We are facing unique, unusual, unforeseeable and untoward challenges in life, both economically and otherwise. In order to address such never-seen-before challenges, we need to adopt several measures.
This is true also for mergers, acquisitions and funding transactions, which have dropped since the outbreak of COVID-19. Dealmaking will have to be constantly calibrated to suit the evolving situation.
Investors, promoters and professionals in investee or target companies have their own set of apprehensions while entering into an M&A or a fundraising transaction. We have come across situations where transactions have been stalled, discussions terminated and investments deferred indefinitely.
Initially, the message was to wait and watch until the COVID-19 situation settles. However, as time passed by, the sentiments of stakeholders have changed and they are now looking to explore M&A and investing opportunities in transactions that don’t require regulatory approval, with adequate and evolving risk mitigating measures.
At this stage, cross-border transactions look grim. But investors/acquirers looking to take advantage of lower valuations (including for stressed assets) can seize several opportunities for high return on capital in the long term.
To be sure, there is no set pattern like in a pre-COVID-19 situation, and work is still under process to find an appropriate way forward for M&A and fundraising. Still, we have summarized below certain key provisions and strategies to consider while entering into M&A/funding transactions for balanced risk allocation.
There may be a need to update diligence checklists to examine actions that a prospective target entity may have taken during the COVID-19 crisis which may or may not impact the purchase price or business operations.
The indicative list of areas to assess from the COVID-19 perspective is likely to be from the following section. The list may undergo a change based on the sector, industry, age of the entity and other internal and external factors:
i) Terminated employees or employees which have taken a leave of absence.
ii) Payment of salaries and other payouts to employees under employee welfare legislations.
iii) Payment of taxes and deferment in deposit of TDS (considering extension of time granted by the authorities).
iv) Deferment of loan repayment/EMIs.
v) Performance of important and key contracts by target/investee entity.
vi) Implementation of new technology to address work from home protocol.
vii) Identifying unique financial exposure and liabilities that target/investee entity might have incurred while dealing with COVID-19 crisis.
viii) Compliance with orders/directives issued by the government related to COVID-19.
ix) Ability of the target/investee entity to pay its debts and insolvency risks.
Considering the logistical issues in conducting due diligence and with increased scope of work to examine issues from the COVID-19 crisis perspective, it is expected to have protracted due diligence processes. The obvious consequence of this would be to consider a longer exclusivity period during the term sheet or letter of intent stage.
From the investee/target entity’s perspective, time is of the essence as money has become critical for their survival. In such a situation if an offer is received to close the transaction on an expeditious basis then the investor/acquirer should show some kind of flexibility.
Walk away right
Even after the transaction documents are executed by the parties, the closure of the deal will not be certain as the investors/acquirer will typically negotiate for the right to terminate (without consequences) till the time closing occurs. This means the execution of the agreement will not be an assurance of closure.
As we say: “The deal is not close, until closed.”
MAC, change in law and Force Majeure
Provisions related to material adverse change or material adverse effect (MAC or MAE) and force majeure will be heavily negotiated keeping in mind the current crisis. Looking at the number of new measures being taken almost on a weekly basis, even a change in law will be an aspect to consider for termination of the deal.
To balance it out, consequences of MAC and force majeure should be limited to restoring each other in the same position as they were prior to MAC/force majeure, to the extent possible. Negotiating for onerous financial consequences may not be feasible as the deal may break. Even if the deal goes through, performance or implementation of onerous obligations will be a challenge.
Purchase price impact
Looking at the current scenario, freezing the purchase price for any investor/acquirer is very difficult as everything seems like a moving goal post. The external factors are so volatile that it becomes impracticable to draw up a feasible business plan.
Even if formulas and mechanisms are built-in in the agreement to adjust the purchase price, it seems like parties will sit across the table to re-negotiate the price if MAC/force majeure occurs. Otherwise, there will always be a right to walk away, break away or terminate the deal, which may be exercised.
Deferred consideration and tranches
To ensure a deal closes, it is best for the target/investee entity to accept conditions precedent to any subsequent tranches as no investor/acquirer will be in a position to agree to a binding obligation to invest in subsequent tranche.
As far as a deferred consideration for shares already acquired is concerned, a firm, irrevocable and binding commitment should be taken from the investor. There should be adequate protection to ensure the payment of the purchase price to the target entity and/or the seller, as the case may be.
Earn-out consideration adjustment and earn-out period
Earn-out structures will be the most difficult to negotiate as neither party would want to commit in view of an uncertain future.
Even if earn-out structures are agreed, it will have to be backed by some security or heavy financial deterrence for implementation and performance. Normalized EBITDA (earnings before interest, tax, depreciation and amortisation) and other known methods could be considered. However, the issue still remains as to what is normal (something which used to prevail pre-COVID or something which is being accepted as new COVID-19 normal).
Risk mitigation, warranties and transaction insurance
There will be heavy reliance on warranties, indemnities and insurance to give confidence to the acquirer/investor to invest. It is advisable to get transaction insurance to mitigate transaction risk, to the extent possible.
Parties should consider negotiating for contracts that make it difficult for them to dispute or litigate. Accordingly, the mediating and conciliation mechanism should be contractually agreed in the agreement before parties could issue an arbitration notice.
As the contracts will be heavily negotiated, keeping in mind the COVID-19 crisis, all parties will have to be open to negotiating evolving provisions, which may or may not be standard and customary provisions of the past.
The provisions will have to be tailor-made keeping in mind what best suits the parties, industry, sector and other internal or external factors affecting the deal.
Allocation of risk in a fair and balanced manner will be the key to a successful deal. Negotiating deals with the intent to remove any and every risk may result in deal failure, either before closing or post-closing. In such a situation, it is better to call off the deal pre-closing. Otherwise, parties will end up in unwanted avoidable litigation or arbitration.
Parties will increasingly rely on e-execution and e-signing to address logistical, transportation and travel issues.
Rishabh G. Mastaram is the founder of law firm RGM Legal. Views are personal.