Why Adopting the Right Diligence Strategy Can Accelerate Divestiture Success

For companies looking to sell part of their business, it’s important to understand and resolve potential financial and operational challenges that may lie below the surface of a promising deal. Without a rigorous sell-side diligence approach, a seller may make it nearly to the finish line, only to find that the deal it has put on the table has unexpected red flags or isn’t properly valued. Adopting the right diligence strategy early on can position a company for a successful divestiture and ensure the deal closes at maximum value.

Strategic considerations

Before a company embarks on a divestiture, it should clarify its reasons for selling part of the business and define the intended outcomes to help maximize deal value and minimize execution risk. Companies should start this process early by taking the following considerations into account.

• Know the purpose of the divestiture. While a company’s primary mission will be to maximize shareholder value, its approach will depend on the specifics of the divestiture. Defining the purpose of the deal and understanding the target’s strategic vision can help influence the approach that management will take. For instance, companies may divest to shed non-core businesses, pay down debt, fulfill regulatory requirements, or to realize the higher value of a business unit once separated from the parent. How the company structures the transaction, executes the deal, and plans for separation will all be impacted by the deal thesis.
• Set the deal for success. Clearly defining the business to be sold early in the process will allow all parties to effectively strategize on timing and method of marketing. This includes identifying both the assets and employees that will be transferred as part of the divestiture. Once scope is adequately defined, companies can obtain the data required to consistently  present the business to all stakeholders.
• Understand the buyer pool. Knowing a company’s buyer pool can help to maximize the value it receives for its assets. Since financial and strategic buyers will have different goals, it is important to take the buyer’s unique point of view into account when crafting a company’s business story. Understanding what each buyer brings to the table—such as speed of deal, ability to separate quickly, price, etc.—will allow companies to target their efforts toward those buyers that most closely align with their divestiture goals.

Tax considerations

When it comes to tax planning, there are both ample opportunities and potential pitfalls for a company deciding to carve out a portion of its business. Sellers and buyers alike should conduct tax diligence and tax planning prior to closing a transaction, keeping the following considerations in mind.

• Structure strategically for maximum return. Buyers generally prefer asset deals, while sellers may opt for stock transactions. Although it is typically easier to structure and execute a stock sale, there are some downsides for the buyer. For example, buyers often pay a premium for the business that exceeds the fair market value of the physical assets. In a stock deal, the excess may be attributable to goodwill or other intangible assets and generally cannot be deducted for income tax purposes, as opposed to an asset deal. Additionally, in a carve out, the business or the assets that the buyer is purchasing are often owned by more than one legal entity. This may make structuring the deal as a stock purchase more difficult than structuring it as an asset purchase. By thinking through the potential alternatives, sellers can maximize their value while presenting an attractive structure for buyers.
• Understand the IRC Section 338(h)(10) election considerations. In certain circumstances, parties may be pemitted to make an IRC Section 338(h)(10) election which allows a stock deal to be treated as an asset purchase for US federal income tax purposes and “step-up” the value of goodwill and other intangibles. This step-up may be amortizable for US federal income tax purposes over a period of 15 years. Additionally, by making this election, while sellers must pay tax on any gains from the deemed asset sale, the proceeds are considered a non-taxable deemed liquidation. The selling company may agree to this election to help close the deal, however, it can negotiate the purchase price to offset any increased tax burdens as a result of the election.
• Know how successor liabilities are treated in your deal structure. In a stock deal, the buyer’s investment will be subject to the historical tax exposures of the target company. Asset deals typically do not carry the same risk of successor liability since ownership of the tax paying entity is not changing hands. However, the acquisition of assets may potentially result in the buyer assuming certain state and local taxes as well as employment taxes. This successor liability will occur pursuant to applicable state or federal law, notwithstanding that the asset purchase agreement expressly provides that the buyer is not assuming any tax liabilities of the seller. While there are fewer successor liabilities that may transfer to the buyer in an asset deal, the seller should conduct tax due diligence and provide for indemnity protection in the acquisition agreement.

Financial information considerations

Prospective buyers want to understand the financial performance of a carved-out business before agreeing to a transaction. As such, it is important to anticipate buyer needs and be prepared with the right financial information in order to mitigate value leakage and satisfy buyer asks.

• Know the key differences between deal basis financial statements and US GAAP financials. When divesting a carved-out business, a seller will want to prepare for all potential scenarios. To this end, companies should anticipate the financial needs of their prospective buyers, which can mean preparing deal basis carve-out financial statements, a quality of earnings report, and/or US GAAP based carve-out financial statements. Deal basis financial information includes adjustments, such as incorporating estimated standalone costs or removing one-time charges, meant to reflect what the performance of the carved-out entity will be on a post-transaction basis. US GAAP carve-out financial statements will likely include an allocation of historical shared costs to the carve-out entity, adjustments for the treatment of intercompany charges, a potential allocation of debt, and more. It is important to maintain a reconciliation between the all types of financial information presented to buyers. This will help to avoid surprises throughout the process.
• Ensure that estimating standalone costs are flexible for multiple buyers. Sellers should be prepared to determine an estimate of what the standalone costs would be for a carve-out entity when operated separately from the parent. This estimate will likely be different than the allocation of historical shared costs required in US GAAP financial statements and can vary among financial and strategic buyers based on their specific goals for the business and its post transaction structure. This means that the estimation of standalone costs should be flexible enough to allow for multiple alternatives that align with the needs for a large pool of buyers.

Summary

As companies begin the process of divesting part of their business, it is important to be adequately prepared with a robust diligence strategy. The right approach can accelerate the deal timeline, mitigate potential risks, and yield maximum value. By building a comprehensive strategy that addresses potential financial and operational hurdles, sellers can identify buyers that understand their deal goals and successfully close on the most opportune transactions.