8 June 2011
Services agreements are becoming more important in mergers and acquisitions (M&A) as companies increasingly rely on external providers for critical functions. Early attention to services agreements in M&A planning, due diligence and negotiations can increase deal value for, and mitigate risk to, both buyers and sellers. This article describes best practices for buyers and sellers in addressing services agreements in connection with M&A transactions.
Changing Business Structures Are Creating New Opportunities
Intense cost pressures have forced companies to reduce the costs of performing services1 that support their core businesses, such as information technology, human resources, finance and accounting, procurement and facilities management. One effective way to reduce those costs is to outsource traditionally internal functions to service providers that can offer both economies of scale and service delivery centers with world-class tools and processes. Thus, a company being bought and sold in an M&A transaction (which we refer to as the target company here) is increasingly likely to depend on services being provided by multiple unaffiliated outsiders.
M&A practice evolved in an era when “third-party services agreements” could generally be ignored until the transaction was nearly final. Even today, deal teams often focus on the M&A transaction first, leaving the services agreements and other post-closing operational details until the frantic rush to signing, or sometimes even as a post-signing or post-closing item.2 In many cases, the people who know what services are needed and who can provide them are excluded from the deal team until very shortly before, and sometimes even after, the M&A agreement is signed. As a result, deal teams can sometimes miss opportunities to preserve the value of existing agreements and mitigate the risk of leakage of all or some of the transaction’s economic benefits to a third-party service provider.
In this regard, there are a number of opportunities to increase deal value and mitigate risk. These include:
- Existing third-party services agreements used only by the target.
- Existing third-party services agreements shared by the target and the seller.
- Steps that potential sellers can take to prepare for future M&A transactions.
- Steps that potential buyers can take to prepare for future M&A transactions.
Existing Third-Party Services Agreements Used Only by the Target
If the target of the M&A transaction is the only business in the seller’s corporate group using a services agreement, the easiest approach is generally to have the target continue using the existing agreement (and being bound by the existing agreement) after the acquisition. However, services agreements often prohibit assignment or change of control. Savvy third-party providers can, and often do, use those prohibitions as leverage to exact a price for the ease of continuing the services agreement—particularly if the existing pricing is not favorable to the provider, or if it is costly to replace the agreement.
Replacing an existing services agreement creates operational risk and might be surprisingly costly due to early termination fees or minimum volume commitments. Similarly, adding the target as a service recipient under the buyer’s existing arrangements may require lengthy negotiations with the buyer’s third-party providers.
Replacing third-party providers on complex or large-scale services agreements often takes far longer than the M&A deal cycle and may require the involvement of people beyond the M&A team’s “circle of knowledge.” Rushed negotiations may result in substantial opportunity costs. In many cases, better pricing is available to customers that have the time to identify their true needs, conduct a robust sourcing process and make long-term commitments. For a large-scale agreement for a critical service, this process can take three to twelve months from start to finish.
The current service provider’s leverage will grow as the closing date of the M&A transaction approaches and the buyer’s options narrow. As a result, there is a risk that the current provider’s demands will grow with its leverage.
Existing Third-Party Services Agreements Shared by the Target and the Seller
If the seller and the target both depend on one of the seller’s third-party services agreements, the target may be able to continue receiving services from the provider as a “service recipient” under the existing agreement, even after the buyer acquires the target. The seller would then invoice the target or the buyer for target’s allocable share of the charges under the existing agreement.3 This method has the benefit of preserving the value of the existing agreement, if it works. In considering this option, the parties should address questions such as:
- Does the seller have the right to designate the target or the buyer (as applicable) as a service recipient? If so, what are the associated costs (e.g., for set-up or third-party consents)?
- Will the terms of the existing services agreement meet the buyer’s needs?
- Does the pricing permit the seller to allocate charges to the target or the buyer?
- Will the buyer have the right to require the seller to dispute charges or make claims for damages under the existing agreement?
- Will the buyer have the right to audit the provider? Audit rights may be required to comply with legal obligations or the buyer’s policies.
- Who prevails if the buyer and the seller disagree • on directions to be given to the provider (e.g., with respect to in-flight projects)?
- Which party will own the intellectual property • (IP) developed by the provider in the performance of the services agreement?
- Will the seller be liable if the buyer fails to comply with • the existing agreement? The risks of adverse consequences to the seller due to buyer noncompliance will be particularly troublesome if the existing agreement is critical to the seller’s retained organization.
- Will the seller be liable to the buyer if the service • provider fails to perform, or if the services are otherwise deficient? In other words, is the seller responsible for its third-party provider’s services, or is the seller merely managing and passing through those services to the target or the buyer on an “as-is” basis?
Another approach is to negotiate a new contract with the provider to continue the service. This approach provides a much easier separation between the buyer and the seller and allows the buyer to assess the existing third-party provider against its competitors to obtain the most favorable pricing and other terms. However, this may result in the buyer losing value because the new services contract covers only its own volume. A new contract may also cause the seller to lose value because it may pay higher unit prices under the existing agreement (or even face termination or termination charges) because of the reduced volume. Time constraints often make this approach impractical.
In some cases, there is an easy path to obtaining a new contract with the service provider because the seller has a right to split the existing agreement in a way that preserves its value (i.e., “cloning”). Or, the seller may be able to create two new agreements that divide the service scope, revenue commitments, termination charges and other similar terms of the existing agreement (i.e., “cleaving”).
Cloning can have unintended consequences. For example, it might have the effect of doubling minimum revenue commitments or of requiring the provider to dedicate a specific person or asset to multiple customers. Thus, cloning is generally used only for simpler services agreements.
Cleaving means reducing service volume baselines and minimum charges under both the existing agreement and the new agreement. But it also can mean allocating key personnel, intellectual property rights, rights to dedicated assets upon a termination and other key resources and assets between the existing and new agreements. New projects may also be required to separate service delivery facilities, teams and reporting capabilities for the buyer and the seller; to decouple the seller’s confidential information from the buyer’s confidential information; and to adapt to the buyer’s unique needs or integrate with the buyer’s systems.
Cleaving typically involves more negotiation than does cloning. The provider has likely scaled its service delivery organization for the combined volume under the existing agreement. As a result, the provider sees more economic benefit in providing services under two similar agreements, without the costs of negotiating a new agreement, than in any increase in per-unit charges that may result from the cleaving. At the same time, the service provider may see an opportunity to obtain provider-favorable terms and pricing in return for continuing to provide an essential service, particularly if the buyer has run out of time to find a different provider.
Steps that Potential Sellers Can Take to Prepare for Future M&A Transactions
Sellers can take steps to position themselves to maximize value and mitigate risk. These steps include:
- Developing an organization to support divestiture activities, with an “M&A Playbook” and a staff for supporting divested businesses.
- Maintaining a database of services agreements and the businesses that they serve.
- Ensuring that outside service providers are committed to (i) taking on work, shedding work, supporting divested businesses, and providing M&A support upon request; and (ii) permitting the seller to clone or cleave existing agreements.
- Ensuring that outside licensors, lessors and similar third parties have agreed to allow their software or assets to support divestitures, at least for a minimum time period.
- Including in the divestiture team, at an early stage, the people who will be responsible for arranging services to be provided by or for the seller.
- Analyzing the target’s internal servicing capabilities, the services the target needs from shared contracts or from the seller’s organization, any services the target provides to the seller’s organization, the costs required to provide those services, the effect the divestiture will have on the seller’s retained organization (including pricing impacts under existing services contracts), and how best to provide the needed services.
- Identifying projects under third-party services agreements that the buyer may not need and that should be put on hold pending a transaction.
Steps that Potential Buyers Can Take to Prepare for Future M&A Transactions
Buyers also can take steps to maximize value and mitigate risk. These include:
- Incorporating rights to expand services and obtain acquisition support into third-party services agreements.
- Developing an organization to support acquisition activities, with an “M&A Playbook” and a staff with responsibility for supporting acquired businesses.
- Identifying in advance any services that will need to be replicated or replaced, as well as the means to mitigate the impact of service failures.
- Documenting services and associated service levels that the buyer’s own internal services organizations can perform for acquired businesses, and determining the expected timing needed to bring those services online for a target.
- Assigning to the acquisition team, at an early stage, the people the buyer will use to procure the needed services from a third party.
- Commencing negotiations with third-party service providers as promptly as possible.
- Leveraging best practices developed in outsourcing and large-scale agreements for critical services.
Dramatic changes in the ways that companies source core business functions require timely, substantial attention to services agreements in M&A transactions. Leaving these issues to the end of a deal can cause delays, squander value, increase risk and lead to disputes. The best time to begin developing services agreements is well before the target is identified. Integrating the approaches described in this article into contracting policies and overall M&A strategies and approaches can help both buyers and sellers to maximize value and mitigate risk in M&A transactions.
||1. In keeping with current terminology for strategy consultants and technology architects, this article uses the word “services” broadly to include back-office processes, functions and capabilities, including all of the underlying people, systems, technology, facilities and other resources, along with the set-up, operation and disengagement of those service|
||2. In some cases, leaving service agreements to a later stage in the M&A process is a conscious decision driven by the seller, the buyer or both. Factors such as confidentiality, the buyer’s familiarity with the target, limitations on internal resources and cost can drive such a decision. |
||3. For simplicity, we are assuming that the existing agreement is between the third-party provider and the seller. Typically, the principles stated here would also apply if the agreement were between the third-party provider and the target.|