatment of accounting estimates, such as including a knowledge deadline (only considering facts known or knowable up until a certain point in time) or agreeing to specific methodologies or practices to be applied in measuring these accounting estimates.

2. Negotiating specific accounting principles to account for changing market conditions

Parties often agree to calculate net working capital in accordance with “GAAP, consistently applied.” But how can parties prepare accounts on a consistent basis when circumstances have shifted so dramatically and so quickly?

Parties can instead agree to use an accounting hierarchy, setting forth specific provisions governing the treatment of subjective areas of accounting. For example, how will you calculate an allowance for doubtful accounts when many debtors may face financial difficulties or delay payments in the following months?

3. Earn-out provisions and the calculation of financial metrics

Earn-out targets are commonly based on EBITDA or similar financial metrics, such as revenue or net income. Purchase agreements already signed have likely not factored in the impact of market changes due to COVID-19. Parties may want to work together to consider revisions. For those nearing signing, metrics may need to be reconsidered to account for any impaired future performance and the ability of the target to meet post-closing thresholds.

Parties may have agreed that post-closing EBITDA calculations may add back or exclude any one-time events or extraordinary items (which may now include any insurance recoveries, supply chain cost increases, or shutdown periods). In light of COVID-19, they will now need to work together to reach an amicable position concerning any earn-out calculations. For those agreements not yet signed, parties should consider not simply calculating the earn-out in accordance with GAAP or past practices of the company, but instead including more specific language to address how one-time events resulting from COVID-19 should be measured.

4. Target net working capital

Parties often struggle to agree on what ‘normal’ working capital is, which can be a highly subjective area. Agreement can be even more difficult when they aren’t sure what ‘normal’ business will look over the coming months. Typically, working capital is measured over an extended period and an average is taken to remove the effects of seasonality and monthly fluctuations. In the current environment, this may include adjusting the target (if recent accounting information is used) for the impact of COVID-19.

Parties may wish to normalize the historic working capital data to better illustrate the ongoing position. Selecting a reference period that aligns with the EBITDA period underpinning the enterprise value can ensure the working capital target represents the requirements of the business at the level of earnings used for the headline price. If this headline price has been discounted to take into account expectations of lower earnings, the parties may also consider adjusting the working capital target to reflect the level of working capital required to support these lower earnings.

5. Representations and warranties – understanding risk-sharing implications

Sellers provide buyers with representations and warranties regarding the current state of the target business. These provide an outlook on the health of a business both at the time of closing and into a future timeframe. In general, these representations and warranties do not consider specific events such as COVID-19. Buyers and sellers should therefore contemplate on whether specific amendments need to be made to language within the purchase agreement to appropriately consider the breadth and extent of the promises being made. For example, both parties should consider the drafting concerning:

• any new or undisclosed liabilities,
• valuation and provisioning of inventory
• excess manufacturing capacity or supply chain issues
• recoverability of existing debtors.

The breadth of the representations and warranties provided is an important consideration when understanding the risk-sharing in a deal.

The economic impact of COVID-19 is huge and evolving. Failing to effectively consider its effects when negotiating and documenting your purchase agreement can put the value of your deal at risk.