Embark with us on the path of successful distressed M&A, defining startup value and navigating structures! Discover potential transaction formats that could lead investors to the purchase of valuable assets and at the same time save a startup facing financial difficulties.
In the last period, there has been a significant decrease in the distressed M&A sector, particularly in Europe. Namely, transactions involving distressed companies dropped significantly. This trend is linked to the pandemic and geopolitical situation, leading to structural changes in economic and legislative systems. Especially, the IT sector faces a challenging year marked by increased inflation and corresponding rises in interest rates. Many startups are dealing with difficulties in sustaining their operations, and unfortunately, the current situation might spell the end of their journey.
What is the Distressed M&A?
Distressed M&A involves the purchase of assets, partial or the entire business of a company facing financial difficulties, that are threatening its viability. Buyers in distressed M&A transactions usually seize value at a lower cost. This strategy facilitates deals despite challenging circumstances, preserving the startup’s essence. It presents an opportunity for founders and investors to extract value from the distressed company. The primary aim is to eliminate the startup’s debts and provide the business with a fresh start.
Distressed M&A vs Conventional M&A – Key Differences
Distressed M&A, compared to regular M&A, has distinct features. The process is usually quicker, and there’s less information available to potential buyers. Transactions often operate on a “buyer beware/as is, where is” basis, in most cases meaning fewer contractual protections, especially regarding warranties. This emphasizes the importance of pricing in risks, conducting targeted due diligence, and acting swiftly.
On the other hand, traditional M&A transactions follow a standard timeframe, providing comprehensive information and documents, incorporating extensive warranties, and following a more structured and protected process, often involving a regular auction or competitive bidding for the sale of the business with potential completion account-type adjustments.
Distressed due diligence is, in principle, focused on identifying the risks, together with the growth opportunities. Experienced advisors play a crucial role in navigating these unique complexities. Investors may find opportunities in acquiring discounted debt, offering access to critical company information and a strategic advantage. On the other hand, sellers of distressed businesses prefer fixed prices, avoiding completion account-type adjustments that could prolong the process or introduce uncertainty.
Key Steps for Successful Distressed M&A
When an investor finds a potential distressed investment opportunity, it is crucial to have the right strategy. This will help in assessing the risks and consequently make the right investment decision.
Define the Value
Knowing the value helps in negotiations, strategic decision-making, and determining the feasibility of salvaging the business. Additionally, a clear understanding of value facilitates the assessment of potential returns for investors and ensures that the distressed company receives a fair valuation during the transaction.
Therefore, in distressed M&A, the essence is to identify the factors contributing to the worth of a startup before engaging in a transaction. In this regard, it is crucial to examine the following:
In most cases, the core value of a startup is its IP (such as software, patents, non-patentable intellectual property, and trademarks). Before investing in a distressed startup, make sure that it has a valuable IP and that it is properly protected.
A good core team can be essential for the success of a company. Investing in a startup that has talented IT experts could be a game changer for further development.
The value of a startup can be hidden in its commercial contract. Make sure that you examine them carefully.
For example, a startup can have a contract with the main players in the market. This by itself can be a significant advantage for the future business.
Tangible assets can boost the startup’s value and business. Make sure that you are aware of them.
Due Diligence in Distressed M&A
In distressed M&A deals, potential buyers often face a scarcity of information, and available information may not meet standard quality. This limitation usually results in a short timeframe for thorough legal due diligence.
Identifying potential issues at an early stage is crucial. For potential buyers, it is essential to conduct focused due diligence on key matters and significant risk areas. These areas are essentially like those in a regular M&A process. However, the buyer may emphasize the importance of ensuring clear ownership of the target company or its assets, the key commercial contracts, and awareness of any change of control and their implications, along with obtaining necessary consent.
In situations where time is of the essence, as it usually is in distressed M&A transactions, the key is to focus on the review of essential matters that could be a deal breaker.
Distressed businesses are frequently unprepared for a sale, and their management teams may struggle to provide the usual array of due diligence materials and documents typical in a traditional sale process. In such situations, a focused due diligence exercise may concentrate on issues directly related to value.
Possible Transaction Structures
The structure of the M&A transactions determines to the way the deal is organized, including how the acquisition is structured, how the purchase price is determined, and the legal and financial mechanisms involved. The choice of transaction structure can significantly impact the parties involved.
In distressed M&A, the primary objective of the seller is to eliminate the problematic aspects of its startup, especially the debts. Such transaction could concentrate on specific assets, typically taking the form of an asset deal. This means the investor has the flexibility to choose the assets they wish to acquire.
Asset Deals vs Share Deals
When deciding between asset deals and share deals, the M&A practice often leans towards the latter. In an asset purchase, the buyer acquires specific assets and liabilities of the target company. This structure allows the buyer to select particular assets while avoiding some liabilities. These transactions may transform into share deals through a hive-down process. The idea involves establishing a new wholly-owned subsidiary for the startup and transferring all valuable assets to it. Subsequently, this new subsidiary is sold in a share deal with the investor.
Acquisition of Specific Assets of the Distressed Company
Unlike traditional M&A transactions, where the subject of the acquisition is usually the entire company, in distressed M&A, the investor often selectively targets and acquires specific assets of the distressed company. This flexibility is significant because it enables the investor to tailor the transaction to their strategic interests and financial objectives. It also provides an opportunity to leave behind unwanted liabilities, thereby mitigating risks associated with the distressed company’s financial challenges. In this manner, the investor gains control over the assets that align with their goals, making the transaction more strategic and adaptable to their business needs.
In distressed M&A transactions, an investor may choose to acquire specific assets of the company, such as intellectual property (IP), through a process known as “cherry-picking” or selective asset acquisition. This decision is often influenced by various factors:
Due diligence is conducted to assess the value and viability of individual assets. The investor evaluates the assets’ quality, potential for generating value, and any associated risks.
The investor aligns the acquisition with their strategic objectives and focuses on assets that complement their existing business or address specific needs. For example, acquiring key IP may be prioritized.
Acquiring specific assets can be more cost-effective than purchasing the entire company. It allows the investor to target and acquire assets critical to their business goals without unnecessary expenses.
Selective asset acquisition provides flexibility, allowing the investor to structure the deal based on their preferences.
The investor identifies market opportunities and gaps that can be addressed by acquiring particular assets. This approach enables them to capitalize on the specific strengths of the distressed company.
Ultimately, the investor’s decision to buy specific assets in distressed M&A is driven by a combination of strategic, financial, and risk-related considerations tailored to their business objectives.
Purchasing a Business in Bankruptcy
In rare instances, distressed M&A transactions can proceed even after a company is declared insolvent. The bankruptcy authorities, in such cases, aim to maximize the sale of the company’s assets to repay creditors to the fullest extent possible.
This underscores the importance of meticulously estimating and explaining the worth of a company’s assets during a distressed M&A transaction. A thorough assessment becomes crucial as it guides the negotiation process, aids in determining a fair deal structure, and facilitates communication between the distressed company’s directors and potential buyers. Accurate valuation helps identify valuable assets, assess their market potential, and enables a transparent discussion regarding the assets’ role in the transaction. This ensures that both parties involved have a clear understanding of the assets’ value, fostering a smoother and more informed negotiation process.
Navigating distressed M&A requires strategic acumen. Here are some practical tips for investors:
Due Diligence is Key
Thoroughly investigate the distressed company’s financial health, assets, and liabilities. Assess risks and potential roadblocks to make informed decisions. Even though time is of essence in the distressed M&A transactions, make sure that you conduct adequate due diligence.
Understand Legal Implications
Before entering into the transaction ensure that you considered all potential liabilities, existing contracts, and any legal constraints that may affect the transaction.
Evaluate Intellectual Property
Assess the value of patents, trademarks, and other intellectual property and the possibility that these assets will contribute to future profitability.
Assess Workforce and Talent
Understand the skills and expertise of the existing employees. Evaluate the importance of key team members and their potential impact on the company’s recovery.
Consider Integration Challenges
Anticipate challenges in integrating the distressed company into your existing structure. This should include compatibility, potential culture clashes, and technological integration.
Evaluate Debt and Liabilities
Understand the existing debt structure and liabilities. Determine how these factors may impact the overall cost of acquisition and the financial health of the distressed company.
Plan for Post-Acquisition
Develop a comprehensive post-acquisition plan. Identify immediate action steps to stabilize the distressed company and outline a roadmap for long-term recovery.
Engage Experienced Advisors
Seek guidance from professionals experienced in distressed M&A. Legal advisors, financial experts, and industry specialists can provide valuable insights and navigate complexities. For more information and legal advice, feel free to reach out to our specialized attorneys in Corporate Law and M&A Transactions.