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Carving out a business: Easier said than done

Scott E. Linch
In these challenging economic times, companies are evaluating their overall corporate strategies and are exploring all their options. This strategic evaluation process includes assessing the divestiture of certain facilities, product lines or businesses which no longer contribute to the overall corporate strategy. Carve-out transactions, also known as corporate divestitures, have been a popular transaction type during 2010. Capital IQ reported that 2,692 corporate divestitures in the United States during 2010. The carve-out businesses sold through corporate divestitures are purchased by other strategic companies, private equity firms, private investors and entrepreneurs. PitchBook Data, Inc. reported that 209 corporate divestitures in the United States involved private equity investors during 2010. statements. As a result the seller attempts to develop carve-out financial statements, which may or may not represent the complete results of the carve-out portion of the business. The financial statement aspect is only one of many concerns surrounding a carve-out transaction, but it plays a critical role in determining the overall value of the carve-out business.

Carve-out financial statements Development of carve-out financial statements creates unique challenges as the portions of a business to be included in the statements are typically reported through unaudited internal profit and loss statements. Internal reports could be as simple as reporting only the revenue related to a product line and are not always prepared in accordance with Generally Accepted Accounting Principles (“GAAP”). Reported revenue may be impacted by such issues as internal transfer pricing arrangements on intercompany sales, cross-selling between overall corporate customers and trade names and trademarks that may not transfer with the carve-out business. Buyers should consider whether any revenue sources will terminate after a carve-out transaction. The loss of revenue may include common customers across businesses within the corporate entity or intercompany sales. Additional commercial due diligence should be performed to ensure sales will continue at the same level with common customers once the carve-out business is separated from the corporate entity. In addition, supply

Corporate divestitures are sometimes termed orphan businesses as they are no longer considered strategic assets of the overall business and may not be actively managed. Divesting of these orphan businesses allows companies to raise capital to focus on the strategic areas of growth. These divested businesses could either be operated as a stand-alone business or combined with similar businesses to create synergistic values. Nevertheless, from a valuation standpoint, a buyer should consider the stand-alone value when determining the purchase price of a carve-out business. Buyers normally do not want to include synergistic value in the purchase price. In many instances these portions of a company do not report financial results through stand-alone financial

payables.Carving out a business: Easier said than done Scott E. In addition. an understanding of the costs of sales of the carve-out business outside of the overall corporate entity is extremely important. This assessment may include estimates for the incremental costs surrounding new personnel to be hired. As a result. such as warranty reserves or bonus accruals may be estimated at the corporate level. Costs of sales may be impacted by such issues as internal transfer pricing arrangements for costs. Many of these costs and services may be handled for a period of time through a transition services agreement (“TSA”) after the closing of the transaction. A stand-alone cost analysis should be performed to assess these costs on an ongoing basis. favorable vendor arrangements at the corporate level and corporate overhead allocations. professional fees for stand-alone audit and tax services and numerous other costs that may change once the business is outside the corporate umbrella. insurance. accrued expenses and other assets and liabilities to the carve-out business. Favorable vendor arrangements could provide price reductions based on purchase volumes. legal. Carve-out balance sheets likely are developed for the first time in anticipation of a transaction as balance sheets may be reported only at the corporate level. human resources. For example. the opportunity to analyze these expenses may not be available. accounting. Since these types of costs may be captured at the corporate level. such as executive personnel. required system upgrades. The seller’s reimbursement expectations related to the TSA may be an indication to the buyer of the seller’s opinion on the actual corporate costs of the stand-alone business. Separation of these receivables may or may not be possible depending on how the transactions are reported in the financial reporting system. Carve-out balance sheets Carve-out balance sheets are necessary in understanding the net assets that will transfer after the closing of the transaction and evaluating the working capital needs of the carve-out business. For example. In addition. many liabilities. the carve-out business may report its receivables co-mingled with other lines of business. Substantial analysis is necessary to properly allocate receivables. is critical. occupancy and other costs captured at the corporate level. Stand-alone costs Capturing the expenses related to the carve-out business may be the most difficult aspect of developing carve-out financial statements. Internal profit and loss statements often include allocations of corporate overhead and selling expenses which may be significantly different than the stand-alone costs of operating the business. Performing an in-depth analysis of stand-alone costs. the gross margin of the carve-out business may not be comparable to the gross margins reported internally. a component of the carve-out businesses’ finished goods may be manufactured by a common entity and the standalone cost of manufacturing that component may be significantly different. Linch agreements should be entered into with the seller to establish pricing and volumes of sales to the corporate parent after the carve-out transaction closes. sales and marketing. If supporting documentation does not allow for a clear .

. Planning for a corporate divestiture When buying or selling a piece of a business. careful planning and analysis should be performed. Scott E.Carving out a business: Easier said than done Scott E. bridging the historical carve-out financial analyses to the forecast is essential in assessing the valuation of the carve-out business. Any due diligence adjustments to the earnings of the carve-out business may impact the valuation by a multiple of each adjustment. Linch is the Practice Leader for the Transaction Advisory Services Practice at Dixon Hughes PLLC. Scott can be reached at slinch@dixon-hughes. Involving outside assistance early in the process may contribute to a more simple transition and sale. sellers may develop a methodology to allocate the assets and liabilities such as percentage of total sales for receivables. Furthermore.com. As more transactions involve carve-out situations. the largest accounting firm based in the Southern U.S. buyers need to be aware of the risks associated with evaluating a portion of a business and ensure that the reported carveout earnings and net assets are approached with the highest level of scrutiny. Carve-out financial statements may be audited but often corporate and private buyers and sellers prefer to involve transaction due diligence professionals to assist with the carve-out and evaluate the quality of related earnings and net assets. Linch process to separate assets and liabilities.