Large corporates divesting subscale businesses effectively

July 2023  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2023 Issue

As sunset follows sunrise, divestitures are a natural part of the M&A lifecycle for large corporations. In 2021, there were divestitures globally worth over $2.1 trillion in deal value. Most large companies are doing ongoing or at least regular reviews of their portfolio of acquired businesses.

This is often done as part of the annual budget process and the annual or biannual strategy refresh process. But during a down-market there is often increased focus on evaluating portfolios and divesting businesses that are deemed off-strategy. This often includes subscale businesses that were either built or more often acquired, but which proved off-strategy. In some cases, there was an assumption of synergies that proved to be false.

Acquirers often assume they can drive cost savings by combining operations and leveraging shared technology, operations and offerings. They also see the potential for incremental revenue by leveraging existing customer relationships and larger parent company sales operations. But the reality of complex deal integration often causes these assumptions to be over-optimistic. In other cases, the strategy of the company shifted away from the segment or offering targeted by the business.

Particularly in rapidly evolving businesses like technology or financial services, what was a core part of the strategy five or 10 years ago may have been leapfrogged by higher priorities or changing customer needs. A recent KPMG study suggests that more than eight in 10 acquisitions fail to enhance shareholder value because of poor planning, poor execution or both, while by contrast most executives (82 percent) believed their deals were successful.

Over the 2022 budget cycle, many large corporates conducted such portfolio reviews with an increased focus on rationalising their businesses and a higher bar for both financial performance and strategic fit. As is often the case, during a strong market where companies are experiencing strong growth and margin expansion, there is less pressure to shed assets or cut off funding to underperforming businesses. As we ended 2022, many companies put a sharper focus on streamlining their operations and identified more businesses – large and small – to shed.

For large businesses, there is more capital at stake and thus more resources that can be deployed, including hiring bankers and advisers. But for subscale businesses, the company often struggles to divest in a cost-effective manner. Additionally, for these subscale divestitures, the parent companies’ priorities are often shifted away from purchase price (given their small size).

Corporate sellers are seeking a range of outcomes including strong and undamaged employee morale, strong and undamaged customer satisfaction, limited operational distraction, few if any ongoing operating obligations (or if they exist, making sure they are highly profitable) and very limited legal liabilities. For subscale divestitures, these non-price variables expand in importance. When a small business is being sold, the purchase price received is unlikely to be impactful or even relevant to the parent company. It is often outshone by other terms and structures of the deal.

Small divestitures often have an impact on employee morale. Current employees are likely to maintain contact with those in the divested business and how they are treated can have an impact on the morale of the employees retained. Beyond that direct impact, most companies have a standard of employee treatment they would like to extend for at least some time to employees who they hired but are now going with the divested business.

Sellers often want to ensure that a buyer will maintain similar levels of compensation (base, bonus and equity) as well as other benefits, including most notably health insurance. Sellers may also want to ensure that transferred employees are retained for at least a certain period of time. They may select buyers and even sacrifice some purchase price to make sure that at least their former employees are treated well.

Perhaps even more important to most sellers is customer morale. In most cases when you divest a small business, the customer contracts travel with the business. So technically, the seller has no ongoing responsibility for delivering the goods or services to the customer in an effective, timely and quality manner. This assumes the contracts are transferrable, which is something a seller should consider before beginning a divestiture. However, bearing no legal obligation is not the end of the story. In most cases, customers of the divested business are also ongoing customers of the parent company for other goods and services (this ties to the point above about revenue synergies as a driver of the original acquisition).

And these customers are unlikely to neatly bifurcate their experience with the buyer from their views of the parent company. Rather, they are likely to view the parent company as bearing the responsibility for ensuring they receive the goods and services they were originally sold, at least through the first contract renewal post-divestiture. A failure of the buyer to keep those customers happy is likely to have an impact on the parent company’s broader relationship with the customer.

In an extreme case, the sale of a subscale business for perhaps $4m could actually put a $10m customer relationship at risk for the parent company. So the seller will often want to create obligations of quality customer delivery a part of any divestiture to protect those relationships.

Corporate sellers also need to consider the ‘overhang’ of legal liabilities in any sale. As general counsel will be eager to point out, the sale of a business often comes with extensive representations, warranties and indemnifications that can last years. The heavier those legal obligations, the greater the chance the buyer will come seeking recompense which could, for a small deal, theoretically overshadow the entire purchase price received. When divesting a subscale business, there is good reason to limit those legal liabilities, particularly if that can be done in exchange for a relatively modest reduction in purchase price.

Brand is another important variable for the seller to consider. The very fact that it is divesting a business can have a negative impact on its brand, as can no longer having a particular offering. In some cases a seller may want to characterise the divestiture to address these effects. The seller may want to characterise the sale as a ‘joint venture’, where the buyer is simply taking day-to-day responsibility for the operation. It may want to make sure the market knows it will continue to offer the product or service through some kind of a partnership or channel relationship.

In other cases, it may want to publicise the divestiture to demonstrate an increased focus on other areas or a streamlining of the business. This messaging may be particularly important for public investors and more so in a down-market. Being able to craft the public messaging around the deal may lead a seller to select one buyer over another and to be more flexible in price negotiation (again, where the incremental reduction in price is worth the control over public or customer messaging).

Minimising distraction and accelerating the sale process is another non-price variable that should be considered by sellers. A divestiture process can be a heavy lift for the parent company team. The work required to provide a buyer with diligence information, disintegration planning and post-deal support of a divested business through a transition services agreement, can last for months or in some cases years. Since presumably the team that does this work is being pulled away from more strategic priorities of the company, there is a strong incentive to minimise the time they spend on this work, and often that can be the subject of negotiation with a buyer – for example, limiting any transition services to the ‘plain vanilla’ services currently provided to the subsidiary without any custom or new things.

The other side of the coin on transition services is the potential for that relationship to generate very high margin ‘leave behind’ incremental revenue for the seller. Since a buyer will usually pay for transition services, making a long-term commitment to buying services or licensing technology from the parent part of the deal is often a way for the seller to ‘turn lemons into lemonade’ with a contracted stream of high margin and certain revenue. Examples can include long-term licences for technology platforms that are currently shared by the to-be-divested business and other businesses to be retained, continued provision of shared services like finance, HR, IT or real estate.

There is an art as well as a science to doing these subscale divestitures for both the corporate seller and the acquirer. Effective divestiture of subscale businesses can have a substantial financial and strategic impact on the parent company. While maximising sale price may not be as important given the relative size of the business and the parent, avoiding negative outcomes and maximising positive ones in these non-price areas can have an outsized impact. Effectively positioning the transaction in terms of corporate brand, employee and customer relations, and even ongoing sources of revenue and value, can have a big impact on the seller, and are well worth focused effort during the divestiture process.

 

Michael Frankel is the founder and managing partner of Trajectory Capital Partners. He can be contacted by email: michael@trajectorycapital.com.

© Financier Worldwide

BY

Michael Frankel

Trajectory Capital Partners

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