Internal Forecasts and M&A

Paul M. Tiger is partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Tiger. Related research from the Program on Corporate Governance includes M&A Contracts: Purposes, Types, Regulation, and Patterns of Practice and Why Have M&A Contracts Grown? Evidence from Twenty Years of Deals, both by John C. Coates, IV.

Uncertainties about the near and long-term future of companies at which boards are considering strategic alternatives will result in significant impediments to the ability of management teams to produce internal forecasts upon which boards may rely in good faith to support their duty of care when choosing a strategic alternative.

Often a company considering selling itself or pursuing another strategic alternative does not have an “off-the-shelf” set of long-term projections that has been vetted by management and the board in a meaningful way to support the decision to enter into a change-in-control transaction. In addition, a board does not always decide to initiate a sales process with the benefit of advance planning. In today’s era of investor activism, a company will often find itself considering a sales process on short notice—triggered by a quarter or two of weak earnings, the emergence of an activist in the stock and/or significant changes in management. In the same way, consideration of non-control transactions, such as a PIPE transaction, can often morph into a sales process.

Once a change-in-control transaction is on the table, however, the target board needs to have conviction that the company’s financial projections are the board’s best estimate of future performance, not only to support its decision to sell the company or stick with the status quo but also to justify that decision to shareholders, plaintiffs and the courts.

It’s easier said than done, but here are some common scenarios that we frequently see boards encounter, and our recommendations for how directors should deal with the concomitant issues that often arise:

The Company Has Multiple Sets of Projections

It is not uncommon for a public company to have multiple sets of projections for future performance at any one time. These are often used for different purposes and different audiences: budgeting to instill fiscal discipline on managers, setting aspirational goals to incentivize and compensate management, and providing short-term or annual guidance to the Street or creditors. Often, these forecasts are prepared by different teams and may be derived from different sources and different data. But their mere existence may complicate directors’ selection of a particular set of projections as the best estimate of the company’s future performance, and give rise to 20-20 hindsight by plaintiffs and courts later questioning whether the board acted in good faith in selecting the set of projections ultimately used.

As a result, before getting too far into a sales process, evaluation of strategic alternatives or “quiet” market check, the target board should take stock of the company’s various sets of projections. In this context, the board and its advisors should not be using a set of projections that depict what the company “should” be doing but cannot achieve or are so easy to achieve that they will lead to an understatement of the value of the company. The projections should represent the board’s best estimate of the company’s future performance.

To ensure that’s the case, we have found it useful for target directors to consider, in consultation with management:

  • What sets of projections has management previously prepared? For what purpose? What are the key differences between them?
  • Do these projections reflect current developments? Are they outdated or have they become stale?
  • What are the underlying assumptions? Are the assumptions reasonable and do they reflect both historical and current performance, as well as actual and anticipated developments?
    • For instance, does the revenue growth trend in line with the company’s historical growth?
    • Do profit margins reflect the company’s actual profitability or wishful thinking on the part of the board and/or management?
    • Have recent changes in tax laws or the regulatory environment in which the company operates been appropriately reflected?
    • Have there been significant customer wins or losses that need to be woven in?
  • If the directors had to place a bet, which set of projections best reflect future performance?

In our experience, by answering these questions, directors can typically quickly dispense with projections that fail to reflect facts on the ground and zero in on the most realistic set of projections or alternatively come up with a clear set of instructions to management to derive improved projections.

The Target Board Determines that the Projections Previously Circulated to Bidders and their Lenders No Longer Represent the Board’s Best View of Future Performance

It sometimes happens that discussions with bidders, sales processes and the route to a transaction occur in a meandering way. Even if the company has approached a transaction in a deliberate manner, sometimes the facts change, businesses succeed or fail, or the board simply spends more time considering a particular set of projections that may have already been provided to bidders and their lenders, and in that way realizes that those projections are no longer the most accurate prediction of future performance and that the more accurate forecast is materially lower.

Reducing the company’s internal forecasts in the middle of a sale process triggers two issues. First, a need arises to come clean to the bidders and their lenders as soon as possible. Second, a sense of internal awkwardness may set in if bids are already on the table and the board is at risk of appearing to have lowered its forecast to make it easier to find that the bids on the table are in the best interests of the shareholders and within the range of financial fairness. Despite these two issues, boards still need to prioritize assuring that the current best estimates are used. Decisions and fairness opinions that are based upon a stale set of projections will not help the directors demonstrate satisfaction of their duty of care.

In these circumstances, it is worth directors taking a brief pause, to sit down with management and the company’s financial advisor to revisit the assumptions underlying the prior projections in order to come up with a more realistic set of projections. Care should be taken to document these deliberations in the board minutes:

  • Why was the prior set of projections unrealistic?
  • What assumptions need to be revisited? Why? What makes the new assumptions more realistic?
  • Do these changes relate to new facts or developments?
  • Do they result from looking at the company’s business in a different way or result from new strategic plans?

Although it is now common practice for a target to disclose all the sets of projections that have been provided to the bidders and/or the financial advisor(s) in order to get the benefits under Delaware law of a fully informed shareholder vote, the potential awkwardness of revisiting the projections “midstream” can be managed by describing in the disclosure when the new projections were created, the reasons therefor and the significant differences in the assumptions underlying them.

At the end of the day, it’s more important for the board to get it right and believe in the numbers.

Major Legislative, Regulatory or Other Changes Have Occurred or Become Increasingly Likely

Another common scenario arises where a new legislative or regulatory change is just on the horizon. In the fall of 2017, we helped lots of companies and their financial advisors work through the potential ramifications of tax reform, in all the various forms proposed. Similarly, Medicare and Medicaid sometimes act unilaterally to change reimbursement rates. Analogous situations exist where new entrants in the market or the potential loss of a customer may drastically affect a company’s prospects.

Under these circumstances, we will advise in most circumstances that the company undertake the necessary work so that the board may confirm whether the projections continue to reflect the board’s best estimate of future performance. Projections should never be based on speculative changes or hypotheticals. But if a significant change has indeed occurred or is imminent, the projections should be revised to address it to the extent practicable. In addition, as potential or hypothetical changes become more likely to happen, it is advisable for boards to prepare for the impact of these changes by requesting, in addition to the forecasts reflecting the current state of play, a set of sensitivity analyses that show the potential effects that these changes may have on future performance.

A target board’s consideration of the company’s financial projections will continue to receive significant scrutiny by shareholders, plaintiffs and courts in evaluating the directors’ satisfaction of their fiduciary duties and, accordingly, whether a company is simply conducting an annual evaluation of its strategic alternatives, doing a quiet market check or conducting a robust sales process, it is worthwhile for target boards to spend the time to ensure that, when the day comes to approve a transaction, the board is comfortable that its projections reflect the best estimate of the company’s future performance. It may involve a bit of art and science, but by following these guidelines, target boards can avoid missteps that others have made.

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