How COVID-19 impacts private business transactions and what you can do to prepare
While the full extent of the social and economic impacts of COVID-19 remains to be seen, many business owners who were otherwise considering selling their business are now revisiting their plans.
Based on conversations with our business owner clients and private business advisors over the past several weeks, whether you are thinking of selling in the near term or at some point down the road, what follows are six observations on how things have changed, and what you can do to prepare for a sale in the current environment.
Over the past ten years, the number of private business sales in the U.S., and the prices that buyers were willing to pay to acquire these firms, have been robust relative to historical averages. Many business owners have entertained multiple competing bids for their company, and we have advised numerous business owners who have received unsolicited offers to acquire their business.
Despite recent economic uncertainty, the market for the sale of private businesses has not dried up. Many private business sale transactions continue to move forward, though at a slower pace, and private equity firms in the U.S. have a significant amount of investor capital that they still need to invest in private enterprises.
Nonetheless, recently we have seen several private business transactions postponed or fall through, as buyers reprice the risk of acquiring these companies without a clear view of the financial impact COVID-19 will ultimately have on them and on the economy over the long term. We also expect to see buyers paying a greater portion of the purchase price in the form of an “earn-out.” This results in the business owner being paid over the course of several years, but only if the firm achieves certain predetermined performance targets.
On the lending side, as investors grapple with the economic uncertainty brought about by COVID-19, we anticipate that buyers of private businesses will find it more difficult to secure debt financing on attractive terms. With the cost of debt expected to increase, lenders may be less comfortable saddling companies with large amounts of debt, and financing agreements will likely include more restrictive covenants on the business than we have seen in the recent past.
Business owners who are able to update their financial forecast and present a strong case for why their business will not be significantly impacted by COVID-19 over the next several years will have a better chance of differentiating themselves with buyers. These sellers may still want to consider moving forward with a sale process once the current market volatility subsides. We also believe sellers who adjust their mindset, show a willingness to be more flexible on deal terms, and who recognize that the transaction process is going to take longer in this new environment are likely to be at a competitive advantage.
During the sale process for a private business, buyers and their advisors typically conduct an in-depth “due diligence” review of the business. Moving forward, we expect the due diligence process to include questions that help buyers better understand the specific impact of COVID-19 on the business, and its general level of preparedness for a global pandemic. Questions from buyers’ diligence teams may include:
- Does the company have a business continuity plan, and has that plan been stress tested?
- Do employees have the ability to work remotely, and what technology systems are in place to allow them to do so?
- How will the business maintain operations in the event of government-mandated travel restrictions, quarantines and factory closures?
- Do the company’s information technology systems provide for appropriate redundancy, data recovery and security?
- How will the business address potential supply chain impact from a global pandemic?
- Does the business have business interruption insurance?
Review your business continuity plans now, so that in the event you decide to sell your business, you and your management team have anticipated buyers’ diligence questions. Buyers will expect responses that offer reassurance that your company is prepared for these contingencies.
One of the characteristics of a strong business is a well-developed succession plan for identifying and grooming the future leaders of the business. In the current environment, buyers are assigning even more weight to succession planning when evaluating a business. Buyers want to know how the management team will be impacted if certain senior executives encounter health issues which make them unable to lead the business, or entire teams or offices are isolated or compromised.
Review your business’ succession plan, including the strength of your board of directors, employment policies for identifying and promoting talent, and corporate governance practices for how your management team, board of directors, shareholders and family members make decisions about the business.
Purchase agreements for the sale of a private business in the current environment are more likely to include language that addresses the potential impact of COVID-19 or another global pandemic on the business. For example, buyers are asking businesses to disclose whether they have any knowledge of the actual or expected impact of COVID-19 on their business operations (supply chain, inventory, customer relationships, etc.) in the purchase agreement.
Purchase agreements may also include proposed language that gives buyers the right to walk away from the deal if there has been a “materially adverse effect” on the business as a result of a pandemic, including COVID-19. Buyers and sellers will likely end up reaching a compromise where the buyer can call off the deal only if it is determined that the pandemic has had a disproportionate impact on the business as compared to other businesses in the same industry or geography.
Consult with your legal advisor to understand the type of disclosure and transaction terms specific to COVID-19 and pandemics that they are seeing in purchase agreements for the sale of private businesses, and discuss what language you would be comfortable with in a purchase agreement for the sale of your business. Work with your management team to understand whether you expect COVID-19 to have a greater impact on your business relative to your competitors.
The practice of “social distancing” due to COVID-19 is requiring advisors to rethink how to conduct the sale process for private business transactions that are currently underway. Historically this process has involved multiple in-person meetings between the buyer and seller, including initial strategic discussions, formal management presentations, and contract negotiations.
Lessons learned from COVID-19 may result in transaction advisors evolving to a more virtual sale process for the foreseeable future. In an environment where face-to-face interaction is limited, it will become more challenging for buyers and sellers to get to know one another, establish trust, and broker compromises, all key elements to achieving a successful transaction outcome.
If you are considering selling your business, assume that you may need to substitute virtual meeting alternatives to maintain frequent and regular in-person interaction with buyers and advisors during the sale process. Start planning early for how you can put your business in the best possible light for buyers, and how your management team will work with the buyer’s team, in a tech-enabled virtual environment.
To the extent that COVID-19 results in a prolonged economic downturn, the value of many private businesses could decline. Lower equity valuations, coupled with a low-interest rate environment, nonetheless may provide attractive estate planning opportunities. Owners of private businesses should consider taking advantage of any resulting lower valuation to transfer shares out of their estate (for instance, to a trust for the benefit of their children) in advance of a future sale of the business.
Consult with your advisors to review your current estate plan and discuss what estate and gift tax planning opportunities may be available to you in light of a decrease in the value of your business, particularly if you currently own shares that you would be willing to transfer to your heirs.
While the impact of COVID-19 may present new challenges to business owners currently considering selling their business, it is important to remember that the strength of the economy is only one of several factors to address when determining whether and when to sell. During this time of market volatility and economic uncertainty, engage with your advisors to understand what you can do now to prepare your management team, your family and your wealth for the transition of your business when the time is right for you.