Transaction Advisory Services

Divesting for value

Contents
Executive summary 01
In strategically managing their capital, companies are looking to divestitures and spin-offs as a tool to raise capital and enhance shareholder value. This requires a proactive, comprehensive and strategic approach.

Tax issues and consequences 15

by Todd Miller Attention to tax issues can lead to more efficient deal structures and higher valuations.

Proactive portfolio management 03

by Doug Campbell Proactive portfolio management brings strategic benefits and improves divestiture outcomes; a rigorous process helps enhance shareholder value.

by Regina Balderas and Brian Pastroff As companies increasingly turn to spin-offs they need to appreciate the benefits and complexities before committing to the task.

Considering the tax-free spin 17

Transaction strategy 05

Operational preparedness 20

by Jim Carter and Kevin Magee Sellers must understand who buyers are and what they want before engaging.

by Andy Lorenzetti and Neil Desai Operations are the heart of divestiture value. Sellers must retain focus on the business and plan a smooth transition to a new structure.

Sell-side due diligence 07

by Brent Borio Sell-side due diligence is a cornerstone of effective divestiture execution, enhancing both seller credibility and deal value.

Effective divestiture management 23

Carve-out financial statements 09

by Mitch Berlin Leadership, project management and clear communication are needed to cleanly divest a business that preserves its value and ability to perform from Day 1.

by Brent Adam and Bill Keirse Carve-out financial statements help present a clear and credible picture of the future stand-alone business.

Conclusion 25

Careful preparation can help companies extract greater value, increase speed to close and minimize disruptions to the core business.

Divestitures in a private equity setting 12

by Frank Petraglia and Philippe Leroy Private equity firms focus on maximizing selling prices.

Executive summary

As companies reassess how they strategically manage their capital almost invariably, the need or desire to divest arises. Too often, companies view divestitures as the mark of failure. As such, they devote inadequate resources to the endeavor. While many companies have established rigorous M&A management, when it comes to divestitures, managers have been too eager to just get rid of it, and rush through the sale of a business or asset, leaving value on the table or overlooking other strategic opportunities. The reality is that divestitures should be viewed as essential means of raising, reallocating and preserving capital. A sale, after all, is generally the recognition that an asset will be more valuable in the hands of another. Companies should be mindful of valuation and more forthright in conveying the value proposition to a new owner. But whether operating from a strategic mindset or executing a sale out of mere necessity the key to obtaining optimum valuation is through preparation. Divestitures, ultimately, are a process demanding excellence from beginning to end. A value-focused divestiture process begins with proactive portfolio management. Reviewing the corporations businesses and assets against strategic goals, performance metrics and industry benchmarks enables a current valuation of each component and helps identify divestiture candidates for each asset or group of assets. Once tagged for sale, a business must be viewed from a buyers perspective. To shape a realistic divestiture campaign, sellers need to understand the likely buyers and their needs and concerns. Todays marketplace rewards multi-tracking having more than one buyer waiting in the wings and considering alternative structures for getting the deal done. Developing an appropriate transaction strategy that is flexible, minimizes closing risk and reflects market realities is critical to preserving value for both buyer and seller. To make a case for value to the buyer and to enhance the strategic value of the sale, the seller must thoroughly understand the business being sold. Sell-side due diligence anticipates buyers

Divesting for value

questions, addresses tough lenders standards and helps eliminate surprises that could impact value or jeopardize a deal. A key step, often given short shrift, is the preparation of accurate carve-out financial statements for the business being sold. Sellers must determine early on whether these financial statements need to be audited (generally a requirement today) and SEC-compliant, based on the profile of the prospective buyer and various regulatory tests. Identifying the right information to include and meeting compliance standards can be highly complex and time-consuming, but they tend to improve divestiture outcomes and time frames. Taxation issues are rarely the primary drivers of a divestiture, but they can add or diminish deal value. In structuring a divestiture, sellers must address the tax consequences for their buyers and themselves. Close analysis of the assets being sold, their location and tax attributes

is critical. Given potential volatility in financing outright asset purchases as well as valuation thresholds, some sellers are exploring alternative divestiture formats, such as tax-free spin-offs, asset swaps and joint ventures. The importance of operational preparedness cannot be overestimated. A focus on operational continuity and risk management should begin in the early days of divestiture planning and continue through every phase. Sellers can enhance value by developing a detailed stand-alone business model, managing seller cost overhang, improving key business processes, outlining the orderto-cash system and promoting crossfunctional collaboration. Transition service agreements (TSAs) can be critical elements and should be designed and negotiated with care. Managing divestitures to preserve and enhance value and achieve strategic goals

calls for a highly structured process. This process is led by a divestiture project management office (PMO) that oversees what is typically a virtual deal team representing diverse functional areas and geographies. Strategic communication protocols and attention to people issues facilitate the myriad planning, coordinating and transitional efforts under the purview of the TMO. Those who are most adept at managing their capital agendas will be in the best position to succeed. In the past decade, corporate strategy relied heavily on M&A for growth. But the most sophisticated executives now realize that divestitures are as essential to stewardship and strategy as an acquisition. Divesting well always with an eye to raising, preserving or optimizing capital builds value. Going forward, leaders will view divestitures as an essential core competence, and will embrace and incorporate ideas such as those that follow.

Executives are learning that a greater focus on capital can result in better enterprise performance. Divestitures, a primary means of optimizing the portfolio and preserving and raising capital value, deserve greater attention.
Stress and distress e.g., liquidity issues and turnaround plans Customer and supplier analysis Preserving tax assets and minimizing costs Renancing or restructuring debt, equity and other obligations Optimizing asset portfolio Delivery of synergies and effective integration Improving working capital and releasing cash

Dispute resolution

Acquisitions and alliance Planning and structuring transactions to optimize stakeholder return Focused due diligence to mitigate risk and drive value Asset valuation Cost- and tax-efcient structures

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Dealing with stakeholder relationships and pressure

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Optimizing capital structure Optimizing tax and corporate structure

The Capital Agenda

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Fundraising (equity and debt): IPO readiness, rights issues, PE, private placement and capital markets Optimizing funding structures Asset divestment Infrastructure projects Cost- and tax-efcient structures

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Proactive portfolio management

Proactive portfolio management brings strategic benefits and improves divestiture outcomes; a rigorous process helps enhance shareholder value.

Key points:
Conduct thorough and regular portfolio reviews Objectively assess the contribution of each business Identify a threshold value for each asset or business and identify potential buyers Identify potential gaps in the portfolio to enhance balance and drive growth Rethink performance metrics that emphasize revenue growth over profitability and strategic value Challenge corporate culture to view divestitures in a strategic light

At a time when corporate growth is difficult to achieve and efficient capital allocation is a priority, actively managing corporate holdings and divesting noncore businesses can add substantial shareholder value. Proactive portfolio management provides a current picture of the contributions of each business, aligns corporate and business unit strategy and drives managers to be explicit about how they will deliver value. Corporate portfolio management uses clear performance metrics and views all holdings as potential sale candidates for the right price.

Proactive portfolio management includes: Communicating a value-creation model supported by appropriate metrics. Establish clear financial criteria, such as generating economic returns above the cost of capital. Balancing strategic and financial goals. Understand how each business fits into the companys overall strategy. Develop clear guidelines on what constitutes core versus noncore holdings, and periodically evaluate the portfolio against those guidelines. In leading companies,

Establishing world-class portfolio management requires that the top of the organization commit to align incentives, structure, processes and tools.
Establishing world-class portfolio management with aligned incentives, structure, processes and tools requires a strong commitment from the top of the organization. The effort involved is considerable, but worth the results: well-timed divestitures, stronger balance sheets and increased readiness for strategic acquisitions through a better understanding of portfolio gaps. the head of strategy and the corporate development officer work together to combine strategic insights with the discipline of corporate finance. Matching the allocation of capital against strategic value. Dont overinvest in components not worthy of resourcing. This may lead to inadequate capital to fund strategic growth areas.

Divesting for value

 Establishing meaningful units of analysis. Portfolio management may focus on individual key assets, business units or geographies. Ask whether each value chain activity (research, design, manufacturing, sales, etc.) is best owned by the corporation. Capturing the appropriate information. IT systems and accounting policies help rigorous portfolio management when they supply accurate data to monitor returns on invested capital. Inputs should include consistent, economically rational cost allocations, reliable balance sheets for each business and knowledge of each entitys tax attributes and role in the parents overall tax strategy. Calculating threshold values for each business. Determine an up-todate threshold value for keeping each business in the portfolio. Consider past and future financial performance, industry outlook, management strength and product or service offerings. This analysis helps determine whether a business is worth more to another owner. It also helps the board of directors respond quickly to unsolicited acquisition interests. Scanning the external environment. Even if a business fits strategically and generates healthy returns, it may be worth more to someone else. Portfolio managers should be on the lookout for buyers with synergistic profiles and keep track of market valuations for similar businesses. Be alert to industry developments new entrants, regulatory changes, demographic shifts, technological breakthroughs that could put a business unit at a disadvantage or make it an attractive property for someone else. Challenging the conglomerate rationale. There are good reasons for conglomerates to exist, but these reasons are frequently overwhelmed by the costs of maintaining a multi-business

For portfolio management to be effective, executives must understand that the process itself can add value and that divestitures do not mean failure.
firm. Without a compelling explanation for how the corporate parent adds value, the whole may be worth less than the sum of its parts. Consider business cyclicality. Active portfolio management can help prevent overexposure to the ups and downs of the business cycle by proactively identifying ways to offset business cycle sensitivities in the portfolio through strategic acquisitions or divestitures. Redeployment concerns. The question of how to use the proceeds from a sale sometimes prevents prompt execution. The redeployment decision whether to reinvest, acquire, pay debt or build cash balances should be considered separately from the divestiture analysis. Board focus. The Sarbanes-Oxley Act of 2002 led many boards to focus on risk management. Opportunity costs to shareholders from ineffective portfolio management are less visible and more difficult to measure than the effects of poor financial risk controls. Employee perceptions. While selling may be the right approach to maximizing shareholder value, it can be unsettling for employees who think their business unit may be sold even if its performing well. For portfolio management to be effective, executives must understand that the process itself can add value and that divestitures do not indicate failure. Incentive systems must reward value maximization rather than growth alone. Companies can reduce barriers to effective portfolio management by instituting systematic, independent processes and systems that produce timely and accurate economic returns on capital. Doug Campbell is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Cleveland, Ohio.

Barriers to success

Why dont more companies take a systematic approach to portfolio management? There are many factors. These can include: Misaligned incentives. When the primary financial metrics that drive executive compensation are deal size, revenue growth and earnings per share, operating managers will be reluctant to consider selling off portions of the portfolio. Negative connotations. Divesting is often perceived as an admission of failure; executives are rarely celebrated for a well-executed divestiture. Conflicting interests. A good portfolio management process relies in part on judgment and information from managers and staff. These people may be directly affected by a divestiture and therefore unwilling to share complete information related to it. Corporate complexity. In contrast to private equity-held portfolios, large conglomerates often dont have the resources to provide the equivalent of a hands-on, independent board for each business that stays in touch with the environment, closely monitors industry developments and makes quick changes.

Transaction strategy
Sellers must understand who buyers are and what they want before engaging.

Key points:
Develop a sale strategy to achieve your objectives Understand the priorities and needs of potential buyers Create competitive tension among buyers to maximize value and mitigate risk Consider alternative structures and implement a multi-track approach

Many sellers patiently wait for market conditions to improve in order to monetize the true value of their company, subsidiary or division. Buyers are often hesitant to overpay or to assume unmanaged risks. Navigating an evolving market environment calls for strategic selling, keeping the following concepts firmly in mind: Sellers need to understand the buyers perspective in the transaction. What are the key risks in the business? How is the business positioned relative to competitors? Is the growth plan viable? Are there customer, product or geographic mix concentrations? Are margins sustainable? A carefully crafted message to buyers often enhances valuation and increases the probability of completing the transaction. Performing commercial diligence in advance will help the seller fully understand the competitive landscape and

memorandum that presents to buyers the key investment considerations and a positioning thesis around which the value story is presented. Sellers need to decide what type of sale process is most likely to achieve their speed, certainty, value, confidentiality and risk objectives. Does it makes sense to run a pre-emptive situation with a single bidder, a limited auction with a handful of the most likely acquirers, or a full auction process with dozens of prospective bidders? The sale process is directly correlated to the eventual outcome. Targeting the most likely strategic and financial buyers is essential to creating a competitive bidding environment. Sellers should take care to understand buyers profiles both domestically and abroad and their unique information

Proactively establishing a heighted state of readiness to divest is a best practice.

the position of the business in its market. This background is essential to properly position the business with prospective buyers. Typically, the sellers investment banker prepares a confidential information needs. Planning for and providing the relevant information or considering alternative deal structures can reduce buyers risk assessments by making the deal more attractive. Similarly,

Divesting for value

understanding the potential synergies for each buyer can yield better deal pricing. Preparing compelling and credible support for the value story, along with other required information, can be complex and time consuming, so sellers should develop realistic deal time frames. Delays or missteps in the transaction process damage the sellers credibility and reduce transaction value.

Effectively negotiating the form of consideration and the terms of the transaction are key elements of a successful transaction. Is it a cash for stock, cash for assets, stock for stock or stock for assets transaction? Is the buyer asking the seller to finance a portion of the purchase price by rolling over equity, accepting a seller note or structuring a contingent earnout?

What representations and warranties must be made to sell the business? How long will the representations and warranties survive the closing? What is the indemnification cap and exposure to the seller? Each of the foregoing are essential elements of the deal and require significant attention and a well-planned negotiating strategy. Sellers should also consider and prepare for multiple transaction scenarios. In such a multi-track approach, sellers may consider various strategic alternatives, including: sale to a strategic buyer, sale to a private equity firm, sale in a leveraged Employee Stock Ownership Plan (ESOP), a management buyout, an IPO, a tax-free spin, a joint venture or selling in two or more transactions by breaking the business apart (to make the sum of the parts greater than the whole). A multi-track approach provides sellers with flexibility, but also increases the level of seller preparation and expands deal timelines. Proactively establishing a heightened state of readiness to divest is a best practice. Companies should undergo an exit readiness assessment well in advance of a live transaction to identify the risks, opportunities, complexities, preparation and timing in connection with a contemplated divestiture. Jim Carter is a member of the Transaction Advisory Services practice of Ernst & Young Capital Advisors, LLC, the broker-dealer affiliate of Ernst & Young LLP. He is based in Detroit, Michigan. Kevin Magee is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Detroit, Michigan.

Sellers should prepare for multiple transaction scenarios.

Sell-side due diligence

Sell-side due diligence is a cornerstone of divestiture preparation and strategy, enhancing seller credibility and deal value for both buyer and seller.

Key points:
Conduct sell-side due diligence to build a strong value case for the deal and avoid costly surprises Define due diligence broadly, to include financial, tax, accounting, compliance, operational transition and synergy issues Establish an electronic data room, supplied with transparent, consistent information Build a synergies story

Sell-side due diligence is a staple of the divestiture process. Once the divestment decision is made, sell-side due diligence compels the seller to examine the business from potential buyers perspectives including relevant opportunities, risks, synergies and other salient issues. Sell-side due diligence requires the seller to think like a buyer, discerning what drives value and where potential risks may exist. This can provide the seller with a unique advantage in negotiations that can help maximize value in a divestiture.

Focus areas

Sell-side due diligence should be both broad and deep. This means addressing such factors as historical financial results, pro forma and forecast financial results, the specific assets involved in the deal and implications for the sellers remaining businesses, including stranded costs and discontinued businesses. All one-time, transition and residual costs, as well as any transition service agreements or other needed commercial relationships between the seller and the business going

Sell-side due diligence helps prepare management to respond to buyer questions and challenges with factbased positions of strength.
To view a transaction through a buyers eyes, it is essential to understand the likely pool of buyers and their different needs and views on value. The onus is on the seller to identify a sound value story and illustrate how current and future financial performance reflects that value proposition. Sell-side due diligence helps prepare management to respond to buyer questions and challenges with fact-based positions of strength. A well-prepared management team is able to articulate a sound strategy and reveal detailed knowledge of what has driven historic performance, and what likely could drive future performance. forward, should be taken into account. In addition, sellers should develop a stand-alone business model for the entity being divested depending on the buyer pool. Sophisticated global buyers often ask whether a spun-off or carved-out entity is ready to implement International Financial Reporting Standards (IFRS). Sellers can expect questions about compliance with other regulations, such as Section 404 of the Sarbanes-Oxley Act of 2002, along with associated compliance costs. Sellers should also conduct advance work with respect to tax planning and structure, which can add significant value to a deal.

Divesting for value

Principal forms of sell-side due diligence

Sell-side due diligence can aid the buyer and thus add to the attractiveness of a transaction. A supplement to the offering memorandum, which is the primary selling document, can vary depending on the nature of the sell-side due diligence. The main forms include: Independent report. An independent report is developed by a qualified third party. For example, Ernst & Youngs sellside due diligence report (SDD) provides potential bidders with information to assist in their decision making and due diligence. It includes detailed analysis of the financial aspects of the transaction, along with relevant commercial and operational details. An SDD also delves into key separation considerations. White paper. An alternative to an SDD is a due diligence white paper. Prepared by the seller, this consists of schedules, analysis and accompanying memoranda identifying key issues and matters of potential interest to the purchaser. This information can be provided to buyers or used for management purposes only. The key advantages of sell-side due diligence are as follows: Clarity, particularly when explaining a complex carve-out or a complex business model Up-front communication, providing bidders with an early notice of potential challenges or untapped value Efficiency, enabling the seller to simultaneously address the diligence requirements of multiple bidders Focus, streamlining demands on management, enabling greater focus on the ongoing business during the sale process Speed, often reducing bidders overall information demands and accelerating deal processes

Essentials for your data room

Adequate information to support a controlled question-and-answer process Full information on commercial and legal matters Validation of key valuation assumptions Alignment of data room with financial reporting structures Audited financial statements Presentation of normalized stand-alone financial statements Compelling support for stand-alone costs, run rates and projections Location and use of corporate real estate (owned, leased, ventures) Ability to identify and understand enterprise value opportunities and risks

different levels of access to different buyers at different stages of the deal. Buyers also vary from one deal to the next and use different guidelines or metrics to establish value. Compared to a financial buyer, a strategic buyer may more easily determine the value of business based on its own experience and integration plans. The financial buyer may need more exhaustive detail in order to develop its business case. A data room will contain all key performance, financial, tax, organizational, operational and legal data that potential buyers will need to understand a business and develop their own view of value. A well-run data room will contain data that is relevant, consistent and logically organized. It is also crucial that this information be aligned with that presented in the offering memorandum and any management presentations. Inconsistencies lead to concerns with the overall control and reporting environment, often leading to deal failure. It is also crucial that senior management, especially the CFO or controller, as well as others involved in the deal, be intimately familiar with the information loaded into the data room.

Data rooms

Perhaps the most important task associated with sell-side due diligence is the establishment of a complete and transparent electronic data room typically an online repository of information which the seller makes available to buyers via a third-party provider. Although access to complete and robust data is the guiding principle of data room construction, it is not always in a sellers interest to provide everything buyers may want, particularly in the early stages of due diligence. Full disclosure often makes sense for a seller working with a single buyer, but sellers seeking to create competitive tension among a group of buyers may find value in releasing information selectively or in phases. Additionally, sellers may want to provide different sets of data to strategic buyers who compete in the same industry than that given to private equity buyers without competitive interests. Most electronic data rooms allow sellers to assign

Synergies

An important aspect of sell-side due diligence is building a compelling synergies story for strategic buyers. Some corporate buyers will have clear synergies in mind and care little about the sellers view. Others may envision modest synergies based on slightly different expense projections. In many cases, a convincing presentation of likely synergies could increase the chance of a successful sale. Brent Borio is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Detroit, Michigan.

Carve-out financial statements

Carve-out financial statements help present a clear and credible picture of the future standalone business. They help crystallize the buyers understanding, build the value case for the business and accelerate a closing.

Key points:
Allocate adequate expertise to preparing carve-out financial statements Consider potential buyer requirements in determining the appropriate form of carve-out financial statements Invest the time upfront to prepare compliant, accurate, thorough carve-out financials statements

To carry out successful divestments, sellers must determine the value of the business or assets being sold and clearly communicate that value to potential buyers via financial statements. Creating a carveout or stand-alone financial statements is a complex exercise regardless of whether the carve-out represents the separation of a subsidiary, segment, division or other group of assets. This is particularly true when the business being sold does not align with the way the business was historically managed or reported. Although carve-out financial statements are crucial to preserving deal value, sellers often fail to adequately plan for and prepare them, even in cases where audited financial statements are required due to SEC regulations, lender stipulations or other requirements. Appropriately preparing carve-out financial statements, whether audited or only unaudited deal-basis, is a time-consuming process that is often underestimated by sellers. As a result, sellers are often forced to rush through the carve-out process due to liquidity pressures or so buyers dont lose interest or financing. Haste, though, can be counterproductive if it means cutting corners. It is important to understand the likely buyers of the business and their potential needs regarding financial statements, as well

as the sellers own needs and requirements regarding historical financial data. If sellers dont take the time up front to identify the data needs and the potential buyer pool needs, it may mean delayed closings, reductions in purchase price and issues with lenders. These factors can lead to increased tension between predecessor and successor companies, and strained business relationships post-transaction. In todays deal market, audited carve-out financial statements are often required to close a deal.

Different forms of statements

The form and requirements of carve-out financial statements vary depending on the type of transaction, and can range from unaudited deal-basis financial statements to SEC-compliant audited financial statements. In a transaction, especially one that will result in a public filing by a buyer who is a public registrant, financial statements must comply with SEC guidance. Some private transactions, such as a sale to a PE fund or private company that may issue public debt or equity, will also require public filings and be subject to SEC guidance. However, while there are guidelines related to specific aspects of carve-out financial statements, much is based on historical practice. Executives, in consultation with their internal compliance leaders, auditors and transaction advisors, must exercise significant judgment.

Divesting for value

To determine the information to include in the carve-out financial statements, firms must consider investor needs, availability of information, the nature of the business and whether or not the transaction will be subject to public filing requirements. While issuing unaudited financial statements may seem the path of least resistance, they are often complicated later by adjustments to reflect the business on a stand-alone basis or a buyer request for audited financial statements. Buyers typically feel that unaudited financial statements are less credible. If management is unable to provide full, SEC-compliant carve-out financial statements, some types of abbreviated

the same following the transaction. While an acquired subsidiary or division may clearly be a business, determining the status of other components may require professional judgment.

Accounting complexities

inventory count must be performed in the current period and rolled back to the historical periods. Acquisitions made by the carve-out entity during the historical period may require separate audits subject to SEC significance tests.

Sellers often underestimate the magnitude of effort required to prepare carve-out financial statements. The SEC requires that carve-out financial statements represent the business as it was historically managed and reflect all the costs of doing business whether or not they were historically allocated (SAB 55). All carve-out-related adjustments such as impairment or restructuring charges,

Generating carve-out statements

Although carve-out financial statements are crucial to preserving deal value, sellers often fail to adequately prepare them.
asset statements may be permitted with advance agreement of the SEC. purchase accounting adjustments and topside entries must be pushed down. Other accounting complexities include, but are not limited to: Third-party debt and intercompany debt Related-party transactions Determining the capital structure for the carve-out entity Identifying the reporting segments for the carve-out and related impact on goodwill If the financial statements will be audited, it is leading practice to involve the auditors and other professional advisors early on in the process and to make sure the auditors concur with managements conclusions along the way. Auditors generally need to reduce the materiality level of the carveout audit compared to those used for the parent companys audit. Even if a reporting unit has been audited before, additional or expanded procedures may be needed. For example, accounting policies will need to be revisited to ensure the new policies for the carve-out financial statements align with the parents historical policies. If the auditors have not observed physical inventory counts for the business, an

Sellers accounting systems frequently lack the capabilities that allow for an easy carve-out. Much of the carve-out process requires manual data manipulation and, accordingly, it is important to be wary of tools purported to readily extract all requisite data. No two carve-outs are alike. Rather than attempt to anticipate every possible issue that may arise, a better approach is to define a robust process using these guidelines: Identify and empower a carve-out project leader and team. The project leaders role is to make decisions and keep the project on schedule. If knowledge of the transaction must be limited to a small number of people due to confidentiality, the project timeline is often extended, whether planned for or not. If the business includes operations abroad, it is leading practice to identify carve-out coordinators in each region or country in order to identify local issues in a timely fashion. Determine what kinds of statements are needed. Carve-out financial statements often need to be audited or made SECcompliant based on the sellers situation or the probable needs of anticipated buyers. In addition, regardless of the audit, stand-alone deal-basis financial statements are generally always a requirement. Sellers must also consider: What historical periods (e.g., annual, quarterly, trailing 12 months) will be covered What pro forma information will be provided The level of detail and effort to expend around estimating stand-alone costs and stranded costs

Defining a business

When determining whether to allow abbreviated financial information in an SEC filing, the SEC considers whether the separated and sold entity is in fact a business or merely a group of assets. The SECs view of a business tends to be broad. If costs cannot be identified or associated with the separated entity, the SEC may indicate that the buyer has acquired assets. Generally, asset acquisitions do not trigger the need to report historical audited financial statements in SEC filings as acquisitions of businesses do. However, determining what constitutes a business versus a group of assets for accounting purposes is far from simple. To determine if an entity constitutes a business for SEC reporting purposes, the SEC focuses on whether there is sufficient continuity of operations. So that disclosure of prior financial information is material to an understanding of future operations. The SEC has typically focused on whether the nature of the revenue producing activity will generally remain

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 In what order such information should be prepared Determine the scope and related complexity of the carve-out. Define the parameters of the business being carved out, and identify the assets, liabilities and related operations to be included in the financial statements. If appropriate, consider SEC filing requirements, and determine the need to link the proposed business to be sold to the companys legal organization, historical segment reporting or managements business unit reporting. Due to changing market conditions, businesses are often forced to develop innovative strategies to unlock the value that may be hidden within the organization. This often leads to the sale or spin-out of a business that is not intuitive or does not match the way the business was historically managed. This creates a number of financial and reporting complexities that likely have not been previously encountered due to the need to split various assets, liabilities or portions of contracts. Many of these situations may warrant preclearance with the SEC on certain fundamental bases of presentation, as well as other issues around the scope of the carve-out in order to avoid surprises further down the transaction timeline.

Identify the necessary financial data and their sources. Financial data necessary for proper carve-out financial statements includes previously reported financial statements, detailed general ledgers and sub-ledgers. This data typically becomes the basis for determining what should be included in the carve-out financial statements by identifying items directly attributable to the business. Use care in allocating costs. SECcompliant carve-out financial statements must reflect all costs of doing business and, as specified in SAB 55, use a welldocumented and relevant allocation methodology for costs that cannot be directly attributed to the business. Examples include interest expense, corporate overhead expenses and employee benefits. The allocation methodology must be reasonable and not overly complicated. Be mindful that such cost allocations will generally need to be bridged to the stand-alone costs during the process. Use dynamic reporting. Creating a separate IT instance or a web-based financial reporting tool makes it easier to update and access data for the carveout financial statements compared

to a static tool such as spreadsheets. Establishing separate reporting modules for the parent organization and the carve-out allows for regular updates to buyers and frees the seller from having to repeatedly disentangle stand-alone data from integrated businesses. Current data is required by buyers and lenders throughout the process, often long after the audited carve-out financial statements are issued. Communicate with auditors. Early and ongoing dialogue expedites the process of auditing and finalizing carve-out financial statements. The effort invested in up-front planning and communications reduces the time needed to complete the audit and improves quality and often leads to a faster close. Brent Adam is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Chicago, Illinois. Bill Keirse is a member of the Financial Accounting and Advisory Services practice of Ernst & Young LLP. He is based in Chicago, Illinois.

Audited financial statements vs. bidder information

In most instances, the carve-out financial statements do not represent the ultimate deal-basis financials. The seller needs to address both the rules of a carveout (definition of a business, SAB 55, etc.) and the needs (pro forma adjustments, stand-alone estimate, one-time costs, etc.) of the potential buyer. The carve-out audit and sell-side due diligence of the business to be sold are commonly two separate workstreams that should be linked or bridged together throughout the divestiture process. Performing reconciliations between the historical, carve-out and deal-basis financial statements adds transparency to the process and provides comfort to the potential buyers that the information holds together. Carve-out financial information roadmap
Internal financial information R
Parent company financial information (public filings)

Carve-out financial statement considerations (audited)

US GAAP/SEC requirements Materiality levels SAB 55/73 adjustments Other carve-out adjustments Sarbanes-Oxley compliant Audit trail Periods to be presented

Deal-basis financial information

Buyer needs/value proposition Pro forma adjustments Stand-alone costs Forecasts One-time costs Stranded costs Operational separation agreements (TSAs) Data room materials
R

= Reconciliation

Divesting for value

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Divestiture in a private equity setting

Private equity firms focus on maximizing selling prices.

Key points:
Private equity portfolio companies face increasing competition for buyer attention Pre-sale exit readiness processes can help unlock hidden value and mitigate potential exposures Buyer expectations are evolving toward a thorough pre-sale preparation to facilitate a smooth transaction A sell-side report helps demonstrate the value proposition and drive transaction efficiencies

US-based private equity (PE) buyers are increasingly looking to sell-side reports and services for assistance when entering and exiting an investment. These buyers have seen the value of divestiture advisory services firsthand in the transaction process when exploring the purchase of non-US-based businesses. These services are helpful to PE sellers as well, helping portfolio companies to become well-vetted and prepared for transactions, facilitating a smooth exit from the PE portfolio while maximizing value.

this information is provided consistently and concisely in one document, it helps the PE buyer develop a financial model for the business and provides insights into a normalized operating performance. Sell-side reports also: Provide an independent view of normalized earnings to the PE buyer. This can reduce greatly the time and effort expended to arrive at quality of earnings adjustments that all sides readily agree upon. Provide relevant assumptions, detailed calculations and related narratives. These give the prospective buyer the background and support for quality of earnings adjustments. Offer the PE buyer a level of comfort around the companys performance earlier in the transaction life cycle. This allows the PE buyer to make informed decisions and move more quickly through the transaction. Serve as a resource for the PE buyer to learn important details about the target companys operating environment. This includes general terms and conditions with customers and suppliers, significant accounting policies, the nature of operating systems and human resourcerelated data and issues.

Value to a PE buyer

Sell-side reports provided by the seller of the target business can enhance a transaction in various ways. The report typically provides the PE buyer with an in-depth overview of the business for sale, expanding on topics covered in the offering memorandum and managements presentation. The in-depth perspective on the business when it comes at a relatively early stage in the transaction life cycle can help both parties focus on the most important business issues. This approach can accelerate and streamline transactionrelated activities. Sell-side reports highlight the drivers of the companys performance and often help the reader understand how historical factors might influence future performance. When

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For the PE buyer developing a financial model, sell-side reports are very helpful, particularly when they include a databook of historical and forecast financial metrics. A robust financial model is dependent on the quality of its data and assumptions, and a sell-side report provides a resource for both types of information. The narrative of the report provides a wealth of information about the target companys markets, customers, vendors, operating environment and historical and forecast business drivers. And the empirical data provides the consistent presentation needed for the base-year assumption.

Preparation for sale Each PE portfolio companys specific circumstances will determine how much effort is needed to sell the business. However, before the sales process even begins, the owner should scrutinize each investment to enable maximum value prior to and upon exit. Divested companies are typically sold with excess cash tied up in working capital that selling entities should be able to release. Before the exit, the seller should assess and document working capital requirements of the entity and identify opportunities for cash release.

How will the business operate post-close? What are the value improvement opportunities and value erosion risks? Is the financial information suitable and sufficiently robust for the sale process? What are the tax issues relevant to the exit? What are the HR issues relevant to the exit? Have significant benefit obligations (e.g., pensions, OPEBs, 280G costs) been identified and fully vetted? What will be the key factors in an efficient disposal process? These questions should be answered with an eye toward optimizing the deal value, timing, strategy and positioning of the business. This process gives the seller the best chance of maximizing value, while sticking to an efficient delivery timetable and ensuring a clean exit. When this initial evaluation is complete, the seller should be able to identify critical issues, key workstreams and divestment timetable options.

For the PE buyers development of a financial model, sell-side reports are very helpful, particularly when they include a databook of historical and forecast financial metrics.
Beyond a sell-side report, the buyer can also benefit from a thorough transaction preparation process it typically results in a more focused data room and more acutely prepared management team. The preparation process can serve as an excellent primer for the real deal, allowing the management team to hone data, analyses and findings that ultimately will be shared with potential buyers. A key element of maximizing exit value for a PE owner is identifying and communicating the value story behind the business. It must be credible and appropriately supported by both historical performance and prospects for the future. Further, the PE seller should have confidence in the portfolio company management team to develop and present this value story in a compelling fashion. A successful management team will be able to articulate many facets of the value story, including transaction timing, the competitive environment and transaction structure opportunities and alternatives (i.e., tax attributes). Exit readiness: initial evaluation Its important to give the exit process just as much attention as an initial investment. To prepare, PE sellers should ask themselves and their portfolio company management teams targeted questions, such as: What is for sale? Who are the likely purchasers, and why? Is the core value story credible?

External assistance and sell-side reports

Value to a PE seller

Recent trends in PE markets have resulted in fewer PE exits; consequently, more PE investments are aging within the portfolios. Given exit considerations to generate investor returns, we expect this backlog of portfolio companies will likely come to market soon. The backlog, coupled with the volatility of M&A in general, will drive competition for buyer attention among PE portfolio companies. Portfolio companies will need to be well vetted and prepared for the transaction to facilitate a smooth exit from the PE portfolio while obtaining maximum value.

The well-prepared portfolio company (and its current owners) can further drive value through a structured and focused exit process, enhanced by sell-side activities, including support from external sources. Sell-side assistance may be warranted in many PE exit scenarios. Structured sell-side exercises can benefit portfolio companies with newer management teams or those inexperienced in the transaction process. Portfolio companies built upon a platform and roll-up strategy can also benefit from these exercises, as they can capture and present data consistently and concisely. And those portfolio companies with a complicated value story benefit from the opportunity to validate the story and prepare materials that highlight value, while working to position issues that might erode value.

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External assistance Vendor assistance activities often serve as stress test operating results for potential due diligence adjustments, while providing management with the opportunity to address and position potential vulnerabilities. The involvement of functional leaders from across the organization ensures that appropriate attention is given to all areas. This approach

provides a comprehensive view of the business for sale and can help owners to identify and capitalize on any remaining value opportunities, while identifying and mitigating potential areas of value leakage. Sell-side reports The sell-side report can be branded or unbranded depending on the anticipated audience and intended use. For example, Europe-based buyers are accustomed to

receiving branded reports, and may request them to facilitate financing. Regardless of the form of the final report, the content is similar and includes a description of the business for sale and a quality of earnings analysis that identifies and considers the key factors driving historical and forecast business performance. The preparation of such a report branded or unbranded vets managements adjustments in a friendlier environment, serving as a dress rehearsal for the management team, while also promoting the consistency, accuracy and reliability of the value story and the supporting data and analyses. A branded sell-side report includes an independent view of managements adjustments. From a sellers perspective, a sell-side report (and the ability to share it with interested parties) reduces the amount of repetitive work required to address diligence requests and inquiries.

Both buyers and sellers rely on timely and accurate information to make decisions nimbly and drive successful transactions.

Conclusion

Information is paramount in a competitive transaction environment, and a structured sell-side effort can significantly alter the landscape. Both buyers and sellers rely upon timely and accurate information to make decisions nimbly and to drive successful transactions. More than ever before, focusing on sell-side activities and deliverables is essential. Frank Petraglia is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in New York, New York. Philippe Leroy is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in New York, New York.

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Tax issues and consequences

Attention to tax issues can lead to more efficient deal structures and higher valuations.

Key points:
Introduce tax expertise early in the divestiture process Understand the assets being sold and their location and tax bases when determining deal structure Consider the complex tax issues posed by alternative transactions

By itself, a divestiture is rarely driven by taxation factors. Asset and business disposals should make sense from a broader economic or strategic perspective. However, paying close attention to tax implications is essential, as they are complex and can add considerable value to a transaction. With changing market conditions around credit availability, some companies needing to dispose of assets are exploring alternative transaction structures (e.g., leveraged spin-offs or joint ventures) that

The questions generally are: 1. What assets are being divested? 2. What is the tax basis of those assets? 3. Where are the assets located? 4. What tax attributes can the seller monetize? The first question what assets are being divested? must be answered with precision in order to address the second question what is the tax basis of those assets?

Paying close attention to tax implications is essential, as they are complex and can add considerable value to a transaction.
require less financing than a classic outright sale. However, such structures often introduce tax-driven complexity. The answers to these first two questions help the seller understand the potential amount of gain or loss on the disposition. The sale of individual assets generates a collection of individual gains and losses. Unless a company knows which assets are being sold along with their precise tax basis, it is impossible to allocate the selling price all the way down to an individual asset or inventory and determine the precise gain or loss on the transaction.

The tax process

In any disposition, a sellers primary goal is to often maximize after-tax proceeds. Sellers should work through a series of questions to identify the tax characteristics of the business or assets, as well as the tax needs of the seller and buyer.

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The next question relates to identifying where the assets are located, or in which jurisdiction the assets are located. Tax rates on gain or loss and tax basis of assets can be affected by the location of the assets. Identifying the taxing jurisdiction the assets are located in allows the seller to apply the appropriate tax rules when determining the gain or loss and determining the cash tax due on disposition. When material assets reside in multiple countries, the gain or loss calculations and determining the after-tax

planning for the purchase price allocation in international transactions can benefit sellers, as there may be flexibility in allocating purchase price among assets when identified early in the process. In some cases, tax implications will require adjustments to an existing deal structure. In others, tax implications may lead a company to significantly alter not only the form of the divestitures but also the assets to be sold or transferred. Some sellers may elect to enact changes in existing

of another company. A critical element of qualifying for a tax-free like-kind exchange under tax code Section 1031 is that the assets must be of an equivalent nature. In practice, equivalent nature may be difficult to prove. As a result, paying attention to detail to ensure qualification for like kind exchange treatment is imperative. Joint ventures (JVs). Some companies use JV structures to achieve results akin to a sale. Each partner contributes assets to the JV/partnership, and economic results are allocated in a manner that resembles a sale. The tax codes partnership rules, specifically Subchapter K, forbid disguised sales, so careful consideration to the tax codes rigorous tests to satisfy tax-free treatment for such transactions needs to be reviewed. Tax-free spin-offs. In the recent past, companies would spin off a division or subsidiary, loading the new entity with debt in exchange for cash. In tighter credit conditions, spin-offs are a means of disposing of assets in a tax-free manner. Existing shareholders obtain shares in the new entity. Companies may also shift existing debt from the parent company to the new entity with certain limits. For more information, see the next chapter: Considering the tax-free spin. Todd Miller is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Minneapolis, Minnesota.

In a changing economic environment, a deal can live or die on its tax implications.
cash proceeds can be complex as the value of gains and losses will be influenced by a companys overall international tax position. For example, the ability to generate losses on a sale may enable a company to offset gains from operations. Knowing the precise gain or loss in each taxing jurisdiction will allow the seller to determine what tax attributes can be monetized. For example, the seller might have net operating losses, capital losses or foreign tax credits that can be utilized to reduce cash taxes to be paid on the disposition. In a global divestiture, an additional question is: how will the proceeds be allocated between jurisdictions and taxing locations? Repatriation or transfer of proceeds from the selling jurisdiction to the desired global location may be an issue. If, for example, a majority of sales proceeds are allocated to a non-US subsidiary, but the cash proceeds are needed to fund operations in the US, there can be a significant tax cost to repatriating the funds from the non-US location to the US. For example, there may be additional transaction costs, withholding taxes on dividends or incremental US taxes to move the cash between members of the consolidated group. Early evaluation and structures and assumptions well before the deals anticipated closing in order to drive maximum shareholder value. Tax perspectives are needed early on to help managers make informed decisions.

Alternative transactions

In a changing economic environment, a deal can live or die on its tax implications. Some companies are considering a variety of alternative structures featuring favorable tax aspects, including tax-free deals. Tax-free or alternative structures are not divestitures in the strictest sense. These are often reorganizations, partnerships or joint ventures without a clear buyer or seller. Often, these deals exchange assets or move assets to new ownership structures. Where financing is scarce, alternative transaction structures can help companies achieve divestiture goals. Among the most useful: Structures that use equity as a currency. These are reorganizations in which the US tax code allows companies to transfer assets or shares in a tax-free manner, as long as the seller takes back equity of the acquired company. Like-kind exchanges or asset swaps. A company may be able to exchange its unwanted assets with the unwanted assets

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Considering the tax-free spin

As companies increasingly turn to spinoffs they need to appreciate the benefits and complexities before committing to the task.

Key points:
Dedicate and align sufficient resources for the SEC and IRS regulatory approval processes in order to optimize deal value and meet stakeholder expectations Properly manage the timing and content of investor day presentations Focus on separation related matters, especially long lead time areas such as IT, finance/ accounting operations, legal/tax restructuring and recruiting

Tax-free spinoffs are attracting the attention of more and more companies today. Sectioning off part of a publicly traded enterprise can improve business focus in each resulting entity and provide higher market valuations. A spinoff may also achieve better allocation of financial, intellectual or physical capital, as well as a more efficient use of leverage. When in a credit-starved marketplace in which outright buyers can be few and far between such a deal can deliver many of the benefits of a divestiture. Add the benefit of a tax-free transaction and the concept appears almost irresistible. In its operational, regulatory and strategic complexity, a tax-free spinoff is something of a three-headed beast: it is as demanding as any business carve-out, with added requirements akin to those of an initial public offering (IPO) plus the close involvement of tax authorities and the Securities and Exchange Commission (SEC). This adds up to an undertaking with challenges, costs and pitfalls that should not be underestimated.

SpinCo SEC reporting requirements and regulatory approvals

Spin transactions average 9 to 12 months from the public announcement date to the actual spin date, but can extend much longer based on varying circumstances. A substantial portion of this period is attributed to regulatory approval processes. To qualify for tax-free status, companies must obtain a private letter ruling from the Internal Revenue Service which can take six months longer. Companies must also prepare and file a registration statement on Form 10 with the SEC, whose review process approximates four to five months, assuming no significant findings. A Form 10 filing, which is largely equivalent to an IPO registration statement, requires audited carve-out financial statements, executive compensation disclosures and managements discussion and analysis of the operations results. It can take 6 to 12 months to derive carve-out financial information for a Form 10, depending on factors such as the following: Level of commingled operations and back office functions IT systems and related ability to extract financial information for the carved-out business

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 Changes in operations during the preceding five years Historical autonomy of those who will become SpinCos management Manner by which corporate costs have historically been allocated Extent of international activities The Form 10 also requires pro forma financial statements that depict the effects of the spin transaction, including SpinCos new capital structure, differences between the historical carve-out and deal basis financials, and new commercial, transition service and executive compensation arrangements. While the entire Form 10 requires contribution by all key members of the organization, the pro forma financial statements are unique in that this section requires alignment among many functions, including Finance, Tax, Treasury, Human Resources, Legal and Operations/Business Development. Accordingly, milestone dates must be established and clearly communicated, taking into consideration information that requires a long lead time to derive.

conclusions about RemainCo based solely on such information. Investor Day presentations purport to control expectations of both SpinCo and RemainCo and thus prevent potential misguided conclusions from occurring.

RemainCo reporting requirements

important because the amounts reported by the parent, under accounting guidance for discontinued operations reporting, are inherently different in a number of instances between those reported by SpinCo in the historical and pro forma financial statements included in the Form 10.

Assuming significance thresholds are met and discontinued operations treatment is appropriate under authoritative accounting standards, the parent company must file a Form 8-K within four business days of the spin completion date. This Form 8-K must provide pro forma financial statements, including three (versus the more common presentation of one) annual income statements. Because SEC regulations do not permit, for discontinued operations purposes, the typical 75-day grace period to report pro forma financial statements, companies must begin preparing such information well in advance of the spin completion date. This is particularly

Operational separation considerations (Day 1 readiness and beyond)

Separation activities cut across all functions of an organization, requiring companies to identify all critical activities, assign owners and target completion dates, and monitor progress against milestones in a systematic manner. Mechanisms to address unforeseen challenges should also be developed. For example, from a human resource (HR) perspective, progress towards a spin-off is typically tracked in terms of a series of milestones leading to Day 1 Readiness. Leading organizations define Day 1 Readiness for HR as the complete

Investor relations considerations

Sample timeline of select finance activities

Sample timeline of select finance activities
Project inception Initial Form 10 filing (month 4-6) Deal close (month 9-12)

An important aspect of successfully executing a spin transaction is managing stakeholder expectations relative to the spin effective date, related costs, new executive officers and their visions for enhancing the operational and financial future of RemainCo and SpinCo as separate publicly-traded companies. Investor Day presentations are strategically planned for such communications, often in connection with key dates such as the initial transaction announcement, the initial Form 10 filing and the actual spin date. Communications around the Form 10 filing date are often deemed necessary because the registration statement reflects information only for SpinCo, and companies want to preclude stakeholders from forming

Spin transaction activities

Regulatory and Capital Markets
Form 10 preparation Bond financing and investor activity

Accounting

Intercompany transactions settled Legal entity restructuring activities

Cash funding and working capital activities

Functional separation
Day 1 Readiness
Finance PMO structure implemented Knowledge transfer New intercompany process TSA administration and billing process

Systems
General ledger separation Separation of key applications Consolidation and reporting

Financial close and reporting

10-Qs RemainCo 10-Q NewCo (initial) Next year operating plan/budget

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separation of HR operations, including the selection and transfer of employees to SpinCo and the establishment of standalone compensation and benefits plans, payroll and IT platforms and policies/ procedures for the new organization. It is typically necessary to establish and track a unique set of HR milestones for each country involved, as HR plans, practices and legal requirements, vary from country to country. All functional areas need to plan for critical Day 1 readiness work streams. A small sample of such work streams is listed below. IT networks split and stabilized, data centers operational, data separated and migrated, IT policies/controls implemented and TSAs agreed and tested Accounting/treasury general ledgers set up, accounting processes/ data transitioned, statutory reporting processes implemented for each country, bank accounts for legal entities established, insurance policies in place and internal audit compliance function (including policies and Sarbanes-Oxley documentation) established Financial planning and analysis management reporting operational, budgeting and cost allocation methodologies established and functional data migrated Tax federal, state and international tax compliance operational, transfer pricing agreements finalized and tax functional data migrated Financial operations credit/collections, accounts payable and cash disbursement, fixed asset management, payroll, etc. Human resources employee agreements executed, equity/retention/ severance programs finalized, benefit packages in place, policies/procedures formalized and contracts transitioned

To spin or not to spin?

In concept, a tax-free spinoff is easily grasped. In practice, its achievement is anything but simple. Getting it done requires strong project leadership and an emphasis on change management. As a majority of these transactions are global in nature, companies need to create strong cross-functional and cross-geographic teams. Moreover, they must provide those on the front lines of the transaction access to all of the considerable resources and expertise that may be required. None of this is to discourage an executive team from considering a tax-free spinoff. The rewards can be enormous and given current economic conditions, these transactions can make great strategic sense. Rather, companies should fully appreciate the scale of the undertaking before committing to the task. Regina Balderas is a member of the Transaction Advisory Services practice of Ernst & Young LLP. She is based in Houston, Texas. Brian Pastroff is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Chicago, Illinois.

Reporting lessons learned

Form and empower a Project Management Office (PMO) that understands SEC reporting requirements Consider SEC pre-clearance on the form and content of audited carveout financial statements Begin preparing the pro forma financial statements early in the process, particularly surrounding the estimated ranges of one-time separation and incremental public company costs

Operational lessons learned

Focus on long lead time areas Hiring/recruiting across all former shared services and corporate functions (IT, HR, Corporate, Treasury, etc.) Cross-train over one or two month-end financial closing cycles prior to the spin-off to facilitate separate stand-alone reporting post-spin Plan for managing and pricing TSAs, including reverse TSAs, with an eye toward mitigating stranded costs Establish appropriate governance model at SpinCo Understand technical requirements relative to first SpinCo 10-Q/10K, SpinCo 404 compliance, etc. Determine optimal settlement of intercompany accounts on a legal entity basis required to be complete on effective date

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Operational preparedness
Operations are the heart of divestiture value. While preparing for a sale, sellers must retain focus on the business and plan a smooth transition to a new structure.

Key points:
Pay attention to operational issues at every stage of a divestiture Develop a detailed stand-alone business model, reflecting the carve-outs future full cost structure. Such models enable buyers to value the business, while helping sellers rationalize their own value chain. Develop a realistic order-tocash blueprint early Many months may elapse from the moment a transaction is first contemplated to the time a purchase agreement is struck. During this interval, an intense focus on the quality of operations is crucial to maximizing deal value and minimizing sellers risk. More often than not, the true drivers of value are organizational know-how, managerial capabilities, employee engagement, customer relationships and brand equity.

Many sellers get so focused on the deal itself, or on post-divestiture life, that they begin to overlook the daily matters of the business. In so doing, they may take their eyes off the ball, causing disruptions and operational missteps that contribute to lower valuations and larger post-closing adjustments. Following are some leading practices for operational effectiveness in divestitures, especially carve-outs. Recognize that value erosion is tied to operations. Too many sellers see the divestiture as a sale of fixed assets and not as an ongoing business whose value depends on stability. With senior management engaged in the deal process, it is essential to devise a strategy that promotes operational continuity and interim performance throughout the entire divestiture and even post-close. Integrate deal strategy with operational strategy from the start. Ideally, sellers begin developing the operational continuity strategy at the earliest sign that a divestiture is contemplated. The operations team typically a mix of corporate and business unit managers should begin assessing the risk to operations and asking how these can be avoided, mitigated or transferred. Buyers of a potential carveout typically will ask how managers plan to make the business stand alone.

Anticipate risks. In a divestiture, employees can expect changes in everything from reporting relationships to job responsibilities to business processes. There are potential implications for suppliers, customers, partners and other stakeholders. It is incumbent on management to anticipate operational risks well before those risks become disruptions that reduce value. Having action plans to address such risks, and effectively communicating them, can demonstrate operational control during the distracting deal process. Address operational issues throughout the divestiture. From an operational perspective, separating a business from its parent involves four critical time periods: 1. Pre-signing In the pre-signing phase, when the buyers identity is still unknown, it makes sense to develop an employee communication plan and to identify key personnel to retain. 2. Pre-closing In the pre-closing phase, when the seller knows the buyers identity but the deal has not been finalized, the seller should work through operations-related details: whether and how much to build inventory in advance, for example. Reverse-supply agreements may have to be negotiated if the seller still needs the divested business

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to supply its products. Other tasks include determining where new legal entities must be established, retaining or transferring operating licenses, creating retention strategies for top talent, planning for communication and regulatory compliance as well as implementing transition plans. 3. Stabilization In the stabilization phase, as processes migrate to a stand-alone status, care must be taken to ensure that business activities continue uninterrupted. Lacking a comprehensive stabilization plan, a buyers Year 1 financial forecast may fall short. 4. Independence Independence describes the moment when the spin-off or carve-out is operating on its own and no longer depends on the former parent. Buyers typically view long stabilization periods as adding risk. Develop a stand-alone business model. This series of calculations shows whats in and whats out of the transaction: which sales offices, vendor contracts, employees, factories and so on will migrate to the new entity. Sellers must calculate clearly to avoid inadvertently lowering the value of the business. The existence of corporate shared services complicates everything from deal valuation to post-deal operation. Typically, deal prices are based on a multiple of EBITDA, so buyers and sellers primarily focus on stand-alone recurring costs the costs of managing the business when performing valuations. But where shared services and processes are involved, valuation is also affected by new cost structures, as well as any long-term transition service agreements (TSA) or supply agreements that may be required. Stand-alone business models can help sellers package the business being sold to maximize its value. If there are assets that could erode value a highly polluting plant, for example, or one making a nearobsolete product sellers should decide

More often than not, the true drivers of value are organizational know-how, managerial capabilities, employee engagement, customer relationships and brand equity.
whether and in what way these should be part of the deal. Strengthen the value chain. Developing a stand-alone business model requires sellers to examine each link in their value chain to see if they can take some operational step to enhance value or to keep it from eroding. Tough questions should be asked at each point: Sales and marketing: would the company benefit from expanding into new sales territories? Hiring or letting go of sales people? Investing in new IT or automation? Manufacturing: can plants be consolidated or production outsourced to a third party? Distribution: does the company need its own storage warehouse? Finance and accounting: would it be cost-effective to outsource and offshore accounts receivable and cash management functions? Treasury: can several regional bank relationships be consolidated? Human resources: what is the right benefit and compensation program to meet the needs of the smaller standalone business? Procurement: can the process be rationalized? Tax: can tax efficiency be improved by restructuring holding companies or other legal entities? Operationally astute companies examine their supply chains to consider how they can be improved, identify which assets add most value and, in general, figure out what the business needs as opposed to what its used to having. Acting on this analysis can help sellers improve balance sheets and income statements. Develop an order-to-cash blueprint. Spanning the entire spectrum of operational preparedness is a concept called order-to-cash (OTC) a phrase encompassing anything that must be in place to make a business operational. OTC includes the ability to get the product out of a warehouse, import it legally to a particular market, store it there, take orders from customers, generate invoices, deliver the product and receive payment in the bank account of a stand-alone business entity. Even sellers experienced in transactions may fail to appreciate the input required to produce an OTC blueprint. In an equity carve-out, for instance, its easy to overlook key bits of infrastructure needed to make Day 1 work. The regulatory environment may present obstacles to importing and selling products in particular markets. Sellers wishing to control the process often take responsibility for OTC planning so they can determine when they will receive cash and reduce their transaction risk. Sometimes, however, the buyer may want to handle the OTC process to ensure correct setup of the new legal entity. In either case, both sides must clearly understand their roles to make sure that crucial deadlines are kept. Different deals call for different OTC plans. In a stock deal, the buyer acquires shares of an existing legal entity, rather than buying its assets or liabilities. In an asset purchase, a new entity must be created, raising the risk that some customers may not consent to transfer their contracts. In such cases, a risk analysis by either buyer or seller would be a proper part of OTC planning.

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The OTC model is intended not simply to replicate the activities of the parent company, but to leverage the customer base to grow orders or improve customer service, for example. Buyers would do well to consider how they might change their order processing protocols to fit a new customer profile or whether distribution could be altered to consolidate spending or optimize resource use. Deeply familiar with the business being sold, a seller can point to OTC improvements. New owners may have an opportunity to reshape systems, create new revenue streams or be more responsive to customers. By analyzing existing processes and communicating their potential to buyers, sellers can distinguish themselves and enhance deal value. Pay attention to TSAs. TSAs are temporary contracts in which sellers agree to continue providing HR, IT, finance or other forms of service or support to the business after it is sold or spun tax-free are generally always a requirement. Many buyers, including PE firms, are not equipped to provide such services on Day 1. TSAs document the nature and duration of the parties post-closing responsibilities, allowing the legal and financial aspects of the deal to take place before operational separation is complete. Although TSAs must be tailored for each deal, certain

Developing a stand-alone business model requires sellers to examine each link in their value chain to see if they can take some operational step to enhance value or to keep it from eroding.
elements are standard. Service levels must be defined, allowing for flexibility and ease of administration. The parties must agree on pricing, billing and any administrative fees. Above all, timing must be clear. Lack of clarity about expectations and responsibilities may create hostile or unproductive relationships, adding inefficiencies and costs. As a result, transition periods may be stretched longer than necessary, while the accompanying disorganization provides competitors an opportunity to steal market share. TSAs exist to protect value for the buyer, so negotiating them is critical to the success of a sale. It is important to begin designing TSAs as soon as a potential buyer is identified. If the closing date arrives before all TSAs and operating requirements are finalized, workarounds and stopgap measures allow the deal to close on time. Nontraditional TSAs may allow for the operations to continue through the sellers legal entity, but transfer to the buyer all economic benefit and risk. Further TSAs in tax-free spin transactions must be executed with care; careful attention must be given through the duration. The less clean the closing, the more distracted and concerned the buyer likely will be. Ragged transitions may create confusion among customers. Buyers, aware that a new entitys management team will be concerned about stabilization for its first six months of operation, may push to reduce the price. Promote collaboration across functions. Business operations are fueled by numerous value drivers organizational know-how, managerial capabilities, customer relationships and brand equity reflecting the knowledge and skills of multiple business functions. Companies wishing to enhance sell-side deal value must promote cross-functional collaboration to build operational strength. Prepare for an effective post-closing stabilization period. As for sale progresses to sold, it becomes important to establish close ties between seller and buyer. Typically, the buyer wants to have input on key decisions that will affect the quality of operations at closing. Effective communication enables such input, preserves value and keeps the management team focused on the business. A good model is a joint governance framework covering the time between deal signing and deal close, and continuing for at least one additional reporting period after close. Neil Desai is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Chicago, Illinois. Andy Lorenzetti is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in Iselin, New Jersey.

Companies A and B: toward operating independence

Company A wants to sell a division. The business has good margins, but relies on the parents purchasing leverage to get discounts on supplies, freight and phone service. The division also uses the parents data center and software. A stand-alone business model will identify the impact on margins and operating processes when the business no longer benefits from its connection to the corporate mother ship. Company B provides financial services and raw materials, at a below-market rate, to one of its business units. Now that unit is on the block. To value the divestiture accurately, the seller must quantify these subsidies. The result will be part of the stand-alone business model.

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Effective divestiture management

Cleanly divesting a business that can preserve its value and perform on its own from Day 1 requires strong executive leadership with a history of successfully managing complex enterprise-wide projects.

Key points:
Choose an influential senior executive with an in-depth knowledge of the business being divested as divestiture leader Create, staff, empower and provide adequate resources to the sell-side project management office (PMO) Consider and address HR issues early Communicate the value proposition of the deal and its timeline to build employee support and promote stability

Successful divestitures depend on strong leadership and effective cross-functional teams. No company can afford less than senior-level management to lead its sell-side efforts. Further, the imperatives of coordination and communication call for a dedicated, influential, experienced executive who can lead teams and command attention. The involvement of senior management also clearly conveys the message that divestitures are a strategic priority. Early collaboration across teams that have been cleared into the transaction is also critical for functional alignment of strategic objectives as well as timelines. HR, finance, IT, tax and other business functions should be involved in preparing carve-out financial statements, sell-side due diligence and a stand-alone

to oversee the many tasks and details, including preparation of carve-out financial statements (audited, deal-basis or both), assembling and maintaining the data room, creating management presentations, completing registrations for the new business entity and so on. Project governance such as timelines, communication protocols and recordkeeping tools are also necessary. The PMO is responsible for seeing that operations are both separated from the parent and operational on Day 1. Resources to be transferred must be defined, and shared resources must be identified to either the parent or the entity to be divested. Shared applications and data must be separated. If shared processes are not transferring or being

Successful divestitures depend on strong leadership and effective cross-functional teams.

business model and transition planning.

The divestiture PMO

Creating a TMO helps sellers manage divestment processes effectively. As early as possible, sellers should designate key team members and establish lines of reporting. Transaction leaders should establish a charter for the sell-side team and institute rigorous project management

absorbed by the buyer, they must be replicated, outsourced or temporarily provided via transition service agreements. Shared contracts must be re-novated, and consents to transfer may be required. Shared assets not transferring with the transaction must be replaced or provided through transition service agreements. The PMO is the execution fulcrum for all
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planning and transitional efforts involving both buyer and seller. Financial matters, for example, require significant coordination between seller and buyer. The TMO would also oversee insurance, tax and auditing considerations in the pre-signing phase. In the closing stage, contract issues come to the fore. When the buyer is a PE firm, financial matters become highly complex, involving discussions of working capital, funding sources, the number and location of bank accounts, the composition of the board of directors, value-added tax considerations and the amount of invested capital. The PMO needs to allow plenty of time for these discussions, as bringing together financial, tax and legal counsel from both sides can be cumbersome, especially in a global deal. Also, the PMO must continually ask which side will pay for various dealrelated costs including, potentially, outside counsel. Sellers who forget to include these topics in negotiations with the buyer are likely to leave money on the table. The PMO also plays a pivotal coordination role in establishing operational readiness at the carved-out entity on Day 1. This enterprise-wide effort includes ensuring that legal entities are established, including appropriate licenses and registrations, and that the company can receive and fulfill orders, deposit cash and recognize revenue on Day 1.

Company C: deal team excellence

Highly experienced in corporate development, Company C maintains a core transaction team, augmented with a small virtual team representing functional areas (HR, IT, legal, IP, real estate). The core group directs both buy- and sell-side transactions, with financial and technical support from external advisors. The team and its members, coordinated overall by the corporate development function, have the authority and resources to do their jobs. Company C requires a three- to four-year commitment when it recruits from within for positions on the deal team. Because of the companys high volume of transactions, its key functional groups have people who focus on deals and work on every transaction. The corporate development group steers the ship, with the corporate development officer (CDO) acting as captain. When a business becomes a divestiture candidate, the corporate development group identifies the business units usual corporate support network. In a sell-side deal, this network can help the deal team resolve issues as they arise and enable Company C to fully grasp and deal with the impact of the divestiture.

network of influencers and clearly defining strategic and targeted messages are necessary components that are too often overlooked when managing a sale. With poor handling of the human side, talent poaching can become a problem and impact value in a material way. Employees may flee, fearing upheaval and change. Effective communication can convey to employees the career benefits of working for a new owner who will place greater value on the business. It is critical, of course, to treat employees fairly and provide aggressive incentive

compensation thoroughly is a recipe for low employee morale, provoking good people to look elsewhere. Deciding which employees should stay with the parent can be difficult. Sellers should work actively with potential buyers, especially private bidders, to help them build their new organization. Generally, the buyer does not want to take many employees along, while the seller frequently derives maximum value from sending off as many people as possible. If the offering memorandum makes stand-alone adjustments, the seller must figure out how this translates into headcount. Strong divestiture management can make the difference between a successful and an unsuccessful transaction. Making sure the right team is in place early should be a top priority for firms considering divesting. Mitch Berlin is a member of the Transaction Advisory Services practice of Ernst & Young LLP. He is based in New York, New York.

The human factor plays a big role in whether a sale is successful or not. Often the decision to divest is a difficult one to communicate to employees.
HR and communications
The human factor plays a big role in whether a sale is successful or not. The decision to divest is often difficult to communicate to employees. But, it is critical to sell employees on the value of the deal. Timing the announcement, creating a and retention packages to key personnel. Issues such as payroll outsourcing, benefits and stock options must be ironed out in the pre-closing period. How performance is defined and handled has ramifications for how well the business ultimately goes to market. Failure to address benefits and

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Conclusion
As companies manage their portfolio, they should consider divestitures as an important component of raising, reallocating and preserving capital.

Divestiture Advisory Services contacts:

Paul Hammes +1 312 879 3741 paul.hammes@ey.com

The key to using divestitures as a cornerstone of proactive portfolio management is early and comprehensive preparation. And as private equity firms, in particular, face increased competition when selling portfolio companies, pre-sale readiness can help unlock hidden value. Below are the essential considerations for a successful divestiture. Transaction strategy Target the right buyers, understand their perspective and decide what type of sale will most likely create and preserve value.

a stand-alone business model that examines each link in the value chain. Effective divestiture management Provide leadership, empower adequate resources to the divestiture process and communicate clearly and frequently across teams. Finally, a key to divesting for value is developing a detailed transaction measurement process. Most companies tend to track results only, based on broad corporate benchmarks or the contributions of individuals. However, establishing specific performance and process metrics and tracking them at every stage of the deal improves both process and outcomes, and enables continuous learning and improvement. Successful companies view divestitures as a crucial element of their overall capital agenda. While crafting a divestiture planning framework, companies must prepare early, articulate clear strategic plans and consider the multitude of factors at play during any divestiture transaction. Careful preparation can help companies extract greater value, increase speed to close and minimize disruptions to the core business.

Rich Mills +1 404 817 4397 rich.mills@ey.com

Sell-side due diligence Build a strong value case showing how current and future performance reflects the value proposition. Carve-out financial statements Present a clear and credible picture of the future stand-alone business. Tax issues and consequences Consider tax issues in order to create more efficient deal structures and higher valuations. Tax-free spin-offs Spin transactions are highly complex, but are an effective option with appropriate planning. Operational preparedness Pay attention to operational issues at every stage of the divestiture and develop

Divesting for value

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Ernst & Young Assurance | Tax | Transactions | Advisory

About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a member firm of Ernst & Young Global Limited serving clients in the US. For more information about our organization, please visit www.ey.com. Ernst & Young Capital Advisors, LLC is a broker-dealer affiliate of Ernst & Young LLP and a member of FINRA www.finra.org. 2012 EYGM Limited All Rights Reserved. ED 4-Nov-2012 EYG No. CE0740
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