Carve-out transactions (or “carve outs”) have become increasingly popular over the last two decades. Sellers view carve outs as instruments to extract cash from non-core businesses, while investors view them as opportunities for competitive advantages, provided the carve out aligns with their experience and strategy. A carve-out transaction is typically more complex than a complete divestiture and comes with a host of challenges, but when executed properly, it can optimize value opportunities for both seller and buyer.
What is a Carve-Out Transaction?
A carve-out transaction is when a set of assets and liabilities are identified by a larger enterprise for a divestiture, usually referred to as the transaction perimeter. This is commonly some business line segment or regional carve out. It must be noted a carve out is not synonymous with a spinoff. A spinoff is a new, distinct entity created by the parent company, where there is no initial shareholder transfer.
Advantages and Disadvantages to a Carve-Out Transaction
Carve-outs offer sellers many attractive advantages and opportunities. If an enterprise’s strategy and vision has evolved to a point where a business unit or region is no longer strategic, the enterprise can divest it. This would allow the company to focus its resources and time on the operations of the core and growth segments of the enterprise. Additionally, if a particular segment of the business has performed remarkably over the last few years, the enterprise can look to divest that segment to capitalize on the strong return it may be able to garner from buyers.
Carve outs provide buyers with unique advantages as well. First and most obvious, they allow buyers to invest on a smaller scale and reduce the amount of injected capital. Additionally, buyers can purchase focused businesses that might fit better into their portfolios, allowing them to avoid the “fat” or lagging business segments that they may be forced into when purchasing complete companies.
The biggest risks of a carve-out transaction revolve around the uncertainty of dependencies that the overall enterprise might have on the divested segment(s). The enterprise needs to conduct a careful analysis of how the carve-out divestiture impacts the core business, including the handling of shared customers, agreements, overhead and resources. A buyer of a carve out needs to ensure that the transaction perimeter can actually operate, prove its viability as a standalone business and produce the results that the proforma financials present.
Seven Keys to Ensure a Successful Carve-Out Transaction
In order to avoid the risks of a carve-out transaction, we recommend sellers consider the following before pursuing a carve –out, even if it involves extra work and resources needed. In order to maximize the value and minimize risks and pain points throughout the process sellers should:
1) Clearly Define and Set the Transaction Perimeter.
A poorly defined and fluid transaction perimeter is guaranteed to cause issues and delays throughout the sale process. From a seller’s vantage point, the dependencies of the retained business on the divested perimeter needs to be considered. Almost certainly, assets and resources will be needed between the two segments, whether that be operational and/or from a shared service perspective. The transaction perimeter needs to be well defined financially, operationally and legally.
2) Does the Carve Out Make Sense as a Standalone Business?
For the benefit of both parties, the carve out needs to actually be able to operate and produce as a standalone business. This is practically always true when considering buyers. Strategic buyers may be able to plug some holes and dependencies, but if as a seller, you are selling an incomplete business, you are limiting the types of investors that can complete the acquisition, likely negatively impacting the purchase price.
3) Review Financial Statements and a Commission a Quality of Earnings Report.
Depending on the business, cleanly breaking out companywide financials to the exact transaction perimeter may be a difficult task. Due to the complexity and admitted subjectivity of certain accounting treatment for items like allocations or one-time expenses, these financials are often the most scrutinized during the diligence process. They can have massive implications on the valuation of the carve out.
In order to expedite the diligence process, a quality of earnings report produced by a third party is highly recommended. Even if the company is cleanly audited by business segment, often items like shared SG&A overhead, contracts and agreements and intercompany arrangements can muddy the waters of the true outputs and burdens of the business. A thorough quality of earnings report will go into those nuances and will be a forefront diligence tool that can serve as an unbiased defense of the proforma statements and can help the buyer reach desired valuation.
4) Maintain a Pre-Diligence Checklist.
While this isn’t exclusive to carve-out transactions, getting stage one due diligence requests done before the data room opens is critical to keeping your head above water during the most hectic stage of the sale. Here are some (not all) of the items that are guaranteed to be requested during diligence:
- Schedules for organization structure
- Board minutes
- Capitalization structure
- Detailed financial statements for 3+ years
- Budgets and projections
- Audit reports
- History of legal disputes
- Fixed asset and real estate contracts
Proactiveness is key!
You can learn more about diligence in our blog post, “Types of Due Diligence and What to Expect from the Process,” or download our decision tree:
5) Rationalize Shared Services, Assets/Liabilities, Contracts and Intellectual Property.
The messiest part of a carve out involves dividing up all the entanglements that are generally held and managed at a corporate level. When the business is dissected, both the divested business unit and enterprise need those functions. Hypothetically, a carve-out sale of fifty percent of a business isn’t as simple as chopping everything in half. Perhaps one group requires more sales personnel due to the nature of the product. Maybe one group requires more collections resources due to their customer base being less-established companies. This trickles down all the way to items such as organizational structure, executive compensation, etc. The critical thing to understand is that the new levels of presented shared functions and assets are defensible during diligence.
6) Create Transition Service Agreements.
Let’s be honest, no party in a transaction looks forward to the TSA negotiation and execution. Unfortunately, due to the nature of a carve out, TSA agreements are necessary to keep business continuity throughout the transition and are often more involved compared to a standard divestiture. The duration and complexity of the TSA agreements can be dependent on the type of buyer (i.e., financial vs. strategic), but as a seller, it’s important to think through what items in the carve out pose potential holes in the core business. While there is plenty of time for the TSA to be finalized and negotiated, key functions that are being lost and impacts to the core business need to be understood.
7) Consider Employee Morale, Politics and Transition Plans.
An entirely separate article could cover just this topic. When dealing with a carve-out transaction, especially as the confidentiality of the transaction expands internally, employees should placed into camps. There are “red” employees, who know they are going with the divestiture because that is the business unit they belong to. Then there are “blue” employees, who know they are remaining with the core business because that is where they live. But then there are “purple” employees. They might be shared services, or people who don’t really belong one place or another, and a decision has to be made on if they are in or out of the transaction perimeter. Particularly when employees are concerned about job security during a transaction, employee psychology has to be handled with extreme care.
The worst of it comes when morale is impacted. If an employee is chosen to go with the divestiture while the rest of their team is remaining with the seller, that can cause them to feel excluded, betrayed and dispensable. The reason behind the red, blue and purple descriptions of the carve out is because the environment quickly becomes political and partisan. Allegiances and interests start to shift. Employees may view peers on the other side of the transaction as competitors or hindrances even before the deal is closed. There might be some with malicious intent, trying to take advantage of the carve out by engaging in behavior or expenditures that they wouldn’t get away with during normal circumstances. This can disrupt the business throughout the sale process and potentially impact the terms and valuation of the deal if finances and operations are affected.
Another delicate item is the restructuring of the outgoing and remaining leadership team. Hypothetically, if a carve-out divestiture cuts an enterprise in half, reconsideration of executive compensation and organizational needs are on the table as opportunities for cost savings. The timing for introducing the outgoing leadership team is a tricky process. Done too hastily, you run the risk of too many issues and handoffs at once, creating an issue of too many cooks in the kitchen. However, if introduced too late, the new management team might not have the experience of running the new company and value can be lost.
The solution for all these issues is unintuitive – wait until the final stages of the transaction to decide where employees go. Although seemingly unfair to the employees, delaying this decision will keep the employees honest to not side with one group or the other, and a lot of the political and morale issues can be avoided. The focus is then shifted away from cherry-picking talent to committing a certain level of resources to the deal, and the details of who is red or blue can be worked out in the penultimate phases.
Prepare to Maximize the Value of a Carve-Out Transaction
Carve outs present immense opportunities for the parties involved. For sellers, value can be extracted from a business unit, allowing the enterprise to focus and invest resources on its current and core businesses. For buyers, the barrier to entry is decreased, and the buyer is able to purchase a more focused business, rather than the bundling of non-producing assets that can come with a wholesale transaction. With measured preparation and use of this M&A instrument, value can be maximized and risks can be minimized.
If you need M&A consulting and due diligence support, 8020 Consulting can help. We have a growing team of accounting and finance experts who can support strategic goals and provide supplemental, dedicated resources to in-house teams.
About the Author
Aniv brings a dozen years of finance and accounting experience across the entertainment, manufacturing and e-commerce industries. His areas of expertise include strategic planning, restructuring, buy-side and sell-side M&A, operational finance, corporate finance, financial modeling, capital and liquidity management, planning/budgeting, consolidations and financial system implementations. Prior to joining 8020 Consulting, Aniv most recently was the Director of Finance at Deluxe Entertainment. Aniv served as the Head of Finance for their Cinema division, overseeing full P&L responsibility, and managed the supporting finance team in the United States, Europe and Asia. He then moved into a Corporate Finance role, where he facilitated a companywide bankruptcy, restructuring and divestiture to a private equity group. Prior to his role at Deluxe, Aniv worked at Pictage, a venture-backed startup, where he established and grew the FP&A and accounting functions. Aniv holds a B.S. in Economics from UCLA.
