20 Feb Carve-Outs in M&A for Tech-Enabled Services: A Deep Dive
In the dynamic landscape of mergers and acquisitions (M&A) within the tech-enabled services sector, carve-outs represent a strategic maneuver where a company divests a non-core business division or unit. This is often driven by the recognition that these non-core components may be distracting management focus, draining resources, or hindering overall profitability. For example, you might be a Managed Service Provider (MSP) with a VoIP offering that is dragging your P&L. There might be a smaller practice within your broader firm that you feel is a distraction from your core and 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, so we help them do just that. By shedding these elements, the parent company can realign its strategy towards core competencies and enhance its financial performance.
The Importance of Core Focus and Specialization
For tech-enabled service companies, maintaining a sharp focus on core offerings and specialized expertise is paramount. While diversification into adjacent markets might appear enticing, it can often lead to a dilution of resources and a loss of competitive edge. Carve-outs enable companies to recalibrate their strategic direction by divesting non-core business lines that have drifted from the central value proposition. This renewed focus can lead to improved operational efficiency, optimized resource allocation, and ultimately, enhanced growth and profitability.
Revenue Rocket has developed a method for a systematic business transformation bringing critical stakeholders out of the reactive and into the proactive, allowing your firm to become a top quartile performer. We do this by implementing our Specialize, Verticalize, and Productize model – SVP. The SVP model enables you to:
- Create a unique and differentiated added-value offering
- Making offerings easy for customers to understand and buy
- Enable sales and marketing teams to create and close more leads
If your firm isn’t compatible with the SVP model due to distracting business units or offerings, think about carving out those units so your business can refocus on its core offerings.
Practical Steps in Executing a Carve-Out
The execution of a carve-out involves a series of meticulous steps to ensure a seamless transition. A crucial aspect is the maintenance of separate financial records, including profit and loss statements and balance sheets, for the division being carved out. This financial segregation provides transparency and facilitates a clear understanding of the division’s financial health, which is essential for accurate valuation and due diligence. Here are the key steps for execution:
- Establish separate financials: Ensure the division being carved out has its own profit and loss (P&L) statement. This provides the necessary financial transparency to understand the performance of the carve-out.
- Create a pro forma balance sheet: Develop a balance sheet specifically for the carve-out division, including any assets, liabilities, or debt associated with that part of the business.
- Determine shared services: Identify any shared services (e.g. finance, HR, IT) that the carve-out division utilizes from the parent company. Allocate the costs of these shared services to get an accurate picture of the carve-out’s profitability.
- Assess leadership and staffing: Evaluate if the carve-out division has the necessary leadership and staffing to operate as a standalone entity. Determine if any additional hires or restructuring is required.
- Maintain separation: Run the carve-out as a separate brand or division with its own identity. This helps preserve the integrity of the financials and operations.
- Communicate strategically: Only share information about the carve-out on a “need-to-know” basis, especially with the carve-out team. Provide full notification to employees close to the transaction closing.
- Obtain third-party validation: Engage an M&A advisor to help validate assumptions about the carve-out’s value and positioning for a successful transaction, whether for a sale or integration.
Considerations Around Shared Services
In many cases, the division being carved out may share certain services, such as IT infrastructure, human resources, or marketing, with the parent company. These shared services can have implications for both the valuation of the carve-out and the due diligence process for potential buyers. It is crucial to clearly define the terms of service agreements, allocate costs appropriately, and ensure a smooth transition of these services to the new ownership structure.
Strategic Impact and Buyer Considerations
Carve-outs can have a profound strategic impact on both the seller and the buyer. For the seller, it allows for a realignment of strategic priorities and a sharpening of competitive focus. For the buyer, it presents an opportunity to acquire a business unit with established market presence and customer relationships without the complexities of a full-scale merger. Key factors that buyers need to evaluate include the quality of leadership within the carved-out division, the functionality of its operations, and its ability to operate as a standalone entity.
Customer Concentration and Relationships
Understanding the customer concentration and ongoing relationships within the carved-out division is critical for potential buyers. A high degree of customer concentration may pose risks, while strong and diversified customer relationships can provide a solid foundation for future growth. It is essential to assess the potential impact of the carve-out on customer relationships and develop strategies to ensure a smooth transition and continued customer satisfaction.
Communication Internally & Externally
Communication internally and externally is an important consideration during the carve-out process:
Need-to-know basis:
- Initial Communication: In the early stages of a carve-out, communication should be restricted to those who have a genuine “need to know.” This is to maintain confidentiality, prevent unnecessary anxiety among employees, and ensure that accurate information is disseminated by those directly involved in the process.
- Leadership and Carve-Out Team: The leaders and team members who will be part of the new carved-out division need to be informed early in the process. This allows them to provide input, validate plans, and prepare for the transition.
- Understanding Opportunities and Implications: Early communication with the carve-out team allows them to understand how the carve-out will affect them, both personally and professionally. It also allows them to identify potential opportunities for growth and development within the new company structure.
Timing of Sharing the full news:
- Full Notification: Once the deal is finalized, the entire carve-out team should be notified within a timely matter.
- Ensuring Transaction Completion: Waiting until the deal closes ensures that the transaction is fully negotiated and legally finalized before broadly communicating the news. This prevents misinformation and confusion among employees.
Benefits for the carve-out team:
- Leadership Opportunities: Being part of a carve-out can present new and exciting opportunities for the leadership team. They may have the chance to take on more responsibility, expand their skillset, and lead the new division to success.
- Career Growth Potential: In a smaller, more focused company, the carved-out division may be more core to the overall business strategy. This can lead to increased visibility, greater career growth potential, and new opportunities for advancement.
Importance of validation:
- Early Involvement of Carve-Out Leaders: The leaders of the carve-out division should be involved early in the planning process to validate the plans, provide feedback, and understand the implications of the carve-out.
- Smooth Transition and Buy-In: Early involvement helps ensure a smoother transition and fosters buy-in from key personnel. It also allows the leadership team to address any concerns and communicate effectively with their team members.
Additional Considerations:
- Communication Plan: Developing a clear and comprehensive communication plan is essential for a successful carve-out. This plan should outline the timing, content, and channels of communication for different stakeholders.
- Employee Engagement: Maintaining employee engagement throughout the carve-out process is critical. Regular communication, meetings, and opportunities for feedback can help employees feel informed and valued.
- Change Management: Implementing effective change management strategies can help employees adapt to the new company structure and culture.
- Cultural Integration: If the carved-out division is being acquired by another company, cultural integration will be an important consideration. Leadership should proactively address cultural differences and foster a sense of unity among employees.
The key is balancing the need for confidentiality early on, while also engaging the carve-out team in a timely manner to get their input and set them up for success in the new entity. Clear and strategic communication is critical throughout the carve-out process.
Carve-outs represent a strategic tool for tech-enabled service companies to optimize their business portfolio, enhance their core focus, and unlock value. By carefully evaluating non-core business units, executing a well-planned carve-out process, and prioritizing clear communication, companies can position themselves for sustained growth and success in the competitive tech landscape.
If you’re considering a carve-out, reach out to Revenue Rocket for a no-obligation introduction call: info@revenuerocket.com