June 12, 2020
As the profound impact of the coronavirus (COVID-19) on the UK indie film and TV industry continues, we are now seeing the effects of the pandemic filter through to investment and M&A activity within the sector.
Although well-progressed transactions continue to be concluded, the majority of all other deals (where producers had only recently gone to market and/or entered negotiations with investors or buyers) have now fallen idle.
With content production having been at a stand-still during lock-down (and only beginning to kick back into gear , indie producers’ revenues and reserves have taken a material hit (some £250 million ($310 million) according to a recent study by UK producer trade body Pact), which has in turn driven down business valuations (typically linked to multiples of trailing EBITDA) and made the prospect of new investments/disposals far less attractive for sellers or those seeking finance at this time.
Instead, potential sellers and buyers are looking to the preservation of their own respective businesses through the implementation of various cash-boosting/cost-saving measures, including the furloughing of employees, release of contractor/freelance staff, scaling back of development and, where possible, taking advantage of additional sources of funding aimed at bolstering the UK indie production sector (for example, ITV’s £500k development fund and the additional funding made available by the BBC through its Small Indies Fund).
Issues arising from recently closed deals
Disposals of privately-owned production businesses within the sector typically adopt a modified type of earn-out structure involving an initial sale of shares with further put and call options over the remaining shares, exercisable by the sellers and the buyer (respectively) following an agreed time period after completion (typically 3-5 years), at a price calculated by reference to the performance of the underlying business during that period.
Similarly, where companies have previously taken funding in return for the issue of shares to investors and where those investors wish, at a later date, to consolidate their holdings up to 100% by buying the remaining shares, whether through put and call option arrangements or otherwise, the valuation methodology for that purchase will generally be based on prior performance.
In normal circumstances, these types of arrangements are viewed as mutually beneficial and innately fair. They allow the true value of the business to be reflected in the price being paid by the buyers. At the same time, sellers are properly incentivised to work hard to deliver on promised projections so that they may then share in the upside of the increase in business value, both during the earn-out/option period (through any dividends declared) and on disposal of their remaining shares.
Now, however, the unprecedented levels of disruption have brought a number of key issues into focus for both sellers and buyers:
- With valuations being linked to performance levels/targets that may no longer be realistically obtainable, sellers face the prospect of returns that are drastically reduced from their original projections (or in some cases possibly even eliminated) where those targets/levels are not attained.
- Concerns regarding diminishing returns may also de-motivate and disincentivise sellers and cause a further dip in business performance.
- The cash-depleting effects of the pandemic across the sector may impact the ability of smaller, less well protected buyers to satisfy any outstanding consideration payments that remain due; likewise, the availability and size of development pots (i.e. key additional funding, typically made available by buyers, to enable sellers to option work and build a development slate) may similarly be reduced.
- Reduced resource and management time on the buyer side could also inhibit their ability to provide other essential support/services to the underlying business.
What are the options?
Given their breadth and potential significance, resolution (or mitigation) of these issues will be a key priority for both sellers and buyers.
Where parties are currently within a contractual arrangement where 2020 results are likely to have an impact on valuations, in the first instance, they should consider and seek advice on the terms of their deal. For instance, is there already flexibility to extend earn-out/option periods and/or to defer payment obligations?
If no such rights are contractually available, then this will likely result in attempts to renegotiate or otherwise vary the existing arrangements. Changes the parties could look to implement include:
- varying the terms of the earn-out consideration calculation to negate the abnormally low output for 2020 (for example, to allow for a revaluation of the underlying business and equalisation/top up payment at a future date when normal activity has resumed);
- an extension to the earn-out/option period to allow for the underlying business to recover and attain the performance levels required in order to trigger expected returns on sale, which should ensure that the sellers continue to be incentivised and affords buyers extra time to make the necessary payment(s); and
- alternative means of satisfying outstanding consideration payments (for example, through the issue of loan notes).
Any variation to the original deal terms needs, however, to be carefully considered to avoid unwanted tax pitfalls.
Sellers will be expecting to pay capital gains tax (CGT) on their consideration payments (currently 20% but with the opportunity to access 10% entrepreneurs’ relief (ER) rates).
Changes to the underlying terms of the “earn-out” resulting in an actual (or potential) increase in amounts payable to sellers could put this CGT treatment at risk, with some or all of such payments being potentially taxed as employment income (typically 40/45%) plus employee NICs (likely 2%), with the company additionally liable to account for employer NICs (13.8%).
Analysis of the existing consideration structure and the changes proposed will need to identify and, in so far as possible, minimise unwanted income tax charges.
Simplistically, one needs to determine whether the benefits to the sellers from the re-calibrated arrangements can be said to accrue by reason of the sellers’ employment/directorships with the company, as a result of which the income tax risk could arise, but the legislation is complex and needs care.
The parties may wish to amend the current terms to allow consideration payments to be deferred, possibly through loan notes or simple debt. The choice of how to structure this may depend on a seller’s appetite for guaranteeing that his “earn-out“ sale will benefit from current CGT rates, and in particular the availability of ER – noting that whilst this relief has been reduced to £1m lifetime gains, sellers can gift shares to spouses/civil partners to access their limits.
Typically, a “share for loan note” deal would defer payment of CGT for the sellers until their loan notes are redeemed in the future by the buyer. However, unless at redemption a seller holds a sufficient shareholding in the buyer company that issued the loan notes (of at least 5%), their deferred gain would not be eligible for ER and such gain would therefore be taxed at 20% (or whatever higher CGT rate then in force). A seller might therefore consider electing out of this “share for loan note” treatment , so as to crystallise his CGT bill upfront at the time of the “earn out“ sale, at a guaranteed 10% (20% where ER is not applicable). The possibilities available can be complex and can raise other issues (security, for instance, where the buyer has solvency issues that render it unable to redeem the loan notes), but should inform the sellers’ structuring of the revised “earn out “ deal now.
Parties discussing or otherwise contemplating amendments should proactively seek legal advice to ensure the effects are properly understood, mitigated (as far as possible) and explore options for making the sellers whole where the tax impact is unavoidable and the parties still opt to proceed.
Outlook for the rest of 2020 and beyond
Whilst there are a number of obstacles to overcome, the ongoing desire for new content on our screens and devices will likely provide the stimulus needed to ensure a swift return to normality in M&A activity, once production activity fully resumes.
At the top-end of the market, major broadcasters and distributors will continue to be on the hunt to acquire top tier talent; lower down, certain value buyers will look to exploit opportunities to invest/acquire cash-strapped businesses at a discount.
Furthermore, with the lockdown-induced bottleneck on original content fuelling demand for ready-made programming, producers who have retained rights in historical productions that are capable of exploitation through secondary media will be particularly attractive targets for investment or acquisition.
The pandemic is likely to cause a shift in how deals are negotiated and structured. Sellers, for instance, may look to secure more robust and extensive support obligations during their earn-out/option periods. Buyers are likely to prioritise greater flexibility in payment extension/deferral rights. Finding ways to future-proof against this type of event will be high on the agenda for both sides.
As for recent buyers and sellers or those coming towards the end of their earn-out/option periods, they are clearly faced with the additional challenge of navigating the specific issues on their closed deals but this should not prove to be insurmountable.
Conversations regarding possible options/solutions are already being initiated in the market and we encourage all parties with any concerns regarding their existing deal terms to do the same.