2024年10月24日

Negotiating Transition Services Agreements in Carve-Out M&A Deals

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In mergers and acquisitions (M&A), few transactions are as complex as carve-outs. In contrast to the sale of a stand-alone business, carve-outs involve the sale and separation of an integrated part of a larger business enterprise—and thus are generally characterized by an interdependence between the business being sold and the seller’s remaining operations, particularly with respect to critical back-office services such as HR, accounting, and especially information technology. This interdependence creates a level of cost and complexity that, if not carefully managed, can significantly affect the deal’s value.

This is why a comprehensive and well-crafted transition services agreement (TSA)—in which the seller provides critical services to the divested business during a transitional period after the closing—can be key to a successful carve-out deal. Those critical services can be complex, and a contract is essential because the seller is not in the business of providing those services to outside customers. Thus, crafting and negotiating TSAs can help both buyers and sellers avoid post-closing setbacks and preserve the value of the deal.

Understanding Transition Services Agreements

Not every carve-out transaction requires a TSA. Typically, the parties enter into a TSA only when the buyer does not expect to have all of the resources that are necessary to run the acquired business as of the targeted closing date.

For example, the divested business may rely on the seller’s enterprise resource planning (ERP) system to bill and collect from customers and pay employees and suppliers. Because the seller uses its ERP system across its enterprise, the seller will not transfer the ERP system with the business as part of the sale. If the buyer does not already have a comparable ERP system in place, it will need time to make the internal and contractual arrangements to stand one up. Even if the buyer does have its own ERP system in place, it may take significant time to extract the acquired business’s data from the seller ERP and convert it as necessary for use in the buyer’s ERP system.

A TSA can solve those and similar problems for the buyer by requiring the seller to provide the acquired business, for a transitional period, technology access and other seller-provided services that the business was using before the closing. Additionally, the TSA also typically sets the terms on which the seller will assist with any data extraction, knowledge transfer, and similar one-time “migration” activities required to integrate the acquired business into the buyer’s operations after the closing. In short, a TSA is designed to make certain services available to the acquired business and the buyer in order to give the buyer the time and support it needs to assume responsibility for providing those services itself or obtaining those services from a third party.

The seller also benefits from the TSA. For one thing, a TSA can shorten the time between signing and closing because, without a TSA, the buyer would not be able to close until it could operate the divested business independently. Also, by reducing transaction costs and uncertainties for the buyer, the TSA increases value and thus potentially the purchase price. Relatedly, where the purchase price includes performance-based earn-outs after the closing, the TSA can help the acquired business achieve the necessary performance targets by smoothing its transition to independence from the seller. Finally, by clearly defining and limiting the support that the seller will continue to provide post-closing, a TSA can help the seller minimize the legal, operational, and reputational risks of a rocky separation.

Negotiating Transition Services Agreements

In many ways, negotiating TSAs is similar to negotiating outsourcing agreements. There are service standards to be defined, pricing mechanisms to be specified, and service-related and other risks to be allocated between the parties.

However, TSAs generally differ from outsourcing agreements in at least one critical respect: neither party expects a long-term business solution from the agreement. The seller is not seeking a lasting stream of profits or otherwise acting as a professional service provider. The buyer, in principle, needs the seller’s services only for as long as it takes to replace them with other arrangements. Both parties, in short, are entering into the TSA not as an end in itself, but in support of the M&A transaction that is their primary goal.

The TSA’s ancillary relationship to the overall deal can affect negotiations in many ways, but as a practical matter, what it often means is that the TSA does not get the attention it should. With deal teams focused first and foremost on the M&A agreement, the TSA can easily become an afterthought, relegated to the final, frantic rush to signing and sometimes even left to be completed between signing and closing. In many cases, the deal team excludes the people who know what services are needed and who can provide them until very shortly before, and sometimes even after, the M&A agreement is signed. As a result, deal teams may miss important opportunities to increase value or mitigate risk.

A key best practice in TSA negotiations, therefore, is to get them started as early in the deal cycle as is practical. To the extent possible, sellers should, as part of the initial auction and diligence processes, provide concrete, meaningful TSA commitments to would-be bidders, with the aim of reducing bidder uncertainty and risk, and thus, potentially increasing the value and clarity of offers received. The parties should both, at the earliest stage deemed appropriate under the circumstances, include in their respective deal teams the people who will be responsible for, in the seller’s case, arranging services to be provided or, in the buyer’s case, identifying and integrating the services that are needed.

Once negotiations are underway, the parties should remain alert to the issues most likely to affect deal value and related risks. These key issues include the following:

  • Service Commitment. The seller often takes the position that its service commitment in a TSA is merely to use commercially reasonable efforts to provide specified services on an “as is” basis. At the other extreme, the buyer may take the position that the seller must agree to deliver a well-documented set of services under terms that sophisticated customers would expect from leading providers of mission-critical services. In negotiations, deal teams and their subject matter experts work to identify and document in sufficient detail all major services components, excluded services and service limitations. Those exclusions and limitations may be driven by the buyer’s capabilities, the seller’s existing service arrangements, day-to-day demands on the seller’s resources, or the buyer’s historical consumption of the service. Defining and limiting the services early in the deal cycle can allow the seller to make stronger commitments to the remaining functions and can allow the buyer to seek other sources for excluded or limited functions.
  • Pricing. The pricing for services under TSAs varies. Common options include at-cost, cost-plus, fixed price, fixed base price with volume and other adjustments, and no additional charge. In negotiating the pricing method, key factors include the type of service in question, how the seller will source the service and the business terms of the overall transaction. Cost-based pricing is an appealing approach, but sellers often lack ways to measure cost for providing internal services, and allocations of shared fixed costs are inherently arbitrary. Also, if seller measures the business units that will provide the services on a profit-and-loss basis, then at-cost and no-charge pricing may create a disincentive for those business units to deliver services. In that case, better incentives may be created with fixed prices, unit charges based on service volumes, hourly rates for projects and/or pass-through pricing for third-party charges such as travel, telecommunications and underlying services.
  • Term. At the time the TSA is being negotiated, the buyer often does not know exactly how long it will need the services. Thus, a buyer typically would prefer to have rights to extend the term long enough to build or source long-term services on a comfortable schedule. The seller likely would prefer to shed the exceptional responsibilities imposed by the TSA as quickly as possible, particularly if it has agreed to provide the services at cost or at less than cost. In addition, the seller may be relying on third-party agreements that may be needed for the divested business for only a limited period. Depending on the circumstances, limited extension rights with defined notice periods and possibly higher prices during extension periods can bridge the differences.
  • Third-Party Consents. The seller may require consents from third parties to provide services to the buyer under the TSA. For example, a third-party software application may be licensed for “internal use only.” Unless the seller’s license agreement for that application has clauses permitting use to serve divested entities, the seller may need the licensor’s consent in order to use the software to provide the application to the divested business. In a large, complex carve-out deal, hundreds of consents may be involved, each of which may require negotiations with a third party and the payment of fees. The TSA thus should clearly define which party is responsible for identifying, obtaining and paying for each consent, and for making alternative arrangements if a consent cannot be obtained. Aligning incentives by giving each party a financial stake in the consent process is one way to obtain consents and comply with their terms at the lowest possible cost.
  • Limitations of Liability. TSAs often include a waiver of consequential and other indirect damages and a cap on direct damages, subject to negotiated exclusions. Such exclusions might cover, for example, liability for indemnified claims, negligence, willful misconduct, bodily injury, property damage, breach of confidentiality, data security breaches, and violation of laws. Buyers under a TSA would prefer a broad range of exclusions to support a strong commitment to providing services. However, because the seller under a TSA often is not “in the business” of providing the services, the seller may have difficulty assessing the risk involved and, therefore, often presses for narrow exclusions to those limitations of liabilities—and for further limitations through force majeure and other exculpatory clauses. In negotiations, the parties align the limitations of liability with both the agreed strength of the seller’s commitments for individual services and the allocations of liability for the transaction as a whole.

Conclusion

Transition services agreements in M&A carve-outs provide for ongoing services to help transition business functions that cannot easily be transitioned at closing. The keys to success in negotiating a TSA include recognizing the unique features of TSAs as service agreements, understanding both parties’ perspectives, and focusing on best practices and key provisions. The ultimate goal, a well-crafted TSA addressing all key factors, can increase deal value and reduce deal risk by facilitating the successful integration of the acquired business and the overall success of the M&A transaction.

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