Advisory Article

How does COVID-19 change M&A due diligence

Nothing in recent history has changed the business landscape as drastically or as quickly as the COVID-19 pandemic, which presents a real challenge for mergers or acquisitions. The pandemic may create a wave of new deals as troubled companies look for exit strategies and investors look for a market correction.

Due diligence for the COVID-19 era

In a post-pandemic world, buyers must understand not only the direct impact of COVID-19 on the target but also management’s response to the crisis and the pandemic’s effects on near- and long-term operations.  Below are five areas of supplemental due diligence that buyers and sellers should consider.

Expanded EBIDTA Benchmarks

Consider a pro forma adjustment to reflect 2020 financials under normal operations. The months directly affected by the pandemic are likely not representative of historical financial performance nor indicative of future results. Following are some methods for quantifying the pro forma impact: (a) compare EBITDA trends for the quarter before COVID-19 (on a seasonally adjusted basis) to impacted months and management’s near-term forecasts, (b) benchmark EBITDA trends of the company relative to industry peers, and (c) benchmark performance against growth rates from prior years and future year projections.

Top-line impact

It is important to understand the short- and long-term COVID-19 revenue impact. Analyze sales trends before, during, and after the pandemic by customer, product, end-market, and channel. Consider the company’s position in the value chain and potential for lagged pandemic impacts. Focus on forecasts in addition to historical results and carefully review budgets, backlogs, and pipelines. Evaluate the likelihood of achieving these forecasted results by assessing historical win rates, budget vs. actuals, and post COVID cancellation rates.

Vendors and supply chains

Consider the company’s suppliers and key sourced materials. Determine if there will be permanent changes resulting from the adaptation process. Does the company have reliable sources for the timely delivery of the quality materials, and will those relationships survive the pandemic? What will be the ongoing impact on vendors and product pricing? Does the company have vendor agreements with purchase commitments?  Is the company considering diversifying supply risk to multiple vendors or alternative countries? If so, what are the impacts on margin, order fulfillment and quality?

Employees and contractors

Payroll is commonly a company’s most significant expense. Understand any financial or operational ramifications of the company’s personnel decisions. Will the company be able to rehire the workers needed to resume operations as the crisis recedes—especially skilled and experienced team members? Has the company delayed payout of severance, deferred salaries, payroll taxes, bonuses, or discretionary 401k contributions?

Working capital and additional debt-like items

With the disruption affecting all levels of business, a fresh look at accounting methodology is warranted. Has the company updated its allowance for bad debts to reflect the risk of these assets and to offset inflated AR levels? Has a drop in demand resulted in extended aging of inventories? How is the company accounting for regulatory action and stimulus funds? Is the company accruing for deferred payroll taxes?

Purchase agreement implications

It is essential the risk areas identified during diligence are reflected within the purchase agreement, even more so when COVID-19 creates further pitfalls and nuances that can lead to post-closing disputes. Here are eight areas to consider prior to signing your next agreement:

Subsequent events and accounting estimates

How should your post-closing calculations consider the effects of COVID-19 that could cause post-closing debtor liquidations, supply chain impacts and inventory impairments?

Negotiating specific accounting principles to account for changing market conditions

How can parties prepare accounts on a consistent basis when circumstances have shifted so dramatically and there is no historical practice to compare against?

Earn-out provisions and the calculation of financial metric

Earn-out targets are commonly based on EBITDA or similar financial metrics, such as revenue or net income. Purchase agreements already signed have likely not factored in the impact of market changes due to COVID-19.

Material adverse change or force majeure clauses

Many purchase agreement provisions may now contemplate COVID-19 within the language of the agreement itself. Buyers should consider whether these could impact or potentially override earn-out provisions and the calculation of financial metrics.

Target net working capital

The target set should be based upon diligence financial information and projections.

Paycheck protection loans- Many businesses may have received a Small Business Administration Paycheck Protection Loan (PPP loan) through the recently passed CARES Act and will have a corresponding liability to factor into the definition of Indebtedness. Subject to certain conditions, many PPP loans may ultimately be forgiven.


As a result of the CARES Act, sellers are back in control of retaining actual and negotiating value from NOLs. The purchase agreement should be overly clear on tax return procedure including any tax elections with respect to pre-closing NOLs.

Representations and warranties

Buyers and sellers should contemplate whether specific amendments need to be made to the purchase agreement to appropriately consider the breadth and extent of the promises being made.

Tax implications for post-pandemic deals

The CARES Act included changes that not only increase the availability of NOLs for many companies, but also increase the actual liquidity and trading value of NOLs in deals. COVID-19 and the CARES Act also raises a variety of other potential tax considerations:

Alternative Minimum Tax (AMT) credits- AMT can be immediately monetized, so purchase agreements will need to address who benefits.

Qualified Improvement Property (QIP)

QIP is now eligible for 100% bonus depreciation as if enacted originally in the 2017 tax reform act, so companies have the option of amending prior returns to claim the benefit or to take the benefit on their next return with an accounting method change.

Net business interest deduction

The limit for the deduction of net business interest is increased from 30% to 50% of net taxable income for tax years beginning in 2019 and 2020.

Restructuring debt obligation

Buyers will need to understand the tax implications of any debt workouts undertaken by a target company, including the amount of cancellation of debt income and effects on the target’s tax attributes.

Employee retention credit

Eligible employers can take advantage of an employee retention credit of up to $5,000 per employee.

Paycheck Protection Program (PPP loans)

Ensure eligibility requirements are met, check interaction with other CARES act benefits such as the employee retention credit and determine whether the loan is eligible for partial or complete forgiveness. If eligible for forgiveness be sure to consider the tax implications.

CARES Act compliance

Buyers should confirm the target company’s compliance with regulations concerning any or other stimulus relief, whether or not tax related.

State conformity rules

Conformity rules will affect how CARES Act changes impact your state tax situation. States with rolling conformity should enact applicable IRS rules, but states with static conformity may not.

Foreign tax issues

Several foreign countries have also passed laws providing companies certain tax incentives.

Diligence with 20/20 vision.


How does COVID-19 change M&A due diligence

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