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Presenting a live 90-minute webinar with interactive Q&A

Carve-Out Transactions: Strategies for

Due Diligence and Structuring the Deal

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JUNE 28, 2017

Jason C. Breen, Partner, Goodwin, Los Angeles

Charles J. Morton, Jr., Partner, Venable, Baltimore

Rita-Anne O'Neill, Partner, Sullivan & Cromwell, Los Angeles

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Carve-Out Transactions: Strategies for Due Diligence and Structuring the Deal

June 28, 2017

Strafford Web Seminar

Rita-Anne O’Neill Charles Morton Jason Breen

Carve-Out Transactions – Latest Trends

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What Is a Carve-Out Transaction?

A carve-out transaction is a sale of a business line, division or portion of a larger company. By their nature, carve-out transactions combine many aspects of public company and private company M&A and also raise their own set of unique issues.

Key Attribute of Carve-out Transactions:

Seller remains an operating business once the transaction has been completed.

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ABA Carve-Out Transaction Deal Points Study

The M&A Market Trends Subcommittee of the Mergers & Acquisitions Committee of the American Bar Association’s Business Law Section is in the process of a new Deal Points Study on carve-out transactions expected to be released by the end of 2017.

The Deal Points Study includes analysis of approximately 120 carve-out sale transactions that were announced from January 1, 2015 through December 31, 2016.

The carve-out transactions included in the Deal Points Study are public deals with transaction values in excess of $10 million where the ultimate parent of the Seller is a U.S. public company, the Seller was not in apparent financial distress at the time of the announcement of the transaction and the Seller did not retain any equity interest in the carved out business sold.

The Deal Points Study excludes agreements that expressly contemplate that the Seller will obtain stockholder approval prior to consummation of the transaction.

Note that the data from the Deal Points Study referenced throughout this presentation is preliminary.

Also note that the data from the Deal Points Study only covers public deals and the data may be different for private deals.

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Carve-out Transactions – Structure

Carve-out transactions can take the form of asset purchases in which the Seller identifies and sells or “carves out” specific assets; or the form of an equity purchase in which the Seller sells equity in one or more of its subsidiaries.

Carve-out transactions can also combine the two structures, for example, when the Seller sells both assets and equity in subsidiaries, or when the Seller transfers assets in a pre-closing restructuring to a subsidiary and then sells that subsidiary to a Buyer.

Even with a transaction structured as an equity purchase, it still may involve an asset sale in connection with a restructuring.

Practitioners advising a Seller should discuss very early on in the process whether a pre-signing or a pre-closing restructuring, if any, is desirable.

Structure should also take into account input from tax advisors.

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Carve-Out Transactions – Unique Legal and Business Considerations

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Consideration

Issue of valuation gaps may be amplified in a carve-out transaction. There may not be stand-alone financials relating to the carved out

business.

To bridge the valuation gap, the parties may agree to staged payments and/or earnouts.

Earnouts often address specific concerns and risks of Buyer in assuming the carved out business. For example, milestones based on satisfying integration metrics, sales targets and/or regulatory approvals.

Deal consideration may include mix of stock and cash, which should be considered in the structuring of the transaction.

Parties should consider the scope of the retained liabilities by Seller and post-closing recourse of Buyer against Seller in determining the deal value and the triggers for payment of the consideration.

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Transferred Assets/Liabilities

A key aspect of structuring a carve-out as an asset purchase or with an asset purchase component is identifying the specific assets to be transferred and the liabilities to be assumed.

Describe specifically? List and/or describe specific assets for purchase in an attached schedule.

This may be tedious and creates the risk that an asset related to the carved out business will be omitted.

Describe generally? Describe the assets to be purchased conceptually.

Flexible definitions ensure the intended assets will be included in the purchase agreement. However, the added flexibility leaves room for debate as to whether a specific asset is included in the conceptual definition or should rightfully remain with the Seller.

Pair conceptual description of assets with non-exclusive lists of particularly important classes of assets to be purchased.

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Transferred Assets/Liabilities (con’t)

Example standards used to define conceptually described transferred assets:

Related to another transferred asset or the carved out business.

Exclusively used in the carved out business.

Primarily used in the operation of the carved out business.

Necessary to the carved out business.

Used in the operation of the carved out business.

Primarily related to or associated with the carved out business.

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Transferred Assets/Liabilities (con’t)

Example standards used to define conceptually described excluded assets:

Liquid assets such as cash, tax refunds, accounts receivable, funds owed under outstanding hedging arrangements, etc.

Equity of subsidiaries.

Corporate records of Seller and Seller parent.

Insurance policies.

Assets, rights and interests in employee benefits plans.

Rights under Seller and Seller parent trademarks.

Assets unrelated to the carved out business.

Commingled contracts.

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Transferred Assets/Liabilities (con’t)

Assumed liabilities by Buyer specifically articulated, with all other liabilities retained by Seller.

Liabilities listed on a schedule.

Liabilities relating to transferred assets following the closing.

Liabilities arising from the sale of products following the closing by Buyer.

Assumption of executory liabilities arising following the closing under the transferred agreements (excluding liabilities relating to breaches or events that occurred prior to or at the closing).

If there is a working capital adjustment, current liabilities.

Retained liabilities specifically articulated, with all other liabilities assumed by Buyer.

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Transferred Assets/Liabilities (con’t)

Example standards used to define conceptually described retained liabilities: Liabilities relating to pre-closing and transaction-related taxes.

Liabilities relating to present or former employees of Seller.

Liabilities arising under employee benefit plans of Seller.

Liabilities arising pre-closing or relating to an event occurring pre-closing.

Liabilities relating to excluded assets.

Liabilities associated with Seller indebtedness.

Liabilities arising from Seller's breach of representations, improper performance or defective products/services.

Liabilities arising from litigation for pre-closing actions.

Seller accounts payable.

Liabilities unrelated to the carved out business.

Liabilities arising from Seller's failure to comply with contracts or applicable law.

Liabilities for environmental claims.

Liabilities owed to Seller’s directors and officers.

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Commingled Contracts

Commingled contracts are contracts that cover the carved out business and all or part of the business to be retained by the Seller.

Unwinding refers to the situation in which the carved out business is released from the commingled contract, or the commingled contract is split into separate contracts (whether by novation, partial assignment or amendment, or some combination thereof).

The obligation to unwind or allocate a commingled contract can be reflected in the purchase agreement as a pre-closing or post-closing covenant, or both.

A pre-transaction reorganization can also be an opportunity to unwind commingled contracts.

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Commingled Books and Records

In carve-out transactions, you may also need to address commingled books and records other than contracts.

The Seller should expect to deliver to the Buyer copies of all such commingled records that are primarily related to the carved out business.

Those records typically would contain a mix of information – Seller information that is not related to the carve-out business, Buyer information that is exclusively related to the carve-out business, and shared information. All of this information is often mixed in commingled records that will be transferred to the Buyer.

Consider confidentiality restrictions and mechanisms for both parties to share and use shared commingled information.

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Carve-Out Financial Statements

Carve-out financial statements are financial statements covering the carve-out business on a standalone basis.

Preparing carve-out financial statements may require significant time and resources. Accordingly, if carve-out financial statements will be required as part of a transaction, the parties should discuss this as early in the process as possible.

By preparing carve-out financial statements early, it will help the parties identify the assets to be transferred as well as any commingled contracts.

A Buyer may, for various reasons, require carve-out financial statements with respect to the business it is acquiring. For instance, carve-out financial statements may form a significant portion of the Buyer’s due diligence and impact the Buyer’s valuation of the carved out business, and the carve-out financials may also be necessary for the Buyer to obtain the financing it needs to fund its acquisition of the carved out business.

Carve-out financials may be required if the Buyer is a public company and the transaction is significant.

Rule 3-05 of Regulation S-X requires a Buyer to file audited financial statements with the SEC on the carved out business for up to the three most recent fiscal years, depending on how significant the transaction is; there are various tests to determine significance.

Even if carve-out financials are not required, they may be advisable to provide certainty for the valuation of the carve-out business.

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Carve-Out Financial Statements (con’t)

If carve-out financials are not prepared or audited before a transaction agreement is signed up, the purchase agreement should specifically address the timing of completion.

Include a Seller representation with respect to carve-out financial statements that have been made available to the Buyer at signing.

Include a covenant that provides that the Seller will prepare and deliver additional audited or unaudited financial statements.

Even if not currently needed, consider adding a covenant for Seller to assist in the preparation of financials if a private company may go public in the near term.

Condition the closing on the delivery of carve-out financial statements that are reasonably satisfactory to the Buyer.

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Scope of Representations, Warranties & Covenants

Parties typically will be sensitive to the scope of the representations and warranties. Categories of representations and warranties.

How broad is the coverage of the representations and warranties?

Seller generally.

Business.

Specific assets.

Scope of restrictions on the Seller generally between signing and closing. Seller generally.

Business.

Specific assets.

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Sufficiency of Assets Representation

In a carve-out transaction, the Buyer is acquiring some but not all of the Seller’s assets. Accordingly, a sufficiency of assets representation gives assurance to the Buyer that, upon consummation of the transaction, it will obtain all of the necessary assets to operate the carved out business without the excluded assets that are retained by the Seller.

Agreements structured with an asset purchase component and agreements structured without an asset purchase component both often contain a sufficiency of assets representation.

Because of the importance of sufficiency of the assets representation to carve-out transactions, the specifics of drafting the representation can be critical.

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Third Party Consents

All carve-out transactions, but particularly those structured as asset purchases, can raise significant third party consent issues. This is because a company may not have structured its contractual arrangements in a manner that would have contemplated a partial sale of the Seller.

Buyers should consider including provisions in the acquisition agreement that address the following: outlining the efforts that the parties must undertake in order to

obtain consents; expressly providing for the consequences in the event that certain

contracts cannot be assigned; and/or conditioning closing on obtaining certain consents.

If the acquisition agreement is conditioned on obtaining certain consents, parties should have a clear understanding of the threshold of consents required to facilitate closing.

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Third Party Consents (con’t)

When drafting a third party consent covenant, parties need to think about: Who will bear the responsibility to obtain third party consents (Seller, Buyer or

both). Most agreements have both parties responsible.

Who participates in the discussions with third parties. Important to have a consistent message regarding the transaction.

What level of efforts such party should use to obtain third party consents. Level of efforts commonly used include:

Commercially reasonable efforts; and

Reasonable best efforts.

Whether there will be any limits on the obligation to obtain third party consents. Limiting consideration paid, commencing litigation, modifying the underlying contract, etc.

The time needed for obtaining third party consents. Parties often underestimate the time needed to obtain third party consents.

Who will bear the costs of obtaining third party consents.

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Non-Competition/ Non-Solicitation Covenants

Unlike in a typical M&A deal, in a carve-out transaction the Seller remains an operating business once the transaction has been completed, and therefore non-competes and non-solicitation provisions are probably one of the most interesting negotiations in a carve-out transaction.

The typical non-compete, if any, will restrict Seller’s ability to compete with the business being sold for some period of time, typically between two to five years.

The typical non-solicit will restrict Seller’s, or sometimes Buyer’s, ability to solicit employees of the other party, or sometimes customers and vendors of the carved out business.

Beware of confidentiality obligations creating back-door non-competes.

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Indemnification – Deductibles, Baskets and Caps

Virtually all carve-out deals have indemnification based on breaches of representations and warranties, similar to any sort of private deal transaction.

Most provide an indemnification of Buyer for retained liabilities, while others provide an indemnification of Seller for assumed liabilities.

As reflected in the preliminary data from the Deal Points Study, caps, baskets and survival periods, as well as other indemnification provisions such as treatments and components of fundamental representations and materiality scrapes tend to be similar to those in typical private company transaction agreements.

One departure is that indemnification for retained liabilities may be uncapped.

For indemnification provisions generally, customary private transaction agreements for entire companies are often good starting points for drafting carve-out transaction agreements.

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Indemnification – Use of Escrows and Holdbacks

One key way in which carve-out transactions differ substantially from private transactions is the source of the recourse for Buyer indemnity claims, that is, whether such recourse is supported by an escrow, a holdback or general recourse to the Seller.

The low frequency of escrows and holdbacks in public carve-out transactions is consistent with expectations where there is a Seller that remains to answer for any potential future indemnity claims.

Use of escrows and holdbacks tends to be more common in private carve-out transactions.

Set-off against future payments (staged payments and/or earnouts) may be another source of recovery.

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Retention of Key Employees

From a Buyer’s perspective, it’s often critical to make sure that key employees come along with the carved out business.

Even though key employees can be very important to a deal, the Seller won’t want the entire deal to be at risk over a couple of employees who may refuse to go along. Could include a closing condition that a certain percentage of the employees receiving

offers agree to Buyer’s employment documents.

Require that Seller terminate any offered employees that do not accept Buyer’s employment terms.

Parties often address this issue outside of the agreement, such as by negotiating employment agreements prior to signing or by requiring the Seller to make various representations and warranties about the key employees of the carved out business. Negotiating the employment agreements prior to signing reduces the leverage that key

employees may have on the transaction after the agreement is signed and announced.

Another option is to have the key employee provide services under a transitional services agreement or a reverse service agreement after closing.

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Other Employee Considerations

Condition offers of employment on closing of transaction.

Allocate pre-closing (and closing) obligations to offered employees between Buyer and Seller.

Consider integration matters and what is required to occur by closing.

If offered employees are employed outside of the United States, engage local counsel as employees may automatically transfer with the carved out business, while in other jurisdictions certain procedural requirements may be required that could impact the timing of the closing.

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Ancillary Agreements

In a carve-out transaction, there are a number of ancillary agreements. These ancillary agreements tend to be more substantive than you might see in a whole company transaction.

Some example ancillary agreements include:

IP licenses, if you have IP that’s shared in a business, the Seller may need a license back to the IP that was transferred so it can continue to run the retained business, and Buyer may need a license to shared IP of Seller that was not transferred.

Leases or a sub-leases for the facilities of the carved out business.

Supply agreements.

Transition services agreements.

The most common, and the most negotiated, ancillary agreement in a carve-out transaction is a transition services agreement where the Seller provides services to Buyer for some period of time post-closing so that Buyer can fully transition and integrate the carved out business into its own business.

Sometimes you have transition services going back from Buyer to the Seller if there were assets transferred that the Seller needs to replace or come up with other services to replicate.

Key issues in a transition services agreement are scope of services, the period of time for the services and what the cost will be for those services, if any.

Careful attention should also be paid to the indemnities in the TSA and in the other ancillaries.

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Carve-Out Transactions – Due Diligence Best Practices

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Identifying Key Assets

It is really important to determine early on in diligence which assets will be transferred in a carve-out transaction.

Parties need to identify the key assets (including the type and location) in order to: Structure the transaction.

Determine tax ramifications.

Describe the assets to be transferred or retained in the transaction. As discussed earlier, will these be described specifically or conceptually or both?

Determine which contracts will need to be unwound. If so, how will such contracts be unwound? Is the carved out business released from the

commingled contract, or is the commingled contract is split into separate contracts?

Whether a transitional services agreement, license agreement or other ancillary agreement is necessary.

Whether third party consents are necessary for transfer.

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Assignment and Third Party Consent

As discussed earlier, a carve-out transaction is likely to require a number of third party consents.

In order to inform the parties’ negotiations and drafting, it is important to identify critical contracts early in the transaction, and if any are identified, to understand the consequences if the transaction is consummated without the receipt of such consent, for example: whether the assignment would be void;

whether it would constitute a breach of the contract;

whether that would give rise to a claim for damages; and

what the parties would do if the contract cannot be assigned.

If a contract states that it may not be transferred without consent, then any transfer in violation of such provision would result in a breach of that agreement and entitle the counterparty to any damages incurred as a result of the transfer.

However, if the contract to be transferred expressly states that any transfer without consent shall be void, then the contract cannot effectively be transferred without such consent and the parties should consider methods for ensuring that the Buyer gets the benefit of that contract.

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Other Due Diligence Matters

Release of liens.

Intercompany arrangements (documented, required post-closing, arm’s length terms).

Diligence on Buyer.

Required consents.

Impacts on legacy business.

Integration matters.

Engage local legal advisors early.

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Contact Info

Rita-Anne O’Neill, partner at Sullivan & Cromwell LLP 1888 Century Park East, Los Angeles, CA 90067 (310) 712-6698 oneillr@sullcrom.com

Charles Morton, partner at Venable LLP 750 East Pratt Street, Suite 900, Baltimore, MD 21202 (410) 244-7716 cjmorton@venable.com

Jason Breen, partner at Goodwin Procter LLP 601 S. Figueroa Street, Los Angeles, CA 90068 (213) 426-2574 jbreen@goodwinlaw.com

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Bios

Rita-Anne O'Neill, Partner Sullivan & Cromwell LLP, Los Angeles

Ms. O’Neill has a broad-based practice that includes advising clients on mergers and acquisitions and securities offerings, and providing general corporate advice on disclosure and governance. She has advised clients in a wide range of industries, including apparel, financial institutions, healthcare and life sciences, semiconductors, telecommunications, and transportation. Ms. O’Neill is currently chairing the new ABA Deal Points Study on Carve-Out Transactions.

Jason C. Breen, Partner Goodwin Procter LLP, Los Angeles

Mr. Breen represents startup and later-stage companies in the software, technology and life sciences industries throughout their corporate life cycle, with a particular focus on mergers, acquisitions, divestitures, financings and other strategic transactions. He also represents venture capital, growth equity and private equity funds focusing on technology and life sciences companies.

Charles J. Morton, Jr., Partner Venable LLP, Baltimore

Mr. Morton Co-Chairs the firm’s nationally prominent Corporate Practice Group. His practice focuses on the healthcare, technology, and consumer products industries. Mr. Morton assists lenders, investors, and entrepreneurs as they create, build, and buy or sell businesses. He regularly acts on behalf of private equity groups and banks. Mr. Morton is the past Chairman of the Global Board of Directors of the Association for Corporate Growth.

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