Carve-Out Success: The Crucial Role of a Transition Services Agreement in M&A Transactions

If you are planning an M&A transaction that is a carve-out situation, you want to ensure a successful transition and business continuity. That is the key to retaining value into the future. A TSA defines and drives the process in every detail so the operational takeover can move forward smoothly and nothing is overlooked. Under the TSA, the seller will maintain things as they have done historically for the buyer until the buyer is ready to assume those services on their own.

If the whole company is being sold as a stock or assets deal, a TSA is not needed because everything will transfer over. It is only in carve-out situations where a TSA is necessary. There are several factors to consider in order to create a strong TSA. 

Advantages of a Transition Services Agreement

Every business has its own ways of doing things. The buyer may want to make changes at some point, but for the near term they need to maintain continuity while their team absorbs new data and processes. The seller provides certain services to assist with that for a defined period after the sale.

This allows the buyer time to establish their own services within their company while those services are still core to the seller. It helps the seller identify the functions and people within units to be carved out who are performing or partially performing services. Finance, HR, recruiting, marketing, and IT are all common examples. Everything in operations is already embedded in the business, so that is not an issue, but these other areas are fundamental to business success.

Here are a couple of examples of complex transactions that benefited from a TSA:

• In a multibillion-dollar complex transaction, a parent company sold a brand with stores with a multi-year transition period (not typical duration), during which the parent company continued to provide services for the retail banner. This required a massive, detailed TSA in numerous functional areas.
• A holding company divested a manufacturing business. However, because the entity being sold had been treated more like a factory than a core business entity, all services had been provided by a home office. The TSA had to cover all of those services.

Not all transitions are this complex, but even in small deals, a TSA is the only way to ensure a smooth transition.

Defining the Scope of Services

The seller initially defines the scope of services, but the buyer may want to negotiate based on specific concerns. It takes time and multiple rounds of discussion to define services to be provided. Questions to discuss include:

• What functions and actual task(s) are being performed?
• Who is actually performing those tasks? How many hours are devoted to those?
• What are the built-in economics (allocation or hourly rate)?
• How long will the buyer need assistance?

TSAs have to cover finite details—very technical aspects such as processes related to accounts receivable (order-to-cash) or accounts payable (procure-to-pay), etc. So you have to drill down deeper and deeper, down to the task level, to identify deliverables by task and dependencies related to people, tools, or technology. For example, if a report is created, then the buyer needs to receive a copy of that report. If reports are usually combined, they have to be carved up as needed—making sure details follow properly.

Working through this negotiation happens concurrently with the sale negotiations. It should start early, shortly after the financial quality of earnings and due diligence, which typically identifies shared services, where those services are provided, and if they are dedicated to the business. The seller should create an initial TSA before due diligence begins, as part of the carve-out strategy. It can take months to plan this for very complex transactions.

How long should the transition period last?

Different components can have different transition timelines. Tasks within each area may also have different deadlines, but from an operations perspective, it is best to consider each component as a complete unit (e.g., functional area).

A typical transition takes from 30 days to less than a year. However, the timeframe can vary depending on the complexity. IT integration often takes a bit longer, while some aspects of finance, like the buyer establishing their own reporting, can be completed in as little as 30 days. In extreme cases, large-scale transitions can even extend over longer periods.

Shorter may be better, but the ultimate goal for both parties is to have a successful business sale and successful receipt of the business such that continued uninterrupted operations are not hampered by service disruptions.

Sometimes buyers can benefit from a longer transition:

• It can give the buyer time to get the right people in place when people are not transitioning from the seller side as part of a deal. After all, it can be hard to hire people immediately.
• It may provide a negotiated financial advantage.
• It allows the buyer more time to strategically plan how to build out the operation as desired and make sure it is synced and successful.

Pricing Transition Services

This is often heavily negotiated, although the goal is success. Sellers do not want to surprise the carve-out with additional high costs for the TSA, so the price to ensure continuity of financial performance going forward through the transition period should be similar to the current seller costs.

In most cases, costs are simply passed through or have a slight mark-up due to the complexities and additional work to detangle the data and reporting. Contracts are often a lot of work for a legal transition and that time and costs should be built in. Pricing can be based on allocation costs already built into the process and loss statement or on the cost of salary and benefits times a given percentage of work. 

Governance and Management

Our Redpath M&A team highly recommends creating a governance party (steering committee) composed of key personnel on both sides who can make decisions. Typically this would include a very senior operations and finance person—a CFO, COO, or VP of operations. You also need a project manager to track day-to-day progress and ensure each of the functional areas are satisfied in terms of performance and tracking.

The group should meet frequently at first, then less frequently over time (biweekly, then monthly, then quarterly), to make sure transition benchmarks are on schedule, reports are coming through properly, and any personnel issues are addressed. This requires both sides to regularly check in with their own people.

The management team should watch for other potential problems, too. For example, procurement may not be included in the carve-out, but if procurement on the seller side is spelled out as a service for the buyer in the TSA, then communication becomes critical. If someone on the seller side deletes approvals because the business was sold, not realizing they will still be needed, the buyer will not be able to place orders. 

Knowledge Transfer and Confidentiality

As the transition process moves forward, more people come into play at the task level. Functional teams should meet regularly. Each person responsible for completing a task on the seller side and the person responsible for catching it on the buyer side must communicate continuously until sign-off.

Since the TSA is structured under the purchase agreement, that agreement’s confidentiality terms also apply to the TSA. In larger deals, the TSA may add specific terms. If the TSA is created separately, then it should include confidentiality requirements.

Depending on IT complexity, infrastructure and data may be commingled, in which case massive work has to be done behind the scenes from the seller’s perspective to parse it out properly. That takes time, and it has to be completed before the deal closes.

If there are certain contracts in areas such as procurement that have different cost levels, the seller may not want to give those terms, so this may be another point of negotiation.

Third-Party Guidance Is Essential 

As with all aspects of an M&A deal, the devil is in the details. With so many complexities and so many details, the transition can derail if services and the process are not well defined. Typically the seller is so familiar with their business that it is hard to recognize every little detail and task that should be included.

It is easier to have a third party walk you through the process because they see your business through a different lens. However, this third-party advisor will need to be experienced in working M&A deals if they are to properly guide you. It is extremely important that they understand your financials and can articulate that into other areas. Likewise, lawyers are essential for renegotiating contracts or establishing new ones that ensure similar terms and cost equivalency.

The transition process is extremely complex and time-consuming, which can distract the seller from daily business operations. For the buyer, it is a matter of managing the who, what, when, where, why, and how much it will cost. For both sides, decisions must be strategically sound and timely. A third party can provide better, faster analysis and also identify possible red flags.