This article is written by Yahaan Heerjee who is pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from Lawsikho.
A Transitional Service Agreement is a separate agreement from a purchase agreement that is made between the buyer and seller of a company. Transitional Service Agreement forms a crucial aspect of M&A transactions. When a company is sold there may be some obligations on the part of the seller that has to be fulfilled. This is an arrangement where the seller agrees to provide certain services at a predetermined price and for a specific time period. The acquirer may lack the back office to run the company. This is when the seller steps in to support the buyer in the smooth functioning of the company.
Back-office refers to the administration and support personnel who do not have to deal with the clients directly. The back-office consists of IT services, record maintenance, regulatory compliance, settlements, and accounting. The back office is basically the backbone of the company. For example, in a financial services firm the:
- The front office consists of sales, marketing, and customer support,
- The middle office consists of risk management; and the
- The back office consists of administrative and support services.
In a Transitional Service Agreement, the seller is the parent and the buyer is the child. Here, the parent pitches in for the child till the child is not independent. Furthermore, the seller provides its services to the buyer till the buyer is not capable enough to have the systems or framework in place to accomplish the tasks at hand.
When one company buys out another company there are hurdles to be crossed and quite often it is bumpy. A company that wants to take a leap of faith and buy out a well-established company often faces hurdles of operating that company independently. The selling company has its departments set up in handling various aspects of the company which is seldom in the buyer’s capacity. So, the Transition Service Agreement provides a framework of these departments vis-à-vis services until the buyer is capable of implementing it.
Transitional Service Agreement caters to the smooth separation and helps close the deal faster. Small carve-outs usually take 30 days to close whilst larger deals more than $1 billion take-ups 115 days to close. In this process, the buyer does not get enough time to respond to aspects like confidential information related to the transaction. Here, Transitional Service Agreement allows the business to transition and function separately quite quickly.
When a seller sells his business he has to keep certain objectives in mind. The main objective is to receive funds and focus on other aspects of their business rather than still investing the time and resources post-closing. The seller prefers the Transitional Service Agreement to be as less as possible and the services to be provided should be of the least time period. A transitional Service Agreement can prove to be a burden and a nuisance to the seller. A few considerations have to be kept in check whilst entering a Transitional Service Agreement.What are the key considerations?
- The buyer and the seller should be clear of what services are to be provided by the seller and utilized by the buyer. It should be explicitly in writing to help identify both the parties of the services that are being catered. This avoids confusion on the part of the seller and the seller can provide inter alia appropriate solutions and resources.
- Time estimation– The timeline and the affected cost are of vital importance while entering into a Transitional Service Agreement. The buyer and seller need to be realistic about the time frame of the agreement. An indefinite time period would not allow the buyer to adapt to the nature, system, and environment of the business. This is known as the exit strategy. The exit strategy has to be well planned since there are dependencies to prevent the system from breaking.
- Cost and invoicing– Everything comes at a price and so does forming a Transitional Service Agreement. The cost to be incurred should be categorically discussed between the seller and the buyer. The costs to be calculated should identify variable cost elements as well as fixed cost elements. What drives the cost is of equal importance like the headcount, office, building, and location. Gradually, the buyer’s wills top is dependent on the seller and the costs will go down. Sometimes, there remains a constant dependency on resources until that wears out. Keeping all this in mind the cost structure should be crystal clear to avoid any disagreement in the future. Most sellers are not in the business of selling services and may lack the systems, tools, experience, knowledge, and skills to accurately analyze service costs. In such a case the seller outsources these services to accurately analyze the cost drives.
- The services provided by the seller are set at a particular fee or charge. This fee or charge shall be discussed between the seller and the buyer before the closing. It should not be a hindrance on the part of the seller to provide services without charge.
- Geographical region- There are agreements formed at the global and local levels. It is imperative to differentiate where the services are being provided to avoid confusion while working with multinationals.
- Renewal- In case the buyer wants to retain the services of the seller or wants to renew the agreement, it is important to document this clause. After the time period of the existing agreement, the seller may refuse to continue providing the service, in that case, a renewal clause will help avoid a gap.
- Dispute resolution- No business activity can be a hundred percent smooth and effective. Discrepancies are bound to arise. In order to resolve these discrepancies, a dispute resolution mechanism has to be put in place between the buyer and the seller.
Why does divestiture happen?
When a company grows, it realizes that it has too much on its plate. The company then decides to dispose of its assets by selling, exchanging, or shutting them down, or by declaring bankruptcy. Instead of being involved in too many business activities, divestiture helps the company to stay focused and remain profitable.
The relationship between the buyer and the seller takes a shift after the deal closes. The seller intends to clear up the mess in the end and eventually leaves it to the buyer to take it forward. The seller prefers to wrap it up as soon as possible and resume focusing on its other priorities.
Management of the Agreement
The overall relationship between the seller and the buyer needs to be managed and coordinated. To look into the affairs of the agreement and supervise the services being provided is a crucial aspect. In order to keep moving forward, each company should appoint a coordinator to manage the services. This helps avoid any confusion or chaos. The coordinator is similar to a manager in various organizations. They do not dwell deep into the work but need a holistic view and keep a check on the services being delivered as well as the separation of the activities.
A manager can take responsibility and help in case of any nitty-gritty of the services being provided as it is not always feasible to approach the buyer or seller directly. The vendors or third party in relation to the service provided may approach the manager directly. The manager basically acts as an agent to the principal.
Does the seller keep up with his promise of high-level services or do expectations on the part of the buyer exist?
It is important to note that the seller and the buyer must wrap up the transition quickly and efficiently. The buyer must make it specific in writing of the resources and departments required to fulfill the promise. The seller and buyer must put their focus on the transition by completing it as quickly as possible rather than trying to maintain high-end services to be provided. There has to be a balance between the service cost and the business needs. Anything beyond what is required would be a burden on either of the company’s. There should not be unduly expectations from the seller. In this case, the key consideration is to document the services to be provided explicitly. It is imperative for both parties to agree on the performance metrics.
Thus, the seller basically piggy-backs the buyer until the buyer is capable of himself. It is important to document all the key considerations. Mere verbal promises in a transitional service are not effective. The service to be provided could be denied by the seller post-closing if it is not documented as he has no responsibility after the transaction is completed. It might overburden the seller to still be stuck after the closing. In order to provide a smooth transition, the buyer and the seller must understand the Transitional Service Agreement and avoid any manholes that may come their way. The seller and the buyer should independently consider inter alia all the practicalities, time estimation, documents required, services to be provided, and to be received very thoroughly. This will help them to monitor correctly and stay in touch throughout the process.
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