The Impact of COVID-19 on M&A Due Diligence
The societal, economical, and political strains created by COVID-19 have put business owners in a spot unlike any other in recent history. Thousands of companies were forced to reduce payroll, pursue price increases and decrease discretionary spending, among other potential one-time matters, in order to stay afloat during the pandemic. Many businesses were shut down altogether. As numerous states begin to reopen and businesses start to return to normal operations, management teams remain anxious about explaining the impact of COVID-19 to their banks, investors, stakeholders and prospective buyers.
Each of the business decisions made during the pandemic has a unique impact on a company’s earnings. Since companies are often valued using a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA), the consequence of mis-calculating the impact of COVID-19 could be immense. Combining transaction expertise with detailed information procured through data analysis can help a company drill down into the multifaceted impacts of COVID-19 on their company’s EBITDA.
While most businesses suffered a downturn amid COVID-19, some specialized companies, such as those in the cleaning solution industry, experienced a drastic increase in demand. It is essential that this blip in revenue growth is evaluated in the same manner as a decline. One-time demand increases or decreases, price increases or decreases, and business stoppages should all be factored in when analyzing the impacted period’s revenues.
Additionally, while it may appear important to evaluate pre-COVID-19 revenues, many changes are expected to remain during the near future. Social distancing practices, for instance, could potentially remain in place in heavily populated areas until a vaccine is created, causing capacity constraints at restaurants, bars, retail stores and other public domains. The end goal of properly adjusting earnings is to adjust them to what they will look like in the near-term future, rather than pre-COVID-19 levels, using various industry trends, economic indicators and forecasted scenarios. As operations assume a different normal, using the company’s most recent financial figures will be essential to evaluate what a normalized level of revenue will look like going forward.
Various cost drivers, in conjunction with the revenue factors above, could cause a lasting impact on margin. Supply chain issues, such as factory shutdowns, shipping delays, and other one-time product or service cost increases, should all be evaluated on a case-by-case basis. In a similar approach to revenue levels, the end goal is to normalize margin during the impacted period to what will be sustainable in the long-term.
Management teams will work to retain or rehire as many employees as possible once operations begin to look normal, but they might have a difficult time determining what the right headcount is in a time of decreased revenues. As payroll is normally a company’s highest administrative cost, a headcount analysis, aimed at determining an optimal staffing level for the new-normal of business activity, might be necessary in order to calculate staffing costs in the short-term. In addition to the physical headcount, current payroll expenses, such as overtime rates, expected bonuses or raises, and benefits, will all need to be evaluated to obtain an accurate assumption for the cost on a go-forward basis.
General, Administrative and Other Cost Impacts
Discretionary spending on advertising, traveling to conferences, client appreciation and consulting arrangements, among many others, were likely some of the first expenses cut by management teams at the onset of the downturn. It will be vital for management teams to determine these costs on a go-forward basis and the impact on revenues of each different variable. For example, while the short-term cut of advertising might be a viable cash flow solution, what is the long-term impact on revenues? Other expense items, such as increased remote working costs, sanitation costs and cybersecurity expenses, could all have long-term effects on the company. Conceivably a company may be able to reduce office space as a result of more employees working remotely. All the different consequences of this decision would have a significant impact on EBITDA.
Cash Flow and Working Capital
In addition to the various EBITDA drivers above, government acts including the Paycheck Protection Program and Economic Injury Disaster Loan Emergency Advance program have provided short-term cash relief to companies across the nation. The ramifications of these programs, such as if the loans will need to be paid back or if the receipt of these funds had an impact on business, will also need to be evaluated. As the cash flow from these sources will help keep businesses temporarily afloat, the implications of the potential issues outlined above will impact working capital as well. Days sales outstanding may increase as customers take longer to pay, supply chain issues could impact inventory supply, and vendors requiring quicker payment terms could all have a huge impact on working capital. Management teams will need to ensure that they have evaluated each element of change in order to decipher what the new normal is going to look like moving forward.
Buy-Side and Sell-Side Due Diligence Impacts
Due diligence procedures from both sides of the transaction will be impacted by COVID-19, as well. Companies often move into the buy-side diligence phase rapidly after securing a letter-of-intent (LOI). However, we could see a push from buyer management teams to lengthen out that timeline in order to evaluate the most recent data possible. The seller’s preparedness, particularly if they engaged in sell-side diligence, will also be essential in the timeline of how fast things move post-LOI. Additionally, sellers engaging in sell-side diligence may also want to take more time on the front end to prepare for a sale to ensure that all bases are covered, particularly to evaluate whether some of the changes made during the pandemic were one-time or permanent.
As far as the fundamental nature of deal structures, we will likely see earn-outs become more common due to the unknown nature of each company’s rebound. Sellers will have to be willing to bet on the performance of their company to achieve maximum value for the sale. Furthermore, the procedures involved with sell-side due diligence will help management teams determine the feasibility of those earn-out clauses.
Our seasoned transaction professionals bring expertise from both sides of the table by leveraging data analytics to drive more accurate observations and insights for decision making. To discuss how our transaction advisory and data analysis expertise helps companies not leave money on the table during a transaction, contact Dan Schoenleber, Partner, Transaction Advisory Services, at 314.983.1332 or firstname.lastname@example.org.