Challenges and Opportunities with Carve-Outs in M&A

21 Jan Challenges and Opportunities with Carve-Outs in M&A

Shoot The Moon

Challenges and Opportunities with Carve-Outs in M&A

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This episode is all about considering a Carve Out when starting on your M&A journey.

Key Discussion Points in this Episode

1. Carve-outs are when a company divests a non-core business unit that is a distraction or drag on profitability. If you have a non-core business unit, consider divesting of the non-core asset allowing for monetary gain, and more importantly, focus on core business lines.
2. Maintaining a separate P&L and balance sheet is critical when considering a carve-out. Buyers will need to understand what’s remaining and what’s being acquired.
3. Buyers must carefully account for shared services and their impact on the carve-out’s profitability.
4. Buyers should thoroughly assess the carve-out’s leadership, employees, and ability to operate as a standalone entity.
5. Carve-out valuations may be lower than a standalone business due to the added complexity and risk.
6. Carve-outs can provide a balance sheet boost and allow the company to focus on its core business.
7. Carve-outs with a limited customer base can still have significant value.
8. Communication about the carve-out should be limited to a “need-to-know” basis until the transaction is near completion.
9. Buyers must deeply understand the carve-out’s ongoing operations, financials, and what functions need to be filled.

EPISODE TRANSCRIPT

Mike Harvath  00:00 

Hello and welcome to the Shoot the Moon podcast! As you know, if you tune in regularly, revenue rocket is the world’s premier growth strategy. And M&A advisor to tech enabled services companies with me today my partner, Ryan Barnett, Ryan, welcome. 

Ryan Barnett  00:18 

Hey, Mike. Thanks for having me, and congrats and Happy New Year to everyone out here. We’re officially in 2025 and then excited to be a continue with the shoot the moon podcast. I think we’re already in a couple in. And so as on this podcast, we talk talk about things that we’re addressing and seeing every day in the M&A space, the merging acquisition space for IT services firms. So if you’re running a tech enabled services firm today, this podcast could help you grow through acquisition or sell when the time is right, or help refine and grow a strategy today, one of the topics we’ve seen and have been dealing with for a number of clients on both the buy side and the sell side is dealing with we’ll call a carve out. And essentially, as businesses grow and divisions start to multiply, sometimes it makes sense to get rid of some other visions and divest of divisions that are not living up to your core mission. And today, Mike, you’ve been dealing with this for quite some time. I wanted to pick your brain a bit on what a carve out is and what things to consider from both the buy side and the sell side and when you’re actually dealing with those carve outs. So Mike, help me out. What is a carve-out? 

Mike Harvath  01:36 

Yeah, sure thing. Ryan, so you know carve outs are. You may have an area of your business that’s not core that you feel is either a distraction or is a drag on your P and L or both, maybe that would have value to someone else that might be core. So examples of those things you know, might be a VoIP offering if you’re a managed service provider, or maybe a marketing offering, digital marketing, sort of, you know, we’ll call it mini agency within your business, that’s adjacent to a vertical market that you may focus on, or it could be, you know, some other hybrid distraction services. You know, you see a lot of firms that, you know, for example, do, they might do custom software development, AI development and manage infrastructure managed services. Or they might, you know, be have a small Microsoft apps implementation practice, yet their focus is more, you know, more modern work in the more traditional sense. And I can give you lots of examples of where you know, there might be a smaller practice within your broader firm that you feel is a distraction from your core. And so certainly, we’ve had plenty of clients over the years come to us and say, Hey, this is a distraction. We’d like to sell this as a carve out. And then we help we help them do just that. 

Ryan Barnett  03:09 

So Mike, something I just want to reiterate, or even come back to. So the concept here, and if you think about our talks on growth strategy, they’re oftentimes focused on specialization, verticalization and productization. Core to that message is specialization. So what I’m hearing Mike is, if a company has grown and perhaps you have gone into another line of business that you thought may be helpful to your vertical market or in other offerings or to just help you expand the role of the business. Sometimes taking on that business can be a distraction to the core. So what I guess I’m hearing from you is that it’s critical for an IT services company to have a core focus in executing that core 

Mike Harvath  03:56 

Absolutely. And that core focus is, you know, in our specialized, verticalized and productized mantra. It’s a specialized it’s the technical specialization that you have within your business. And I suppose it could also be technical and functional expertise, where you spend the lion’s share of your business, where you’re the best at it, kind of in your market, where you’ve kind of cut your teeth and grown your business, that is generally what we’re talking about. And oftentimes, when you get to a specific size, there may be a need to you may think, hey, there’s an adjacency here. Adjacency opportunity. You may organically start another practice, or buy another practice, even, which would certainly help clients do that, that where they felt that that adjacency would be a one plus one equals three, uh, kind of like I outlined earlier. But in fact, and in practice, when they’re working in that area, now it becomes a distraction and a dream of resources to try to cultivate that business. And they pretty quick. Come back to saying, you know, less is kind of more here, let’s focus our limited resources, because all firms have limited resources on our core specialization, and divest or carve out a business we may have built or cultivated. That was an adjacency, 

Ryan Barnett  05:18 

Right. And where we’ve seen this come in play. We’ve seen corporations that are they’ve started a division, and they realize this is not core, and I think core focus, and allowing you to really contribute all your effort towards a smaller set of offerings helps achieve more radical growth and more radical profitability. And so when you consider that divestiture, it’s a hard decision all but ultimately, that focus is going to allow you to grow faster, remove the distractions from from that core, and allow you to achieve things that you couldn’t do with almost that anchor of the division. So what we’ve we’ve definitely seen, we see this happen in IT services firms, a lot if this, if you start to specialize in one technology, and perhaps you have a smaller division, it’s still going to be profitable. Still be great division for cash flow. But if you’re pulling resources away from that to run, even if it’s shared services, it can be, it can be challenging for a firm to do. So Mike, how do carve outs? If you’re in a corporation and you want to carve out your business, how do you start? I mean, do you need to run the business with separate financials? Carving out seems like a it’s a very visceral word. What do companies need to do to help get into the mindset to divest of an asset? 

Mike Harvath  06:51 

Yeah, it’s a great question, Ryan. I think what’s important to note is that a separate from profit loss statement is a requirement to do a carve out, and likely you’re going to have to have a performa balance sheet, or a balance sheet that you create associated with the investments and or any debt that may have been incurred in support of that carve-out. Oftentimes it’s an easy conversation if, for example, you acquired an adjacency or a business that you thought would be complimentary to your core, and you got a loan to do that, certainly that loan is tied to that business, and makes good sense that it would be on a pro forma balance sheet. I think most of our clients, when they you know, are contemplating a carve out, they may have 1 P and L and one balance sheet. Or they may, if they’re really, you know, utilizing the best practice, maybe they have a separate P and L for that practice they’re going to carve out and a single balance sheet, right? Because you likely wouldn’t have two balance sheets. You could, but it wouldn’t be likely, and you got to create a sort of stand alone set of financials in order to be effectively able to have a conversation about, what is the carve out, what is the nature of the carve out? What are the assets and liabilities of that carve out, and how is it performing from a profit and loss perspective, 

Ryan Barnett  08:21 

Having a separation is the key. And Mike, if you’re buying a company to start, is it critical to I mean, how long do you keep a separate set of books for infinite case, just in case you need to carve it out again? Is there any best practices that you recommend when a company is dealing with the division to help that separation? 

Mike Harvath  08:46 

Well, there’s no right or wrong answer here, right? Right? I mean, there’s different approaches that have worked for a variety of our clients over the years. I would say that most of the time, if you’re acquiring a firm that you think you might have to divest of later, which is hard to contemplate if you’re if you’re in the mode of acquiring a firm to be a compliment, you likely will run it as a separate brand or a separate name, at a minimum, and run a separate P and L and a combined balance sheet. I would say that’s what we’ve seen most often by running the separate P and L, you can know how well that adjacency is performing, and you can be in a better position to make decisions around whether that be investing further, hiring, firing, just managing the business. Is it growing or shrinking? I think if you start to co mingle financials, especially too early, or brands, it can be much more challenging. Now, the only exception to that might be if you’re simply acquiring assets into your business. And oftentimes that’s an option. But even then, you know you might want to as a separate division with a separate P and L and or brand until it’s proven, and then you can certainly at your discretion, I guess in the future, probably merge those brands if it turns out that that’s what makes sense for your business. 

Ryan Barnett  10:15 

Yeah, that totally makes sense, and a company looks to do a carve out and perhaps taking that to market. And this is as much for buyers as well. How do you start to look at the shared people or the shared services that happen? I would argue that in the best case scenario of acquiring a company, you’re going to take some finance functions and some even perhaps sales or marketing or billing type functions and use those in a shared method. How do buyers account for for those services and when valuing the firm, as well as, how do you ensure that a carve out can run as a separate entity when things are co mingled? 

Mike Harvath  11:08 

Yeah, I think it’s always challenging, right? I mean, you’re going to have to provide some allocations on the cost side of the ledger for the value of those shared services, and there’s always opinions about what that’s going to look like, because oftentimes, when someone acquired the company and or you have shared services, or in general, you know you’re running a separate division with shared services, part of why you’re doing that is to get economies and use those shared services, if you think of it as a standalone business that can impact profitability materially and likely negatively of that division. And you know, because you may need to have more full time resources allocated to GNA and and believe me, again, there’s no right or wrong answer there, other than, I think you have to walk a mile on the shoes of the buyer, or if you’re the buyer, think of it that way, to be able to fortify, you know, the expected profit, because, you know, if you simply look at it in a shared services basis, it’s likely that that profit is higher than it would be if it was a standalone business. That’s the whole reason you’re sharing services is to get economies. And you just need to be realistic about, you know, what is it going to take to run this in a new entity? Now, with that said, Certainly that would be a best practice to look at it, but at the same time, if you’re looking to acquire or buy a carve out into an existing business. You could likely get some of the same economies, and could forecast the profitability with those economies, pretty, pretty logically, right, pretty, pretty confidently. And you know that that’s certainly a position to take. The only caveat would be you may be either overpaying or paying up in that scenario if you don’t fully contemplate or understand what an impact of a non shared services model would be to the DNA cost in a new if you were acquiring that carve out, 

Ryan Barnett  13:21 

okay, and that’s really where my next question goes is, are there certain things that buyers need to do to really dig in and understand the ongoing nature of the firm, and how does due diligence change as you start to look at a carve out, it seems like there’s some moving pieces and even some perhaps ongoing relationships that may continue in some of those shared services to make sure there’s a successful transition. So where do buyers need to dig in and really understand that ongoing nature? 

Mike Harvath  13:57 

Well, I think you have to look at the functions of the roles that are coming with that karma. Is there a leader right that can manage and lead through that transition that’s coming with? What kind of employees and roles do they play? And is that a situation where it can stand on its own right, and if not, what kind of cost would need to be incurred for it to stand on its own as you’re looking at your forecast for profit. Obviously, forecasting growth and profit in any acquisition is critical because it portends what your return rates are going to be on that acquisition. It also impacts the valuation if you’re doing proper valuation modeling around a DCF and sort of future performance as expected. And I think you know, if you’re contemplating a move like that, acquiring a business or that’s a carve out, even if it’s in your core business. So let’s say it wasn’t core for someone else that is core. For you, you have to look at it and say, you know, what will the contribution margin likely be in my business to be able to have a pretty good idea of what the return rates would be on the investment you’re going to make to acquire and, you know, that’s just kind of M&A 101, I think, critically important for you to think through that and make sure that your assumptions are accurate and tested, so that you can, you know one formulate a reasonable offer for that but, but you know, more importantly, understand how quickly will you get a return on investment once You do strike a deal with that seller 

Ryan Barnett  15:42 

and the so the moving parts you got to start to make sure that you’ve got the functions and the leadership there and accounted for the cash flow in what may be lost, as well as the strategic impact to the company. It seems like it might be harder for a financial company to really get their their arms around a car route, compared to a strategic company who is really could integrate into the current offerings and and I mean not to say that you can’t. There certainly are conglomerates that have very clean businesses that can simply be stripped out. I think in our world, IT services we, we see a little bit more blended type companies that are working together. So these, these questions about who stays, the functions that need to be covered, the systems that need to be transitioned in, like companies oftentimes make that best strategic type fit to make that happen. 

Mike Harvath  16:40 

Yeah, and I would just add to that, that a carve out acquisition can range everywhere from just, I’m buying customer contracts, no real P and L, simple asset deal, I’m buying, you know, a number of customer contracts. And because it’s core to my business as an acquirer, it’s easy for me to manage and facilitate the servicing of those contracts all the way through a going concern, or at least a model going concern, that would be a situation that would be required if you’re going to do an adjacency as an acquisition because, or, you know, if you’re a search funder, for example, You’re going to acquire a business that’s a carve out, you would have to have all the roles and responsibilities in it to manage and grow as a standalone entity. And there’s kind of different stops even between there right, everything from just to acquire the contracts to, you know, going concern, depending on sort of what staff may or may not come along at a particular carve out acquisition and how you would plan to staff those roles post deal. 

Ryan Barnett  17:53 

Okay, that absolutely makes sense. And Mike is people contemplate a sale or a car out of a division. How? How should? How should they treat their expectations for valuations? If there’s a bit of complexity, what I’m hearing is a bit of complexity and complexity, complexity typically equals risk, and risk oftentimes equals lower valuations. You know, should companies prepare for market type rates if they’re selling their business or something where it’s a not quite as simple as saying you’re going to get what a standalone business gets? 

Mike Harvath  18:34 

Well, it depends on the level, size and level of maturity of the cargo, right, and how much shared services are probably would utilize. You know, we’ve certainly seen carve outs that would warrant and we represented them to the market that would warrant a market based sales price, because they’re completely standalone. They’re part of a broader enterprise, but they’re very standalone. They may be in a different geography. They may be of the world versus the holco. They may do something different from the core business, right? And they they have their own team, kind of A to Z, their entire own team. It’s a standalone business within a much larger enterprise, and in those cases, that business will sell for market, right? Will sell if it were a standalone business period. Now, if it’s a business that has shared services, material, shared services, and there’s a lot of financial engineering that has to go into the assumptions to make a deal work. You can expect downward pressure on valuation, because, to your point, Ryan, you bring up, you know, it introduces risk. You’re assuming some risk that your assumptions are correct, they may be wrong, right, and you need to be able to have some as a buyer, you got. To be able to have some thick ice to account for, you know, things that may not been uncommon for, frankly, in your pro forma modeling on the business and and you know, as a result, likely pay a lower multiple on the free cash flow streams. 

Ryan Barnett  20:19 

Yeah, that all makes sense. Like this has been very helpful, if I summarize a few key points that I heard a carve out could be considered for a business if it’s non core to what you’re operating on today, and your core focus is critical towards revenue and profitability, to be able to just nail both of those. And so being able to have the control and wherewithal to divest a business, and it can be a very hard decision, can ultimately lead to a and we didn’t really talk about it, but it does bring a boost to your balance sheet. It does bring a boost in cash. So there, there are definite benefits to carve out, just from the financial side, that’s out and beyond a the core focus and anything that’s critical to understand that you can do a lot with the impact of that business and and how it you know, work together. Is there anything you wanted to dig in on that topic? Mike, 

Mike Harvath  21:20 

I’ll just make the comment that, you know, we find interesting carve outs that consist of, you know, material businesses that are a very limited number of customers, for example, that might have great contribution margin, maybe even down to one customer, right? And so those types of carve outs can have material value if they’re not core and you feel that the cash associated with a sale would be better utilized. Those resources would be better utilized either in acquiring a more core business or just fortifying your balance sheet. You know, like, we like to say, add more thick ice or more cash to your balance sheet, to whether any potential storms that might be coming. And so, you know, when you think about a carve out, don’t make assumptions about, you know, is this a viable carve out sale because it’s a limited number of customers, or maybe it has some it’s declining asset, meaning you’re not paying attention to it, so it’s shrinking. You may think some of that stuff just doesn’t have much value, but that’s not necessarily the case. And I guess that’s where a firm like revenue rocket comes in, or an M and A advisor who help you sort of validate and confirm your assumptions about you know, what is the value of potential carve out? Should we exercise our options here to divest of this potential? Carve out if you’re a seller and just get a third party opinion, because you know, you’re pretty close to it, and your assumptions about it may be wildly off one way or another, and having an informed opinion about the value of that carve out and the positioning and posturing of that carve out for a successful transaction, or even just to get a feel for the value of it, is best suited through a conversation With a qualified m&a advisor. Likewise, if you’re contemplating buying one, there’s a ton of things that you have to think about. We’ve highlighted some of them today, but certainly there’s more and you would want again, third party thinking and validation about, you know, could this adjacency or this core acquisition of either customers or carve out, you know, be accretive to our our growth and our P and L, and does it make sense? And you know, what is a fair price to pay for that? 

Ryan Barnett  23:51 

Yeah, no. Thanks for digging into that. And like, there was one other question I before we wrap up that I did want to ask, and maybe it’s nuanced, but if you’re part of the division that’s being carved out, who needs to know about the carve out? Like, is it, if you’re running the division and you’re learning about it being carved out, is that too late, and if you’re on the other side, is it the CEO CFO to kind of helping guide to that process, but who needs to know about it versus the people who perhaps aren’t going to know about it? 

Mike Harvath  24:29 

Yeah, it’s important to understand that, you know, in any M&A transaction, sort of from a reach and a knowledge perspective, glass is more like you want to have the folks that it’s sort of a need to know basis rule, and those that need to know should be in the know at the appropriate time. And so in a carve out, whoever’s leading that carve out, obviously, and the you know, ultimately, the team that will go with that carve out will need to know. It’s just, when do they need to know? I think if they’re a leader in that group, they probably need to know early and often what your intentions are, and you need to validate your plans with them. Usually, that represents more opportunities, not less, for that leadership group and the team in that carve out. Because let’s just say it’s not core. Maybe it’s not getting supported the way it should, and they would be happy to be part of something where it was much more core company, that where it was much more core to their business. It gives them more career opportunities and a variety of other opportunities that may not exist in the existing firm. And then, you know, in a need to know basis, as you get closer to a transaction with a real buyer, then the whole team needs to know. And typically we say that full notification should happen within a week or so a close pursuant to a deal being fully negotiated and papered and just waiting to get through final closing steps. 

Ryan Barnett  25:54 

Yeah, that helps keep things tight to the best until the until the transaction is complete or very, very near to complete. But Micah, the other things I heard from you is that it’s critical for buyers to really understanding the ongoing nature of the firm, so the people process technology that are coming with those assets in that transaction are critical to know. I heard you mentioned it’s very important to have financials that are clean to understand what’s in and out of the business, and that likely a pro forma balance sheet is going to be needed to help address the balance sheet related items. I heard you just mentioned keep the team tied to the best. I heard you mentioned that due diligence, you’re going to have to really go in and understand the ongoing nature and exactly what functions you need to fill and how that hits profitability. And I heard you say that watch for customer concentration and some in some of these accounts from a buyer, and understand that those can be absolutely fantastic customers as for a buyer, and there’s a great reason for doing any kind of transactions like this. But that’s all the questions I’ve got for you. I’ll turn it back over to you. Mike, 

Mike Harvath  27:15 

Thanks, Ryan. With that, we are going to tie a ribbon on it for this week’s Shoot the Moon podcast, and look forward to you all tuning in next week when we unpack further gross strategy topics M&A topics that hopefully are relevant to you and your business. With that make it a great week.