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Mergers and Acquisitions During COVID-19

by Chad Zoretic

Executives want to profitably grow their businesses, either organically or inorganically. When organic opportunities are limited, when speed is a critical factor or when target values are depressed, a merger or acquisition may be the best option. Deals can be tempting, and if a company has cash or access to liquidity, this may be the right time to move.

But, with COVID-19 pausing most of our nation’s economy, it is no longer business as usual when it comes to M&A. We are operating in a new environment that will continue to evolve and be marked by an abundance of headwinds, choppy waters and uncertainties. Early trends suggest there will be longer-term, more fundamental shifts in overall deal strategy, valuation and liquidity.


How to Avoid Costly Mistakes

Given these realities, business leaders may adopt either a reactive or conservative approach to deals. Sometimes, a company will simply jump on an asset because it is a “shiny” object in play. Management may create a strategic rationale to justify pursuing a deal, as opposed to developing the strategic rationale and then looking for the right opportunity. On the other side, management may take a conservative approach, limiting their options to profitably grow their business.

For any deal, the senior leadership team must step back and ask themselves some key questions to assess the transaction and ensure it is in their company’s long-term best interest:

What are the financial considerations?

  • How motivated the sellers are: Cash triage, including a 13-week daily cash flow forecast, cash runway and waterfall analysis is a necessity. Buyers need to know the exact cash position of the target business — if it is a falling knife, how sharp is the knife and how fast is it falling?
  • How cash intensive the target will become: Project net working capital phasing requirements from crisis to steady state. How will working capital investment requirements change during the different phases of recovery?
  • Fair value and scenario evaluation: Do a forecast analysis with detailed diligence on forecast assumptions and alternative scenarios. Does the rock bottom scenario have a basement door? How can a buyer tie their price/deal structure to different scenarios for a seller to align incentives?
  • Pre-COVID quality of earnings/survivability test: Use this as a baseline with modifications built in as a proxy for how the target might look in the “new normal.”
  • Quantification of COVID disruption: The “COVID adjustment” is not a simple exercise. There are many factors to consider. It’s important to adjust not for just deals, but for potential future debt covenant calculations.
  • Supply chain analyses and “source-to-load” analyses: Can the target meet demand and are their limitations due to reduction in force or supplier issues?
  • Demand elasticity analysis: When will sales come back? At what rate? Will there be any permanent changes in customer behavior?
  • Capital expenditure deferral assessment: How do projects placed on hold impact the growth plans of the target?

What are the tax considerations?

  • The legal entity type will likely dictate structure optimization.
  • Insolvency/cancellation of debt (COD) could be applicable.
  • C corp target considerations:
    • Significant tax attribute carryforwards? If so, consider the:
      • Section 382/383 attribute utilization limits
      • Section 338 election to treat as an asset acquisition
      • Value of tax attributes
    • International tax considerations:
      • Is transfer pricing in place?
      • Have all U.S. and foreign tax filings been accurate and timely?
    • Closely held C corps:
      • Excessive compensation could be recharacterized as a dividend, disallowing the compensation deduction, creating income tax exposure.
    • Section 280G (parachute payments) could be applicable. A cleansing vote would allow Section 280G not to apply.
  • S corp target considerations:
    • Is the S corp election valid?
      • Was the election timely made?
      • Disproportionate distributions would effectively create a second class of stock which could invalidate the S election, potentially creating corporate level income tax exposure.
  • Non-income tax considerations:
    • Sales tax:
      • Consider economic nexus (per the Wayfair case).
      • This often applies to more than just sales of tangible personal property.
      • Sales to resellers are still taxable if resale certificates are not collected.
    • Payroll tax exposure:
      • Was stock compensation reported correctly and all required withholdings made?
      • Were ISOs granted at fair market value and supported by a 409A valuation? If not, ISOs could be treated as NQSOs and subject to withholding upon exercise.

What are the valuation considerations?

  • Assess the changes in market conditions arising from COVID-19:
    • How has COVID-19 impacted business projections and key metrics?
    • How is COVID-19 impacting your industry?
    • Are these impacts temporary or permanent? How has valuation changed for fixed assets, property, intangibles, etc.?
    • What is the timing of any COVID-19 related impacts?
    • Is there consolidation expected in the industry?
    • Has your cost of capital changed?
    • What is your cash runway and/or do you have access to additional capital?

What are the profitability/cash flow improvement considerations?

  • Product/service pricing review: Are the target’s products or services priced right? Does pricing have to be revisited given changes in the economy?
  • Freight analysis/dimensional weighting: Rebid logistics and review packaging strategies to minimize costs.
  • Channel pruning: How has the landscape changed for the target? Often, simpler is better. Is there a need for SKU rationalization, product line elimination or geography elimination?

COVID-19’s impact is one of the most complicated and concerning situations we’ve ever faced, and it continues to evolve. To help companies navigate this uncharted landscape, we will continue to share insights, guidance and best practices that hopefully will make this incredibly complex and uncertain environment more manageable.


For the latest regulatory changes and other information on keeping your organization running through disruption, visit our COVID-19 Resource Center.

May 05, 2020

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Author
Chad Zoretic, CFO Advisory Services
Managing Director
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