Without a doubt, the current economic environment forces companies across all sectors to find new ways to strengthen their balance sheets and deliver shareholder value. M&A transactions, especially divestitures, can be an effective way to achieve this. Therefore, companies often identify and divest low-performing divisions or activities that are no longer part of the company’s core business.

In short, a carve-out is a partial divestiture of a division. In this process, the parent company, or RemainCo, creates a new company from the division and sells a minority interest in this new company, or DivestCo. However, carve-outs are complex transactions. They require significant planning and careful execution to avoid value destruction.

If companies execute a carve-out poorly, the transaction can lead to operational disruptions, loss of key customers or employees, and regulatory non-compliance. As a result, it can negatively affect the valuations of both RemainCo and DivestCo.

Over the past eight years, I have guided several firms through complex M&A transactions. During that time, I identified major pitfalls and developed a clear view on how to prevent them. In this article, I share practical insights and recommendations to help companies avoid the most common mistakes during a carve-out.

Insufficient Planning & Preparation

During a carve-out, companies often underestimate the importance of careful planning and preparation. This is one of the most common and critical mistakes. After all, a carve-out is a multi-faceted process with many stakeholders. These include employees, customers, suppliers, regulators, and investors. Throughout the carve-out, the impact on both RemainCo and DivestCo should remain minimal.

Therefore, inadequate planning and preparation can cause delays, cost overruns, and operational disruptions. For example, the new entity may not be ready to take over critical functions such as finance, IT, and HR. In that case, it may struggle to operate independently. This can lead to customer dissatisfaction, employee turnover, and other problems.

To avoid this, companies must invest time and resources in a thorough analysis of the business unit to be carved out. In addition, this analysis should clearly define the transaction perimeter, identify key stakeholders, and result in a detailed project plan.

Companies should also appoint a dedicated, full-time team to manage the end-to-end carve-out process. This prevents disruption to business as usual. Too often, companies treat divestitures as regular strategic projects. However, they require specialized and dedicated expertise.

Not anticipating the complexity of a carve-out process

Companies also often underestimate the complexity of the carve-out process. Overall, carve-outs involve a broad range of difficult legal, financial, and operational issues. For example, they may require renegotiating customer or supplier contracts, transferring intellectual property rights, or establishing new legal entities. These issues take time and require specialized expertise.

To mitigate potential risks, companies should analyze these challenges upfront. They should also create contingency plans to address them. One common contingency plan is to use Transitional Service Agreements, or TSAs. These agreements cover services that DivestCo cannot operate independently at closing, but that RemainCo can still provide.

It is advisable to agree on multiple backup TSAs before closing. This helps cover unforeseen delays. The usual TSA areas include IT, HR, payroll, and finance.

Inadequately Addressing IT & Infrastructure Requirements

After the closing date, both companies need ringfencing measures. These measures ensure that sensitive information is no longer shared between entities. Companies that fail to address IT and infrastructure needs may face major operational challenges. In addition, they may face risk and compliance issues.

The IT domain is complex and specialized. Therefore, it typically has its own TSA framework agreement with stricter SLAs than non-IT services. However, relying only on TSAs can only partly reduce IT risks in a carve-out program.

Some IT services or systems may not be feasible for a TSA. This can be due to compliance, privacy, or competition law reasons. As a result, many carve-out delays stem from challenges in the IT domain.

To overcome these challenges, companies should review the IT and infrastructure needs of the entity to be divested. This includes all hardware, software, systems, and data used by both businesses. The goal is to identify all dependencies.

Moreover, buyers and sellers should consider engaging dedicated IT advisors. These advisors can provide additional expertise. Having the right expertise on board also protects the quality, feasibility, and compliance of IT TSA services.

Limited DD on Intangible Assets such as IP & Software Licenses

Intangible assets are often the most difficult assets to untangle. Unlike physical assets, such as a manufacturing plant or real estate, intellectual property is often shared across business units or divisions.

To manage shared intellectual property, both parties can enter into a license agreement. This allows DivestCo to use the intellectual property in a way that matches how the business used it before the acquisition. Therefore, both parties must carefully negotiate conditions, pricing, and limitations. Neither party wants the agreement to disrupt ongoing operations.

Software licenses are another type of intangible asset. They are often shared by the entire group. At the same time, they are business-critical to both companies after closing.

Therefore, buyers should start negotiations for their own licenses well before closing. This allows them to include these costs in the valuation. It also helps ensure that they have their own license available on Day 1.

Quite often, software licenses cannot be managed through a TSA. Suppliers often do not allow two companies to share their licenses. During due diligence, companies should also review license agreements for a change-of-control clause. This clause addresses changes to the ownership structure of a company.

Concluding Thoughts

To wrap up, carving out a division can be challenging and arduous. Therefore, companies considering a carve-out should invest time and resources in planning and preparation. In addition, they should engage experienced advisors and communicate clearly with all stakeholders to avoid misunderstandings.

Finally, companies should address all IP, IT, and infrastructure needs early in the process. By avoiding the typical mistakes discussed in this article, they can support a smooth transition. As a result, they can maximize value and position the new entity for long-term success.