Carve-out: a smooth transition
Sometimes a division of a company no longer fits with its strategy, capital is needed for growth elsewhere, or another party can extract greater value from that business unit. In such situations, a carve-out can offer a solution. It may seem like a standard takeover, but in practice there is considerably more to it. The business unit being sold has usually never (yet) operated independently. Staff, systems, contracts and support services are intertwined with the rest of the organisation and must be carefully disentangled. This requires not only sound legal arrangements, but also realistic planning and consideration for the remaining business. For both the seller and the buyer, there are pitfalls lurking that can cost a great deal of time and money in the long run. In this article, we explain what a carve-out is, how the process works, what types of transactions exist, and what sellers and buyers need to bear in mind in practice.
What is a carve-out?
In a carve-out, a business unit – such as a division, product line or branch – is separated from a larger entity in order to sell it or make it an independent entity. The difference from a ‘standard’ acquisition lies in the degree of integration. The business unit has usually never operated independently and shares staff, IT systems, contracts, intellectual property, premises and support services such as HR and administration with the rest of the organisation.
It lacks its own set of financial statements, as well as its own management team or independent legal structure. Furthermore, customers and suppliers often have a single framework agreement with the entire group, and software, trademark rights and licences are frequently held in the name of another group company.
The buyers also differ. A strategic buyer can usually integrate the division into its own organisation and provide some of the support functions itself. A private equity firm, on the other hand, often has to build up the division as an independent company, with its own systems, staff and financing. In both cases, a carve-out affects not only the division being spun off, but also the parent company, which must adapt its organisation, cost structure and contracts. The key question is therefore always: what exactly is being transferred and what is being left behind? The answer to this determines the transaction structure, the terms of the agreements between the parties and, ultimately, the price.
How does the process work?
The process begins by defining the scope of the transaction: which activities, assets, employees, contracts and rights form part of the division being spun off from the company? At the same time, financial statements are prepared that present the division (as far as possible) as an independent entity, so that it becomes clear which costs it will have to bear itself in future.
This is often followed by an internal reorganisation to legally separate the business unit. The buyer carries out due diligence, after which the parties negotiate the purchase agreement. This usually includes a ‘Transitional Services Agreement’ (TSA), in which the seller undertakes to continue providing services such as IT, payroll administration or logistics during a transitional period until the buyer has set up these services itself. The TSA is of great importance in ensuring the success of the carve-out.
In addition, seek advice in good time from the works council, which, under Section 25 of the WOR (Works Councils Act), has the right to be consulted on the transfer of (part of) the business. Following the transfer (closing), the actual separation takes place, during which systems are migrated and the TSA is phased out.
What forms are there?
A commonly used form is the assets/liabilities transaction, whereby the seller transfers the individual components of the business unit, such as stock, machinery, customer contracts and intellectual property. In principle, the cooperation of the other party is required for the transfer of contracts (Article 6:159 of the Civil Code). In the event of a transfer of undertaking, employees are transferred to the purchaser by operation of law whilst retaining their terms and conditions of employment (Article 7:662 et seq. of the Dutch Civil Code).
An alternative is to first transfer the business unit into a separate company and then sell the shares in that company. The sale itself is then simpler, but the work shifts to the preparatory phase. The transfer can be effected by contributing the individual assets or via a legal demerger (Article 2:334a of the Civil Code). In the case of a demerger, the assets are transferred under a general title, so that not every asset or contract needs to be transferred separately. This is subject to a statutory procedure, including a period during which creditors may lodge objections.
In addition, a business unit can be spun off without a sale to a third party via a spin-off, whereby the shares are allocated to the existing shareholders. Which route is most suitable depends primarily on the tax implications, the transferability of contracts and licences, and the wishes of the parties involved.
Pitfalls for sellers
Sellers regularly underestimate the complexity and lead time involved in a carve-out. The separation places a strain on the organisation, whilst the remaining company must continue to operate as normal. In addition, so-called ‘stranded costs’ often arise: costs for, for example, premises, IT and support functions that continue to exist after the sale, whilst the contribution from the divested business unit is no longer received. Furthermore, a TSA can prove more onerous than anticipated if agreements regarding duration, remuneration and termination are not clearly defined. You should also exercise caution when giving guarantees regarding a division that has never operated independently, and ensure that a non-competition clause does not unnecessarily restrict your own activities. The tax implications can also be substantial, for example, when a tax group is dissolved, property is transferred, or tax benefits are lost if shares are sold shortly after a demerger or contribution. Always consult a specialist in this field for tax advice. We can also put you in touch with our trusted partners with whom we frequently collaborate.
Pitfalls for buyers
The buyer is acquiring something that does not exist as an independent entity in its current form. As a result, historical figures are not always representative: group costs are allocated using allocation keys, and intra-group supplies do not always take place at arm’s-length prices. Furthermore, the costs of an independent business with its own IT, administration and management are often higher than budgeted. As a reliable balance sheet for the business unit is frequently lacking, a purchase price based on the balance sheet as at the transfer date (completion accounts) is more likely than a fixed price based on an earlier balance sheet (locked box).
A second pitfall is an incompletely defined scope of the transaction, as a result of which key personnel, customer contracts, licences or intellectual property may inadvertently remain with the seller. A provision for so-called ‘wrong pockets’, which obliges the parties to transfer items that have ended up in the wrong hands to one another, offers protection against this. Furthermore, pay attention to contracts containing a non-assignment clause or a right of termination in the event of a change of control. The TSA also warrants attention: it must have a sufficiently long term, contain clear service levels and include a realistic exit arrangement, so that the business can continue to operate without interruption following the transfer.
Conclusion
A carve-out offers opportunities for both the seller and the buyer, but requires careful preparation and clear agreements. Defining the scope of the transaction at an early stage, identifying dependencies and properly organising the transition period will prevent surprises later on. You should therefore involve legal, tax and financial advisers at an early stage.
Questions
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