carve out final

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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 evaluationprocess 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.

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

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 ofthe 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 willterminate 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


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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.

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,

such as executive personnel, human resources,

accounting, legal, sales and marketing, insurance,occupancy and other costs captured at the corporate

level, is critical. Since these types of costs may be

captured at the corporate level, the opportunity to analyze

these expenses may not be available. A stand-alone cost

analysis should be performed to assess these costs on

an ongoing basis. This assessment may include

estimates for the incremental costs surrounding new

personnel to be hired, required system upgrades,

professional fees for stand-alone audit and tax services

and numerous other costs that may change once the

business is outside the corporate umbrella. 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. The sellers reimbursement

expectations related to the TSA may be an indication to

the buyer of the sellers opinion on the actual corporate

costs of the stand-alone business.

In addition, an understanding of the costs of sales of the

carve-out business outside of the overall corporate entity

is extremely important. Costs of sales may be impactedby such issues as internal transfer pricing arrangements

for costs, favorable vendor arrangements at the corporate

level and corporate overhead allocations. For example,

a component of the carve-out businesses finished goods

may be manufactured by a common entity and the stand-

alone cost of manufacturing that component may be

significantly different. Favorable vendor arrangements

could provide price reductions based on purchase

volumes. As a result, the gross margin of the carve-out

business may not be comparable to the gross margins

reported internally.

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. 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. Substantial analysis is necessary to

properly allocate receivables, payables, accrued

expenses and other assets and liabilities to the carve-out

business. For example, the carve-out business may

report its receivables co-mingled with other lines of

business. Separation of these receivables may or may

not be possible depending on how the transactions are

reported in the financial reporting system. In addition,

many liabilities, such as warranty reserves or bonus

accruals may be estimated at the corporate level. If

supporting documentation does not allow for a clear


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process to separate assets and liabilities, sellers may

develop a methodology to allocate the assets and

liabilities such as percentage of total sales forreceivables.

Planning for a corporate divestiture

When buying or selling a piece of a business, careful

planning and analysis should be performed. Involving

outside assistance early in the process may contribute to

a more simple transition and sale. 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 netassets. Furthermore, 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 eachadjustment.

As more transactions involve carve-out situations, buyers

need to be aware of the risks associated with evaluating a

portion of a business and ensure that the reported carve-

out earnings and net assets are approached with the

highest level of scrutiny.

Scott E. Linch is the Practice Leader for the Transaction

Advisory Services Practice at Dixon Hughes PLLC, thelargest accounting firm based in the Southern U.S. Scott

can be reached at [email protected].

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