As a company grows and expands (whether by acquisition or organically), it can encounter issues which may prompt a divestiture. For example, a once high-performing business unit declines or becomes stagnant and drags down the performance of the overall company, or business units within the company create negative synergies, such as where a major customer of one business unit is a major competitor of other business units, or a company undergoes a major change in its business strategy. In each instance, a potential solution is to sell one or more impacted businesses in order to unlock value from the sale of the businesses and/or realign the company in connection with a strategic shift.
Although this solution seems relatively simple on paper, this is not always the case. Often, multiple businesses are closely integrated to save costs on shared services, personnel and administrative services. As a result, in order to sell a single business, that business unit must be identified and isolated from the other businesses of a company. This is known as a “carve-out” transaction. Due to the complicated nature of separating a closely integrated business, companies that are contemplating a carve-out transaction will need invest significant time and resources into planning and preparation. The following provides helpful tips to consider when planning a carve-out transaction.
Before engaging in the separation and sale process, companies should spend a significant amount of time understanding the key components of the business unit to be carved out and how those key components will function on a stand-alone basis. Companies considering a carve-out transaction should ask the following key questions at the outset of the carve-out planning process:
A detailed understanding of the answers to these questions will lay the groundwork for how a company will structure its carve-out.
A key component of every carve-out transaction is determining which assets will be transferred to the carve-out business and which will remain with the company. In most cases, there are significant assets that are important to both the carve-out business and the company. For example, a carve-out business could produce components used by another business of the company. Companies should identify these critical assets early in the carve-out planning process and plan for how these assets will be allocated between the carve-out business and the company, and what, if any, ongoing relationships (e.g., transition services, supply agreements or license agreements) will need to be put in place post-carve-out. Companies should also identify any shared contracts, such as enterprise-wide procurement agreements. Companies need to determine whether these contracts can be “cloned” for the carve-out business or whether there will be a need for transition services between the company and the carve-out business while a new arrangement is established.
Companies need to determine which employees will become a part of the carve-out business. This can be a difficult task where a subset of a company’s employees provide critical services to both the company and the carve-out business. Companies must determine which employees are critical to the operation and growth of the carve-out business and whether the loss of such employees will disrupt continuing operations.
It is important to account for conflicts of interest and issues of divided loyalty, which can arise as employees that will become part of the carve-out business begin to look toward serving their future employer (the buyer) rather than their current one. It is important that the deal team responsible for planning the transaction ensures that stakeholders from the carve-out business and the remaining related business(es) are involved in planning a carve-out transaction in order to provide checks on potential conflicts. In addition, the deal team should also be involved in an oversight role to ensure that the right balance is struck between the assets that will be part of the carve out transaction, which help deal value, and the assets that remain with the company, which impact continuing operations.
Intellectual property assets are becoming an increasingly important aspect of businesses across all sectors and thus require particularly close attention in the context of a carve-out transaction. The ownership and future use of intellectual property assets can be one of the most difficult components of carve-out transaction planning, given the fact that the use of the intellectual property often will not be confined to a single business. As a result, companies must carefully examine the use of its intellectual property to determine whether the intellectual property can be confined to a single business and sold (with potentially a limited license back to the company), or retained and licensed to the buyer as needed.
Companies’ enterprise resource management, payroll, procurement, accounting and employee benefits systems are often operated at the enterprise level and cannot be easily “cloned” such that a carve-out business can have access to these tools and functions on a stand-alone basis. This means the deal team will need to devote significant time and effort to identifying critical services and software and ensuring that the carve-out entity will have what it needs to continue operation as a stand-alone entity or division of another company immediately following a divestiture. This can include establishing a new payroll system, creating a separate benefits structure and acquiring new licenses for enterprise-wide software.
Companies should also consider the category of buyer that would be most interested in the carve-out business when making decisions on these issues. Strategic buyers will often have their own systems and processes onto which they can onboard the carve-out business, requiring fewer stand-alone systems or transition services. Financial buyers will often expect the carve-out business to have the systems and processes necessary to operate on a stand-alone basis, meaning that the carve-out business will need to be ready to operate as a stand-alone entity from day one.
Identifying the physical space that the carve-out business will operate on a go-forward basis can be a complicated issue. In many cases, a material portion of the carve-out business is housed within property that is shared with other business units of a company. Companies should consider whether it is possible to maintain shared facilities by entering into lease or sublease agreements with a buyer of the carve-out business or whether it is best to relocate the carve-out business from a shared facility to a separate facility that can then be sold or leased to a buyer.
After these and many other issues have been considered, companies should consider whether the carve-out should be executed prior to a sale or simultaneously with a sale.
If a company chooses to execute the carve-out prior to a sale, the company has the ability to resolve asset/contract allocation, employment, transaction and entity structuring issues without seeking input from potential buyers, whose desires may not align with the strategic vision the company has for the carve-out. This can give companies stronger leverage in negotiations and minimize the ability of potential buyers to influence the structure of the carve-out. However, executing a carve-out prior to a sale will require a company to bear the full cost of carve-out. The company risks incurring otherwise unnecessary costs in establishing and running the stand-alone entity if it is unable to find a buyer. As a result, a company that chooses to complete a carve-out before selling a business should be prepared to run the business as a stand-alone entity (or unwind the carve-out) in the event a sale does not materialize.
If a company chooses to execute the carve-out simultaneously with a sale, the company can structure the carve-out transaction with the buyer’s input and seek to maximize the value of the business for that buyer. The company may also be able to share the costs of the carve-out with the buyer and make only those investments necessary to transfer the carve-out business to the buyer. However, executing the carve-out simultaneously with a sale may lead to long and protracted negotiations, with the buyer and the company potentially disagreeing on the scope of the carve-out and necessitating that any definitive agreement contain extensive covenants regarding the scope, execution and cost of the carve-out. Additionally, because the carve-out business will have never operated on a stand-alone basis, the buyer may also request a more significant investment from the company in transition services post-sale.
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Given the complexities of carve-out transactions, advanced and detailed planning is crucial to success. Before a company enters into a sale process or begins the process of carving out one of its business units, the company should allocate significant time and resources to developing a strategy for executing the carve-out. To ensure that the issues outlined in this article are fully and adequately considered, it is important for the company to engage legal, financial and accounting experts early in the planning process.