We’ve been closely monitoring the development of the Payroll Protection Program (“PPP”) as the U.S. Department of the Treasury issues new regulations and guidelines related to loan application and forgiveness, and as Congress debates further changes to the program. Plenty of ink has been spilled as attorneys, accountants, and business owners attempt to understand exactly how the program works and what it will take to comply with it. From our unique vantage point in M&A transactions, we’re primarily interested in how deal parties are thinking about how PPP loans will impact deal terms and post-closing obligations.
Consider a transaction in which the target company applies for and receives a PPP loan pre-close, but has not applied for or received loan forgiveness at the time of close. How should the deal parties negotiate around this liability, which necessarily comes with the potential for–but not the guarantee of–forgiveness down the road?
As a starting point, we tend to advise that contingent liabilities (and particularly those with long resolution periods) do not properly belong in post-closing adjustments, but rather are a better fit for indemnification provisions. The reason is that the relatively short timeline of a post-closing adjustment may force buyers to estimate a maximum potential liability, even if that liability might remain uncertain for months or even years after the adjustment has been completed and the parties have moved on. Unless deal parties take the rare step of including some sort of clawback mechanism in the definitive agreement, this over-estimate could result in disputes down the road. This concern is especially salient in the context of a PPP loan, for which forgiveness seems uncertain and, under new regulations, the SBA retains broad discretion to conduct an audit of loan eligibility.
Rather than shoehorn the loan into the post-closing adjustment and hope for the best, deal parties might consider other approaches to avoid a potentially messy dispute down the road:
- If the parties have a high degree of confidence in the likelihood of loan forgiveness, they could potentially calculate the forgiveness amount and treat it as cash for the purposes of calculating closing merger consideration (assuming the full loan value is also included as outstanding debt that results in a downward adjustment to the purchase price).
- Alternatively, to the extent a PPP loan reduces the purchase price paid at closing, akin to other debt (which many buyers may prefer), buyers could covenant to seek loan forgiveness to the best of their ability and agree to pay any amount forgiven to the sellers as a post-closing payout, either directly from the buyer or through an escrow arrangement. In this circumstance, we’d advise being clear about what steps the buyer would be required to take (and along what timeline). Parties might also consider mirroring a typical voluntary disclosure agreement process (i.e., the buyer has the right to seek a VDA with a tax authority, but only with the sellers’ consent) to ensure the parties are aligned on calculations.
- Parties may agree to exclude the PPP loan from the initial price adjustment entirely and provide that any portion of a loan ultimately not forgiven is subject to a separate price adjustment mechanism or is indemnifiable. This, however, may require a longer timeframe than the typical working capital adjustment period with the parties therefore considering a separate escrow and contractual provisions for how it is to be handled.
Finally, parties may need to consider what the result should be if the loan would have been forgiven if the target had remained an independent company but is not forgiven after it is consolidated with the buyer. In that case, how is that hypothetical alternative outcome determined, and which party should bear the risk of that loss?
In our 2020 Deal Terms Study, we reported that over the last three years, EBITDA-based earnouts have declined and that revenue-based and alternative measurements have increased. Nevertheless, as parties consider earnouts as a way to bridge valuation gaps during uncertain economic conditions, it’s worth considering how a PPP loan might impact an EBITDA-based earnout.
If PPP loan forgiveness occurs, one would expect for it to be accounted for as a discharge of indebtedness and therefore as earnings (for financial reporting purposes). Our experience in representing sellers in countless disputes regarding EBITDA, however, cautions that parties often negotiate an adjusted EBITDA that specifically sets forth how earnings (among other items) are to be defined. These negotiated adjustments are fertile ground for disputes, even when they result from vigorous deal negotiation. Parties should consider the following questions when negotiating this language:
- How is non-recurring revenue to be treated? If the parties agree to exclude non-recurring revenue from the adjusted EBITDA definition, they should carefully consider the impact of the provision on PPP loan forgiveness.
- What obligations does the buyer have to seek loan forgiveness? It is quite common to see earnout covenants folded into a catchall “Commercially Reasonable Efforts” provision. Rather than do the same with respect to PPP loan forgiveness, parties might consider something similar to what we suggest with respect to post-closing adjustments: setting forth specific requirements or involving the sellers (via a shareholder representative) in the process.
We conclude by noting that we are likely many months away from seeing how the issues raised in this article might sort out in an actual deal. We will continue observing and reporting from the field as we learn more.