When the coronavirus pandemic hit, merger and acquisition activity in the distribution space came to a standstill as companies adapted to rapidly changing circumstances and worked to keep the lights on and the employees engaged, healthy and productive. Now, many months into the pandemic, deal activity is picking up.
But the coronavirus pandemic has left its mark on M&A in the industry. Deal conversations frequently include phrases like “COVID bump” (i.e., the impact from reduced travel expenses, changes in supply chains from both the vendor and customer perspectives, increased cleaning requirements, stalled capital expenditures, etc., have on a company’s financial health) and “EBITDAC” (EBITDA plus the impact of COVID-19). In this uncertain time, sellers must be able to explain how the pandemic has impacted their profitability. And, to further highlight the true value of their companies, sellers must make a case for the long-term health of their supply chains.
The pandemic has also forced many manufacturers to transition to remote work. According to a recent poll of manufacturing and distribution executives conducted by Sikich, 53 percent of respondents reported that more than a quarter of their workforce still works remotely more than two days a week. This has introduced new cybersecurity challenges that distributors are struggling to solve. In the poll, more than half of respondents reported that their cybersecurity risk has increased during the pandemic. Further, distributors have had to keep employees engaged and safe while implementing new social distancing rules and remote work requirements.
Yet, even without a definitive end to the pandemic, now is still an opportune time for distributors to sell. Keeping in mind COVID-specific considerations, owners can be prepared and maximize the return on a sale.
To avoid any hiccups during the deal process, and even potentially boost the value of their company, owners must take a hard look at their IT infrastructure. Buyers, especially private equity buyers, hate surprises. And one of the biggest surprises that can emerge during a deal is data security issues. Prospective sellers should proactively assess their IT infrastructure – including personnel, policies and procedures, and disaster recovery plans – to ensure the company’s data is as secure as possible and that it is ready to respond quickly to any data security issues. Smart buyers will conduct a thorough IT assessment during the diligence process. Sellers should get head of this assessment and move to bolster cybersecurity well ahead of the start of deal negotiations.
Consider alternative deal structures
Prospective buyers want to understand the company’s revenue trends before, during and after the pandemic. Prospective sellers should therefore consider undergoing a valuation to better understand these trends and get a sense for what kind of offers they can expect. Going into the sales process with realistic expectations will speed up deal negotiations and help both parties get to a closing faster. According to Sikich’s 2020 Manufacturing and Distribution Report, 37 percent of executives said it has been three years or longer since their businesses were valued. Without a recent valuation, a business owner is essentially flying blind into the M&A process.
Owners should also be prepared for longer earnout periods. The pandemic has resulted in a rise in alternative deal structures, such as earnouts and equity rollovers. Under an earnout structure, a seller receives payouts over a longer period of time, based on the company’s future performance (since the company’s valuation is largely based on these future results). When a deal includes an equity rollover, the seller puts a portion of her ownership into the post-closing business in lieu of immediate cash proceeds. These deal structures allow sellers to leave skin in the game and bridge the valuation gap.
The coronavirus pandemic has affected nearly every distributor’s profitability. Buyers, therefore, are working extra hard to understand the true health of businesses they are considering acquiring. They are hyper-focused on assessing a company’s customer and vendor concentration, they are evaluating cash forecasts, not just budgets, and they are taking a hard look at working capital.
Heading into the sales process, a company owner needs to have a good handle on the company’s working capital. Owners must also consider market developments when reviewing working capital. For example, losing a key customer or diversifying a product line can significantly change the amount of working capital in a company, both currently and in the future.
Owners can also add value to their companies by working to strengthen relationships with their supply chains – ensuring smooth transactions with vendors and timely payments from customers. Distributors should also work to diversify their supply chains – including growing their customer bases and engaging with new vendors and suppliers. Diversification will help insulate a company from future economic turmoil.
The Final Word
The pandemic has added many new challenges for distributors to overcome. But for those contemplating an exit, the sales process can actually be a positive experience amid these challenges. The owners who take steps today to boost the overall health of their businesses – from cybersecurity to working capital – can proceed confidently into the M&A market.