What are Divestitures
In the world of M&A, divestitures are probably the most complex type of transaction. Unlike standard M&A where you buy and sell companies, a divestiture is a bit more complicated. By definition, a divestiture is the process of selling business assets such as product lines, services, subsidiaries, properties, or even an entire business sector of a company.
Why do Divestitures?
Businesses get rid of assets all the time for various reasons. The most straightforward explanation is bankruptcy, where the company needs to liquidate all its assets to receive some cash in return. But aside from this worst-case scenario, there are a lot of other reasons why companies go about a divestiture:
As a company grows and acquires more assets, some of the existing businesses might no longer be part of their core strategy. Corporate strategy changes depending on technology developments, consumer demands, and other external factors. If so, divesting the said business might be the best route.
Because the business is no longer part of its core strategy, it will stop getting the attention or resources required to reach its full potential. At this point, this business might be better off with a new owner. This approach is typically seen from proactive buyers who acquire multiple companies annually and eventually need to dispose of some of the assets.
The perfect example of this is Roche Diagnostics. Back in 2007, Roche divested three pharmaceutical products to Actavis - Bezalip, Rapilysin and Neotigason, with the purpose of focusing on therapy and diagnostics.
Some companies might sell their business simply because they need to raise cash for better opportunities. They might need cash for another acquisition or to license an intellectual property of some sort.
The most common type of a divestiture is when a company sells assets or products that are not performing to their potential. The owner can sell this asset in the hopes that it may be worth more to someone else than it is to them.
In 2013, the world’s biggest food group, Nestle, sold its weight management business, Jenny Craig. The Jenny Craig business in France was not part of the deal, as they only sold businesses in North America and Oceania to a private equity firm North Castle Partners. This was part of their project to divest underperforming brands so they could focus more on their leading brands including Nescafe Coffee and KitKat Chocolate.
Sometimes, divestitures are required and mandated by the Federal Trade Commission as part of the antitrust law. This law prevents monopolies from controlling a specific market sector and ensuring healthy competition in the market after a deal is closed.
One of the largest court-ordered divestiture was back in 2015, when supermarket operators, Albertsons and Safeway Inc, merged with one another. According to the FTC, these two companies competed heavily on product variety, price, and services. The merger would have lessened the supermarket competition and negatively impacted consumer experience. The FTC forced them to sell 168 supermarkets before they would approve the deal.
What makes it hard?
As mentioned before, executing divestitures is not as easy as buying and selling a company. The biggest difference lies within the fact that in divestitures, you are selling an asset that has never stood independently apart from the parent company. More often than not, this business will have shared services with the parent company that will no longer be part of the sale process.
The best example of this would be infrastructure. The business that you are selling is probably housed inside your company building. If a buyer suddenly decides to buy your business, they will have to have a ready infrastructure to take in their newly acquired asset. If not, that's when things can get complicated as the transaction will need a transitional service agreement (TSA).
This also includes a shared workforce as there will be people working for the parent company but that are also touching the divested business. The most common example of this is human resources. It is highly unlikely that a business will have multiple HR departments, especially a dedicated one to a particular business segment. In some cases, this can also apply to production and operations management.
Lastly, a company will rarely have a complete standalone set of financial statements for the same business being sold, but buyers will want to see how the business is doing to assess viability and profitability from a financial standpoint. This can be highly complex because of the shared services and the dependence of the business to the parent company.
What are T.S.A.s?
A transitional service agreement (TSA) is an agreement or contract entered into by the buyer and seller of a business. The purpose of this agreement is to bind the seller to provide certain services necessary to operate the company that has just been purchased. These services can include HR, accounting, IT, or even just leasing the infrastructure. In exchange, the buyer then agrees to pay the seller for said services, for an agreed price, for a certain period of time.
As mentioned before, TSAs are necessary for divestitures if the buyer cannot operate the business post-close. The TSA outlines all the essential services that the buyer will need from the seller, with a predetermined end date, price to be paid, and other limitations and conditions.
The process of divestiture is much more complicated than a typical M&A process. It has complexities that will be detailed as you go through execution.
The process starts by clearly defining the asset that you want to dispose. It might sound simple, but this could get complicated very quickly because of the shared resources with the parent company. You need to decide what equipment, furniture, office supplies, computer, and other essential materials will come with the sale. Without the deal perimeter, you won't be able to continue to the following steps properly.
The next step in a divestiture is to identify which employees will go with the business for sale. There will be a core group of people dedicated to running the company that is being sold and who will have to be included in the transaction. However, It gets blurry and complicated for the people that are in the role of the shared service.
People sharing is widespread in any business, like an HR department that runs the entire organization with multiple business segments. If you are selling a software product, the people who developed it in the IT department might be included in the sale. It's primarily subjective on who you want to include in the deal, but the general rule of thumb is that if more than 50% of an employee's time is dedicated to the business being sold, they will most likely be included in the sale.
Typically, the seller needs to communicate the intention to sell with the people within the ring fence. This conversation is usually accompanied by a retention plan to let people know they are locked in once the deal goes public. It means that they will not be eligible to apply for roles outside of that ring-fence within your company.
Due to the dependency of the business to the parent company, such as the shared services of some of the employees and equipment, the business for sale will most likely not have a standalone financial statement. If you are selling this business separately, then you have to come up with financials that will tell the story of how it looks like as a standalone business.
Financial statements are documents that show the financial activities of a business or a person. It also shows the assets and liabilities of the business, as well as the cash flow periodically. These are extremely important because this will be the baseline of the buyer’s due diligence. You need to have these ready before you even consider talking to buyers.
Before you can actually come up with standalone financials, you need to have identified the scope and the extent of the sale process, and who will go with the business. Identify and remove shared services from the financial statements to get a clear picture of what the business looks like independently. The structure of what you're selling will drive the structure of your financial data.
You will also need to come up with several years worth of standalone financials to show stability, consistency, and profitability. This will need to be audited by a third-party auditor.
Due diligence is an excellent way for buyers to fully understand the business value and risks of acquiring the target company.
It is also in the seller's best interest to conduct due diligence on their own business. This will reduce surprises that the buyers might see during their diligence, and if detected early, it will give the seller a chance to fix the problem before engaging with the buyer.
Furthermore, it will allow the seller to better understand the value of their business and bridge the gap between expectations and reality. This is often the number one cause of prolonged negotiations as buyers and sellers can't agree on the purchase price.
One of the essential parts of understanding the value of the business is a quality of earnings report (Q of E). This is usually done by an outside party to ensure parity and objectivity. The Q of E report concept is to understand the business's regular, average run rate without any one-time costs or events. It's usually derived using earnings before interest, taxes, depreciation, and amortization (EBITDA) before adjusting and removing the one-time events.
Looking for a Buyer
After all the preparation is complete, the seller will be ready to sell the business, and it's time to look for buyers. If the seller already has a buyer in mind, then they should be pretty straightforward. If not, there are a couple of ways to find buyers.
The first and the most common approach is to hire an investment bank. Bankers will help you find buyers for a certain fee. The good thing about bankers is that they have many connections that will allow them to find multiple buyers, which will most likely end up in an auction process. The more potential buyers you have, the higher the price.
However, if you have adequate manpower in your corporate development team and don’t want to pay to use an investment bank, you can always find buyers yourself. You can start by contacting competitors, suppliers, or anyone else within your ecosystem.
Divestitures are done due to various reasons and can be highly complex especially with all the entanglements of the business asset to the parent company. If you want to learn best practices in executing your divestitures, be sure to subscribe to our podcast at mascience.com