Divestment activity is poised to increase over previous years as COVID-19 economic conditions put pressure on companies to rebalance operating portfolios.
A 2020 EY Global Corporate Divestment Study, released earlier this year, forecasts a sharp rise in divestitures, with 78% of companies saying they plan to divest within the next two years, and 57% saying they plan to divest within the next 12 months. The survey also suggests that the unprecedented economic uncertainty brought on by the global pandemic and restive activist investors—96% of whom report they will recommend carve-outs of underperforming or non-core businesses within 12 months—is forcing sellers to shorten the timeline to prepare and close carve-out deals. Not surprisingly, company executives face much tougher capital allocation decisions in a disruptive business environment.
So how can companies meet the demand to accelerate the divestiture process without compromising the deal, while also mitigating risks?
Fenwick M&A practice co-chair Doug Cogen, corporate partner Bomi Lee and tax associate Ora Grinberg were joined by EY’s Adi Maheshwari, strategy and transactions partner; Shari Yocum, people advisory services principal; and Manish Dabas, strategy and transactions principal, in a co-hosted webcast to discuss how companies can complete deals faster than the average six-to-nine-month deal cycle. Key considerations for companies include divestiture timing, preparation and risk mitigation.
The reason for a carve-out should be carefully considered and articulated to the entire deal team from the start of the project, as this will be your lodestar. There are many reasons to do a deal, and prioritizing your objectives is critical to obtaining the business outcomes you’d like to see, whether you want to keep your existing customers happy as you transition them to a new business owner, achieve the highest price, manage risks and streamline your operations or reduce go-forward entanglements.
Having a clear separation strategy will also help you understand what period you’re trying to accelerate. Everyone talks about wanting to do a deal faster, but you should focus on the period you want to speed up. Are you trying to get to a faster signing? A faster closing? Or, are you trying to get to a faster disentanglement and complete portfolio separation? Using the separation strategy to guide what period you’re trying to accelerate will dictate the different levers that you can pull and help put the related risks into perspective.
As you’re reviewing your portfolio to create liquidity, the focus should be on selecting assets that are more stand-alone operationally and financially and easier to carve out. If you’re conducting a portfolio review at a time when speed is of the essence, the priority should be given to smaller, digestible assets. Once you’ve determined what you want to sell, you will need to establish the deal perimeter, which includes the exact products, people, locations, intellectual property assets, technology, IT systems, etc., that are in scope.
Critical considerations to avoid delays:
Most buyers are not going to be comfortable closing the deal until they see a set of carve-out business financials. Not every carve-out, however, requires audited financials. Key determinants will be whether the acquisition will constitute a “significant” subsidiary or business for U.S. Securities and Exchange Commission reporting purposes and/or whether the buyer will utilize third party debt financing from lenders that will require audited financials. Set expectations early with potential buyers on the financials that will be reasonably available in the timeframe that you have and, if possible, consider exploring alternatives around special purpose financials that may still satisfy the buyer’s financial requirements and accelerate the overall timeline. These special-purpose financials can be prepared to exclude certain carve-out adjustments that can otherwise take a lot of time, including goodwill and corporate expense allocations.
As a seller, you need to do your own due diligence before you face a buyer. Have your counsel interrogate the business as if they were buyer’s counsel. Turn that chessboard around. Think hard about what the cross-dependencies are between the divested and retained businesses, and where the assets in the business reside. Are these assets owned or licensed-in? Think about where the weaknesses are in terms of people, rights, contingent liabilities, encumbrances and what the significant issues will be for the buyer in diligence and negotiated terms—and get ahead of those issues.
In the process itself, value can be destroyed and buyer confidence shaken because you don’t have ready answers to questions that could have been anticipated. On the other hand, a seller who can offer buyers creative solutions to address potential concerns will be able to retain and create additional value. This takes time, planning and forethought but can accelerate the overall timeline of the transaction once you are engaged with a buyer.
Nailing down the overall value story early in the process can become critical to making diligence seamless and avoiding unpleasant surprises. Put yourself in the buyer’s shoes and do the necessary scrutiny in advance. Make sure you have solid data and reasonable analysis to support assumptions for projected revenue growth, taking into account evolving market dynamics, the competitive landscape and the company’s differentiation.
At the end of the day, the guiding principle should be to make diligence easy for buyers so they feel confident in the valuation of the business they are buying. Get ahead of the questions that buyers will ask and come up with solutions that work for you as a seller rather than letting buyers dictate new terms after they discover an issue in the diligence process.
Make sure that the team you build includes not just the in-scope team being divested but also someone representing the seller, preferably someone from your corporate team who will provide the perspective for how both teams will work together during and after separation. The team that is being sold is central to the deal since they are the ones who know the business the best and can present the information that buyers will need to know. However, oftentimes this team will have differing and competing interests from the seller and may have preferences that can be detrimental to the sale process or seller’s go-forward interests. Having the deal team include a seller representative will ensure that the seller’s post-closing interests are being considered and prioritized during the diligence process and in negotiating the divestiture terms. If both perspectives are factored in early in the deal process and the teams remain coordinated and aligned around the separation strategy, it’s less likely that the deal will get bogged down during diligence and negotiation.
Determining the in-scope employee population early and working with your legal team to understand the criteria that allocates these employees as dedicated to the business is critical, particularly if your company is a global operation. Looking at in-scope employee population by country will also help in understanding who may be subject to automatically transferring under the laws applicable in certain countries, works council processes or other local law regulations. Identifying local law rules and restrictions early will allow the deal teams to structure the transaction to avoid or minimize delays in the timing for signing or closing.
Draft the employee-related provisions in the purchase agreement in a way that will make it easier for the buyer to assume your employees. Removing friction is critical to ensuring a smooth employee transition and minimizing stranded employee costs and post-closing delays. For example, in the “continuing benefits” provisions, focus on the aggregate value of compensation and benefits so that the buyer can create an employee package that is attractive to the in-scope employees in a manner that works within the buyer’s own compensation and benefits structure.
A closing condition around operational readiness often creates real risk to sellers for carve-out deals, but ensuring that you can satisfy buyer’s needs to operate the business is critical for a successful transaction. It is in both parties’ interest to ensure that the operations will be transferred with minimal disruption to the business. Day 1 operating conditions depend on to whom you’re selling your business and their reasons for buying. If your buyer is a private equity firm, for example, the seller may need to ensure nearly every business function is operable on a stand-alone basis on Day 1. Strategic buyers have different needs and will likely want to avoid assuming redundant persons and costs. Structuring any Day 1 condition properly can spell the difference between ensuring closing certainty and opening the door to an open-ended and costly separation process.
Employee transition and operational readiness will be a priority for any buyer and can involve prolonged negotiations and introduce closing risks and delays if not planned carefully. The more effort you put in showing the buyer what the employee and operational transition will actually look like—including how people will transfer, the different systems that will be supporting employee and operational transition on Day 1, ensuring business continuity and other functional processes, including third-party and transition service contracts—the bigger the reduction will be not just in the time to signing, but also the time from signing to close. Importantly, careful upfront planning and ensuring a smooth transition will also reduce the post-closing period that the seller will remain entangled with the divested business through transition services or otherwise.
Understanding the seller’s and buyer’s IP positions, how to allocate ownership interests of patents and other registered IP, as well as determining the paradigm for allocating software code and other technology between the businesses and establishing a governance principle on the front-end, can help bring clarity and efficiency to the deal process. IP portfolio separation does not have to be a zero-sum game and parties can arrive at creative solutions such as cross-licenses, transition licensing or a transition marketing-type arrangement to enable the retained business and the divested business to continue to operate in their respective fields.
It is equally important to know how you are going to package the sale for tax purposes and consider the tax implications in your value story. Whether you are going to sell the business as an entity or as a set of identified assets (or a mix) will determine how attractive the deal is to buyers from a tax perspective. Determine ahead of time what the seller’s preferred tax structure is before you approach potential buyers—in order to set up a positive dynamic that any buyer-requested changes should yield purchase price adjustments.