In recent years, there has been an increase in “carveout” transactions, which are M&A deals pursuant to which a business division or other line of business is sold out of a larger organization. Whether due to pressure on corporations to focus their businesses on core competencies and divest noncore operations, or simply as a result of there being fewer standalone opportunities for private equity and strategic acquirers, such transactions have accounted for a growing percentage of M&A activity. The COVID-19 crisis is expected to accelerate that trend. While the potential benefits of a carveout transaction can be significant to the parties involved, such transactions can also be quite complicated and present a number of unique challenges for even the most sophisticated buyer or seller. Here are some key tips for buyers and sellers to keep in mind when considering a carveout.
- Setting the Transaction Perimeter — Prior to initiating a sales process, it is critical that a seller conduct its own internal due diligence of the business it wishes to carve out in order to set a clear transaction perimeter. Failure to carefully define the business to be sold can result in delays and unnecessary additional costs, wrongly including assets that belong to the retained business, and otherwise negatively impacting pricing and the overall deal process.
- Negotiating the Scope of Assets to be Sold — Once the carved-out business is defined and the transaction perimeter has been set, the scope of the assets subject to the transaction must also be agreed. Buyers will typically negotiate to receive at least all of the assets “primarily used” in the business, while sellers who are engaged in a number of other businesses with interrelated assets (such as intellectual property, real estate and shared contracts) may be unwilling to agree to a “primarily used” standard and instead insist on only selling the assets “exclusively used” in the business. In some instances, a seller may not want to transfer an asset even if primarily used in the targeted business because it is critical to the operation of its retained operations, while conversely a buyer may insist on an important asset being included in the transaction regardless of its use by seller’s other businesses. This can be a heavily negotiated point, with parties often agreeing to different standards (e.g. “primarily used,” “exclusively used,” etc.) by asset class, and requires careful analysis of both the acquired and retained assets of the seller to determine which standard is appropriate.
- Identifying and Agreeing on Terms of Transition Services — In a carveout transaction, it is common that certain assets and services essential to the business are also used in the seller’s retained operations and cannot be included in the sale. As a result, the seller and buyer will often enter into a transition services agreement in order to address this problem and help the business transition to operating on a stand-alone basis after the closing. Typical transition services include finance, accounting and IT support, payroll, human resources, data migration and the sharing of facilities. However, unlike most other M&A deals, the scope, duration, pricing and other terms of such transition services are usually fundamental to a carveout transaction and can take time to negotiate. The buyer should conduct its own diligence to determine the services that are needed, for how long, and at what price, but the seller is usually best positioned to take the lead on addressing these issues and ideally should consider what transition services it can offer (and on what terms) prior to initiating the sales process. Upfront planning by a seller will facilitate the negotiation of these issues and avoid unnecessary delays.
- Financial Statements — While most sellers will prepare comprehensive financial statements at the parent company level, the level of financial statement preparation for subsidiaries and divisions varies widely. As a result, standalone financial statements for businesses being sold in carveout transactions are often unavailable or inadequate for purposes of satisfying a prospective buyer’s financial due diligence, ability to obtain debt financing or stock market reporting requirements. A seller should address the nature and quality of financial information that a buyer requires early in the deal process. Buyers will want to assess the standalone costs of the carved-out business in order to get comfortable with its valuation, so sellers should provide information to help with that analysis sooner rather than later. Lack of adequate financial information is a common reason that such deals falter.
- Shared Contracts — In many carveout transactions, both the target business and the retained business may sell products or services to a customer, or purchase products or services from a vendor, under the same agreement. Or they may license intellectual property to or from a third party under the same license agreement. How parties ultimately address such shared contracts vary, and are often influenced by commercial considerations. Options include partially assigning or “splitting” the contract, or one party keeping the contract while the other party negotiates a new contract or simply continues to share in the benefits of such contract as part of the transition services agreement (although the latter may not always be permissible under the relevant contract).
- Intercompany Arrangements — In most instances, the parties will agree in the definitive purchase agreement that any intercompany arrangements between the carved-out business and retained business will end on or promptly following the closing, subject to any agreed transition services. However, there may be products or other services being bought or sold between the respective businesses that are important to their operations now and in the future. In that case, one or both parties will want to ensure that there is a binding commercial agreement in place to ensure these products or services continue to be provided post-closing. Similarly, the seller may have guaranteed an obligation of the carved-out business, which will need to be replaced by the buyer at closing. Intercompany arrangements such as these are often not documented and are easily overlooked, and both the buyer and seller will need to do some digging to ensure these loose ends are not missed.
- Use of Trade Names — In most cases, the carved-out business will not be able to continue using corporate names and related trademarks of the seller. A buyer needs to understand how these names and trademarks are used in the business (e.g., on product packaging, marketing materials, websites, etc.), and how much time it will need to transition away from them. This may necessitate a transition period, in which the buyer will rebrand the business and secure new domain names.
- Intellectual Property — In most carveout transactions, the transfer of intangible assets such as intellectual property can present unique challenges and can be one of the most difficult assets to untangle. For example, there may be software licenses that exist on a group-wide level in the seller’s organization which cannot be transferred (e.g., shrink-wrap or off-the-shelf software licenses), in which case the buyer should negotiate and purchase its own licenses and factor those costs into its valuation of the carved-out business and expected timing for closing. Similarly, the carved-out business often uses intellectual property that is also used by the retained businesses. In that case, the parties should consider entering into a license agreement permitting the buyer to use that intellectual property in a manner that is consistent with how it is used by the carved-out business prior to the sale and subject to other limitations that are usually heavily negotiated (since neither party wants their ongoing operations to be hindered by such a license).
- Employees — Deciding which employees will remain with the seller and which will go with the carved-out business can be difficult. For example, the seller may have a large number of employees who provide services to both the carved-out business and its other retained businesses who it wishes to retain. Conversely, there may be employees who work primarily with the carved-out business, but the buyer is not interested in taking them with the business. In that case, the seller must determine whether those employees can be reassigned within its other operations or whether it must ultimately lay them off after the closing. Given this dynamic, it is not unusual for employees informed of the transaction in advance to be concerned about their job security, and a seller needs to consider providing stay bonuses or other incentives to ensure these employees remain with the business through the closing. Additionally, sellers must not forget to analyze the impact of the sale on the seller’s benefit plans for its remaining employees – depending on how those benefit plans are structured and the number and percentage of employees involved in the sale, a carveout transaction may result in an increase in benefit costs or even a plan termination.
- Tax — Like any M&A transaction, carve-out transactions raise a variety of tax structuring issues. How they are addressed will depend on a number of variables, including the tax classification of the seller, the assets or entities being sold, and the tax jurisdictions involved. To the extent structured as an asset sale, the manner in which the purchase price (and relevant liabilities) is allocated among all of the acquired assets may also be heavily negotiated.
As you can see, when pursuing a carveout transaction, advanced planning is essential for avoiding unexpected and costly delays. A deal lawyer that has experience working on carveout transactions can also play an important role in identifying key issues and drafting and negotiating definitive deal documents that avoid common pitfalls. When considering such transactions, it is essential that both the buyer and seller understand the issues which can arise. Addressing these issues early on in the deal process can make the difference between a successful or failed transaction.
Seward & Kissel’s Business Transactions Group routinely handles the structuring and negotiation of carveout transactions across a diverse set of industries. If you are considering such a transaction, please consult with your Seward & Kissel relationship attorney early on to walk you through the process that should be followed.
Seward & Kissel has established a COVID-19 Resource Center on our web site to access all relevant alerts that we distribute.