Avoiding M&A Deal-Breaking Disputes During A Downturn

By Ann Gittleman and Jenna O'Brien
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Law360 (May 28, 2020, 4:28 PM EDT) --
Ann Gittleman
Ann Gittleman
Jenna O'Brien
Jenna O'Brien
In addition to its devastating impact on health, safety, welfare and the global economy, the COVID-19 pandemic has complicated the valuation of companies involved in M&A transactions, increasing the likelihood, and therefore costs, of broken deals or post-M&A disputes or litigation.

Prudence will require that M&A participants:

  • Reevaluate their assumptions and estimates relating to revenues, earnings, operations and other material factors affecting performance;

  • Reassess their risk; and

  • Perform informed due diligence to help ensure that there are reasonable factual bases for representations regarding material terms, and that deals are closed in line with contractual obligations.

There are two major financial areas to consider with M&A transactions: business valuation and working capital. Within these two key areas one must be mindful of revenue recognition and valuation, and appropriate reserves and inventory.

Business Valuation

Material adverse change, or MAC, clauses and material adverse effect, or MAE, clauses provide a mechanism to terminate a merger or acquisition prior to closing in the event that a material change occurs that damages the target's business operations or assets.[1]

A MAC clause is generally a representation by the seller that, since a given date (typically the date that the agreement was signed), there has been no MAC in its business, operations, properties, prospects, assets or condition of the target.[2] To invoke the MAC clause, the buyer will need to demonstrate that a material down­turn was suffered by the target, and that material downturn falls within the scope of the merger agreement MAC definition.[3]

Both the party asserting the MAC (typically the buyer) and the party defending against the MAC should analyze whether the adverse event had or will have a material impact on the target. A common adverse event is a downturn in the operations of the target, resulting in impaired profitability relative to historical or expected levels.

Common causes of such downturns include the following:

  • Loss of a major customer;
  • Regulatory or statutory changes;
  • Lawsuits; and
  • Natural disasters.[4]

In cases when a MAC did not occur, the buyer may still be able to seek rescission of the deal based on a breach of certain representations and warranties made by seller. These representations and warranties may relate to the condi­tion of the business at the time of closing.

In these cases, the practitioner may perform an analysis to demonstrate that the actual value of the company is significantly lower than what was represented to the buyer through the seller's financial information.[5]

Revenue Recognition

COVID-19 may impact the amount of revenue recognized as well as the pattern of revenue recognition. Entities may need to account for additional returns and refund liabilities.

Consider the large corporations with flexible return policies and consumers stocking up on nonperishable items. These unused goods may be returned once COVID-19 has subsided. Some stores have now implemented "no return" or "all sales are final" policies in an effort to prevent contaminated goods from being returned to stores, which will accelerate the recognition of revenue.

The outbreak of COVID-19 has hit the global supply chains hard and so-called channel stuffing could become an area for improper revenue recognition. Channel stuffing is when a company fraudulently inflates its sales, and therefore earnings, by sending an excessive amount of products to its distributors ahead of demand.

Event organizers and private education facilities may provide refunds for cancelled events and classes. For entities that recognize revenue over a long period of time, the pattern of revenue recognition may change for delays in rendering services due to significant work stoppages or business disruptions. One must assess if entities will be able to meet revenue, EBITDA margins (earnings before interest, taxes, depreciation and amortization), and/or cash flow objectives.


The stream of earnings used in the deal could be net income, EBITDA, net operating income, revenue, or any other metric relevant to assessing the value of the target. The purchase price multiple is often calculated as the EBITDA multiple implied by the deal price.

For example, company ABC was purchased for $400 million, and the company's annual EBITDA was $50 million. As such, the implied multiple is 8, meaning that company ABC was purchased for 8 times its annual EBITDA.[6]

COVID-19 may impact an entity's valuation and EBITDA multiple due to historical and now inflated projected valuations. Historical financial information must be reviewed to see if it still accurately reflects a target's financial position, which may now have disrupted supply chains, unusual inventory levels, and/or distorted accounts receivable and payable.

Additionally, the financial projections and underlying assumptions must be evaluated to ensure the projections are still achievable. There are certain instances when companies many exceed their goals and their valuations may be positively impacted as demand for products or services is increasing, such as in pharmaceuticals and hospital equipment.

Working Capital

Working capital, or net working capital, is represented by the excess of current assets over current liabilities, and represents the relatively liquid portion of total entity capital that constitutes a margin or buffer for meeting obligations within the ordinary operating cycle of an entity.

COVID-19 has and will continue to cause complications in the calculation of current assets, specifically inventory, accounts receivable and reserves.


The disruptions to supply chains and decreased consumer demand resulting from COVID-19 may decrease the net realizable value of inventory. Entities should assess whether the carrying value of their inventory needs to be adjusted accordingly.

Price gauging in some industries, coupled with the current imbalance between supply and demand, could result in a risk of overvaluation. On the other hand, a decline in sales in other industries can cause physical deterioration, or obsolescence. Inventory valuation adjustments will impact closing balance sheets, working capital, and trailing 12-months EBITDA.

An inventory reserve may have a one-time effect on the balance sheet and a corresponding effect on the trailing 12-month EBITDA. A buyer in a merger or acquisition deal may have relied on this data in deriving the purchase price. As such, a one-time adjustment may affect the buyer's perception of value of the company into future periods.

Alternatively, this inventory may be an item that is not expected to occur in the future and, therefore, would not impact the perception of value.[7]

Accounts Receivable and Reserves

As entities continue to sell products and provide services to customers impacted by COVID-19, they'll need to carefully evaluate the customer's ability to pay and whether write-offs of existing receivables are necessary. One must monitor the financial performance and creditworthiness of customers so they can properly assess and respond to changes in their credit profile.

Thinking Ahead

As the outbreak of COVID-19 rapidly and unpredictably evolves, one thing is certain: A pandemic like COVID-19 injects a degree of uncertainty into the deal-making process.

Buyers and sellers need to think through the different and not always obvious ways that COVID-19 could impact their respective businesses, the transaction process of a merger or acquisition, and terms of a deal.

Sometimes the best deals are done by buyers willing to take more risk during challenging economic periods, when other potential bidders have gone to the sidelines. It is in these circumstances that one must think critically of when to hire experts.

M&A disputes often involve complex accounting concerns: properly evaluating transferred working capital, looking into whether earnout thresholds have been achieved, reviewing claimed breaches of financial statement representations and warranties, and at times, investigating allegations of fraud.

When problems do occur, there are several prudent steps that both targets and acquirers should take preclosing to mitigate the risk of deal-breaking disputes and subsequent litigation.

Ann Gittleman is a managing director and Jenna O'Brien is a director at Duff & Phelps LLC.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] AICPA Forensic & Valuation Services Practice Aid, Mergers and Acquisition Disputes, page 44.

[2] Id.

[3] Id., page 46.

[4] Id., page 47.

[5] Id., page 51.

[6] Id., page 52.

[7] Id., page 57.

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