Avoiding Merger Integration Limbo

A Buyer's Guide to Transition Services Agreements

After a lull in mergers and acquisitions in the early 2000s, activity is once again heating up. In fact, the first three months of 2006 marked the fastest start for M&A activity since the record-breaking year of 2000. During this period, companies signed more than 5,800 M&A deals globally, totaling about $859 billion. Europe experienced the biggest increase, where the value of deals more than doubled over the previous year, reaching $454 billion.₁

Yet increased merger activity does not necessarily translate into successful deals. Bringing a new company into the fold with minimal disruptions is notoriously difficult. Moreover, the complexity and risk of an integration increases when the target company is a "carve out"-a division or unit of another company-and depends on the parent for certain functions, such as sales, supply chain, finance and human resources. Under these circumstances, a divested company may continue to receive functional support from the selling parent company for a period of time after the deal closes. To manage this relationship, the buyer and seller will enter into a transition services agreement (TSA). This document is important because it establishes how the buyer and seller work together from change of control to the complete transfer of all services. A well-crafted TSA can help maintain smooth operations and prevent the buyer from slipping into merger integration limbo.

Unfortunately, in the rush to complete the deal, many companies fail to concentrate on the details of this arrangement. This often leads to the buyer and seller entering the transition period with different expectations, thus risking disappointment, contention, business disruption and lost sales. Indeed, such a rocky start may mean that executives spend so much time making up for lost ground that they are distracted from focusing on activities that create value from the merger. By taking the time to ensure that the TSA works to their favor, companies can confirm that their acquisitions are on the right track.

Dig into the Details
In many ways, the TSA has the look and feel of an outsourcing agreement-it outlines the scope of services, performance standards, service terms and fees that one agrees to provide another. The difference is that in a TSA, the service provider (typically the seller) is not in the business of providing services or maintaining a long-term relationship with the buyer. The seller is bound to provide basic service requirements and no more. In fact, most TSAs do not offer incentives for the seller to go beyond providing basic services.

Despite this fact, buyers often do not scrutinize the language of the TSA as they should, or as they would the details of an outsourcing agreement or any other significant contract. But TSAs should be throroughly scrutinized. The following are key tips for how a buyer should approach major sections of the agreement:

Description of services. The description section of a TSA outlines which services the seller will provide during the transition period. Out of convenience, both companies tend to define these services at a high level-sales, distribution, finance, human resources-and use catch-all phrases to indicate that any service that the seller provided before the deal should be included during the transition. Buyers, however, will only get what they ask for. If the descriptions are too broad, then the buyer may end up paying for functions that it either doesn't need or needs only a part of. For example, in the finance category, a buyer might be able to take over accounts payable shortly after change of control, but not accounts receivable because the customer service and logistics processes and systems have not yet moved over. Yet, under most TSAs, the buyer has to pay for all finance services until the end of the transition period-regardless of what it uses.

Rather than outlining services on a broad level, buyers should break down service categories into smaller functions to make it easier to choose exactly which services they need and the timeline for how long they need them. Alternatively, the buyer can include a provision in the TSA that permits it to prorate the costs if a service ends in phases.

Standards of performance. The standards of performance section is the most critical-and generally most contentious-part of a TSA as it defines the level of service that a seller provides during the trans-ition. Problems often arise because the seller and buyer have countervailing objectives. The seller generally wants to reduce its headcount to avoid excess capacity and limit the cost of the transition; the buyer wants to ensure a consistent level of service and assistance from the seller in transferring the services, which places a further strain on the seller's resources. Reaching a common understanding of service performance is crucial to a smooth transition.

In line with this, the buyer should try to ensure that the definition of "service level" is not a matter of opinion. Often, the language in a TSA gives the impression that metrics for service performance exist when in fact the seller does not maintain extensive performance metrics. Standards of performance are often set relative to a specific point in time. For example, it might say, "the relevant measurement of performance of the services shall be the measurement metrics currently used in the business." Alternatively, the TSA might specify that the service will be equivalent to the performance levels provided in the 12 months prior to the deal.

In either of these examples, it does not guarantee that metrics exist and, in reality, many sellers won't have this information either. In these situations, the buyer should benchmark service levels, such as shipping lead times during the due diligence process (recognizing that some services might decline as a result of the transaction) and use that analysis to establish service expectations in the TSA. Otherwise, the buyer should talk with employees from the acquired company to gauge the previous service levels.