When a company (Buyer) acquires only part of another company such as a division or a subsidiary, a transaction type typically referred to as a carve-out, the part of the company being carved out (Carve-out Entity) is often dependent on the parent company (Parent) for business services critical to its operations. These services may be limited to accounting, finance, human resources, and other administrative functions, but they may also be more expansive and include critical operations such as distribution, logistics, and quality assurance.
In many cases, Buyers are not able to begin providing these services immediately upon closing. In some cases, the length of time required for Buyers to replace services being provided by Parents can be protracted – weeks or months. In this case, for the transaction to be successful, Buyer will need Parent to continue to provide these services for some period of time after closing. Services provided under these circumstances are Transition Services.
When Buyers and Parents don’t have a clear, comprehensive, and mutual understanding of what Transition Services are needed, in what quantity and to what level of performance, and for how long, serious complications can develop. These complications can lead to business disruptions, unexpected costs, and even litigation. These consequences can be so severe as to turn a great transaction into a disaster for Buyers and Parents alike.
A well-developed Transition Services Agreement that defines and governs both Buyer’s and Parent’s obligations and that is signed as a condition of closing the transaction can not only avert disaster but help make the transaction even more successful for both Buyer and Parent.
A Transition Service Agreement (TSA) is a document that captures and governs:
- What transition services will be provided by Parent.
- For how long.
- At what standard of service.
- At what cost to Buyer.
The TSA typically is a document separate from the documents governing the transaction itself (for example, a Stock or Asset Purchase Agreement) but is referenced in such documents and signed as a condition of closing the transaction.
The TSA typically is comprised of two documents:
- A legal agreement containing definitions, terms and conditions, and dispute resolution language.
- One or more exhibits that define the individual transition services, durations, service levels, and costs.
Some TSAs and exhibits may include additional language to address special circumstances such as:
- Transition Assistance, comprising services not ordinarily provided by Parent to Carve-out Entity but needed by Buyer to affect an orderly transition, such as extracting data from Parent’s systems to import into Buyer’s systems.
- Reverse Transition Services, comprising services based on capabilities and resources being sold as part of the transaction that Parent will require from Carve-out Entity after closing to effect their own orderly transition. A common example of this is a Parent needing to continue to utilize space in a Carve-out Entity warehouse until Parent can make other arrangements and transfer out the inventory.
One of the biggest risks to the success of carve-out transactions – for both Buyer and Parent – is business disruption during the transition period. If Parent does not provide critical transition services, the Carve-out Entity’s ability to operate normally, or at all, can be compromised. Disagreements between Buyers and Parents regarding these services, service levels, and costs can escalate rapidly into costly and time-consuming legal disputes. Employee morale – at Carve-out Entity, Buyer, and Parent – can be impacted and loss of critical personnel can occur. In short, issues pertaining to the delivery of transition services can make an otherwise beneficial transaction a nightmare for both Buyer and Parent.
When such disruptions occur, they most often result from:
- Failure to identify all of the necessary transition services.
- Failure to maintain target service levels and efficiently resolve issues.
While the above can be mitigated to some extent via “good faith” language and other terms and conditions in the TSA legal agreement, such mitigation is (at best) one step removed from litigation.
A more effective approach that can be taken in concert with language in the TSA legal agreement is a comprehensive and diligent approach to identifying all of the potential transition services required, creating detailed and unambiguous transition service definitions, and providing clear and measurable service level targets as an Exhibit (or Exhibits) to the TSA legal agreement.
These two components work in concert to set clear, mutual expectations between Buyer and Parent. Signing the TSA as a condition of closing helps to ensure both Buyer and Parent go into the transaction with an equal obligation to affect an orderly transition.
Developing the TSA legal agreement and the supporting Exhibit(s) is a collaborative effort between:
- Buyer’s and Parent’s legal counsel.
- Buyer’s transaction advisors.
- Parent’s management team.
Buyer’s or Parent’s legal counsel typically take the lead on creating the TSA legal agreement, often leveraging commonly available or proprietary templates, with input from Buyer’s transaction advisors.
The supporting Exhibit(s) generally are created by Buyer’s transaction advisors leveraging a “triangulation” approach to identifying the full breadth and characteristics of all needed transition services:
- Allocations and chargebacks from Parent to Carve-out Entity.
- Utilization of Parent employees to provide services to Carve-out Entity.
- Key business process.
With the transition services identified, additional, straightforward analysis is performed to:
- Briefly define the service and develop the associated service description.
- Identify minimum required service levels for the transition service to minimize potential business disruption and support an orderly transition.
- Identify or roughly estimate Parent’s likely cost to provide the transition service based on estimated personnel costs and such identifiable or estimable direct costs that are available and consumption volume.
- Identify the potential duration for which the transition service may be required based on Buyer’s integration assumptions and plans and propose extensions that may be required to address unanticipated contingencies.
At this point in the process, the draft TSA Exhibit(s) are incorporated into the draft TSA legal agreement and reviewed jointly by Buyer and Parent.
As with the agreements governing the transaction itself, the TSA is negotiated. This can be a brief or protracted process but typically moves quickly as the transaction cannot be closed until this agreement is in place.
Once the transaction has closed and the transition services begin to be provided, Parent’s performance against the service levels defined in the TSA must be monitored to help ensure that any discrepancies can be addressed between Buyer and Parent amicably and without escalation. In the unfortunate and unlikely event such efforts fail, the legal remedies available in the TSA provide Buyer with some degree of recourse.
During the TSA period, Buyer may (and often does) wish to terminate specific transition services on a selective basis as Buyer’s integration plans progress and those specific transition services are no longer required. Preparing for selective transition services terminations may require efforts by both Buyer and Parent, but tends not to be onerous.
Developing, negotiating, monitoring, and terminating reverse transition services typically works in the same way.
The TSA remains in effect until all transition services have been terminated.
Looking for more information? CFGI can help — contact us today!