An ever growing number of U.S. economists have forecasted an economic downturn in the coming year. With vehicle sales creeping down for 2019, many dealers are starting to feel the bind. Economists and accountants are predicting mergers and acquisitions activity (“buy/sells”) to remain slow through year end and into 2020. While periods of financial turmoil are particularly difficult in industries providing durable and luxury goods, adding on to the thin margins seen by auto dealers in recent years and a recession could prove disastrous.
Auto sales and M&A activity both slow down before a recession for the same reasons: first, out of the buyer’s uncertainty about incurring the expense of the acquisition before hard times; and second, in the expectation that a better deal is to be had when times get tough for the seller. The question becomes, why pay $6 million in blue sky today, when that dealership may be distressed in six months and sell for $2.5 million in blue? Economic downturns provide unique investment opportunities for companies positioned to weather the storm. Buying a new dealership during economic downturns, however, presents particular risks and concerns that are often not present in the usual deal process.
First, take sufficient time in the letter of intent phase (and definitive agreement) to consider what events should allow the parties to walk away from the deal. Buyers generally want to get a deal signed as soon as possible because manufacturer and governmental approvals can only be sought once the deal is signed. Despite this, without adequate thought given to termination provisions in your agreements, a buyer could end up buying a dealership which has seen goodwill deteriorate sharply over the last 3 months, without a corresponding adjustment to purchase price. The buyer will want to make sure that, should the recession worsen, they are not stuck doing a deal at a rate that is out of sync with the actual underlying value of the dealership. For example, termination rights may include a right for the buyer to exit the agreement in the event of sales dropping off by some certain percentage. Relatedly, a seller may want the ability to exit the deal if its prospects improve substantially (though this is probably better addressed through pricing, discussed below).
For buyers who know they want a foothold in the seller’s market, regardless of the health of the seller, these concerns can partially be managed through pricing mechanisms. Instead of agreeing to a fixed goodwill number today, agree on the formula used to come up with that number. That way, the passage of time is less likely to leave the buyer upside down at the closing table. Using a formula, instead of fixed numbers at signing, can also be helpful to the seller by giving them the full value of the business at closing, not just the value that was determined a few months prior when the deal was signed.
Alternatively, an earnout may be an worthwhile option to consider. Earnouts are payments made to a seller following the closing. These payments are tied to a business metric, often EBITDA, and allow the seller to get the benefit of a strongly performing dealership in a case where the buyer is skeptical of performance. Buyer’s also like earnouts because it lets them pay added purchase price out of actual performance post-closing. Earnouts are fraught with their own risks, but they work best when the outgoing dealer is staying on in the dealership post-closing (at least through the earnout period).
Next, while its not common in automotive deals, break-up fees should be considered when market downturns are on the horizon. A break-up fee is a payment by one party to the other when a deal falls through to cover costs of conducting due diligence and other transaction costs. In this context, it would most likely be sellers seeking break-up fees from buyers, if the buyer exits a deal due to general economic concerns.
Finally, a key part of almost every transaction is the decision on whether to lease or purchase the real estate. When buying a dealership that is under performing in a weak market, it may be more beneficial to a buyer to sign under a long term lease with an option to purchase. Rental values can be negotiated in advance, as can forms of purchase agreements on the exercise of the option, to avoid any future seller disruption of the buyer’s option exercise. Conversely from the seller’s perspective, dealerships are special use properties. This means they are specifically designed for a particular use, i.e., selling and servicing motor vehicles. Thus, if a tenant does not renew the lease, the owner may experience significant difficulties selling or leasing the dealerships to another party.
These are just a few of the specific provisions that are particularly important when negotiating a buy/sell transaction during an economic downturn. Just as the financial decision to enter into a sale transaction requires extra thought in bad economic times, so do the legal documents underlying that transaction.