Divestiture: Definition, High-Growth Approach (Step-by-step)

M&A activity has been rising recently, and divestitures have played an important role in this trend. It is a powerful strategy that can generate value just as much as acquiring an entire company. This article will discuss divestiture, including how to execute one and its benefits. Here at M&A Science, we have talked to plenty of practitioners who specialize in this field and would like to share everything we've learned. 

What is Divestiture?

Divestiture is the strategic process of selling a business unit or an asset. It is one of the most complicated transactions in the M&A industry because the seller is not selling the entire entity but a portion that is part of a larger entity.

Understanding Divestitures

To understand divestitures better, it is essential first to know the different types. 

Carve-out

A carve-out is when a parent company sells one of its business units to another company. The business unit can be sold in its entirety or in parts.   

Spin-off

A spin-off is when a company separates a business unit and forms a newly independent company from it. This is normally done because the company expects the newly independent entity to be worth more separately. Though spin-offs do not generate cash, many organizations do it as part of a strategy to increase shareholder value. 

Split-off

This is very similar to a spin-off. The critical difference is that the existing shareholders of the parent company have to choose between the two separate entities. 

Seven Reasons Companies Divest

Divestitures are very common in large public companies because they have more than one business unit under their organization. Here are some of the most common reasons why companies divest. 

Bankruptcy

When a company is financially distressed, companies often sell unwanted or non-core assets to reduce costs while improving cash flow in the hopes of turning the company around. Divestiture is one of the primary strategies in combating bankruptcy. 

Raise Cash

There are many reasons why companies would need cash. It could be to strengthen their balance sheet and pay off debt, or they saw a great opportunity that they could not pass up. Divestitures are a great way to achieve liquidity.

Non-Core Assets

Corporate strategies change all the time. When this happens, assets can sometimes become irrelevant or less important. As a result, companies can divest these assets to reduce costs and distractions within the organization. 

Underperforming Assets

There is a concept in M&A regarding the best owners of a business. Sometimes, a company needs to maximize the potential of a particular business and be deemed underperforming. There are potentially better owners of that business willing to pay more than what it's worth for the parent company. 

Unlock Value

Companies also spin off business units because they can be more valuable as a standalone asset. Also, different parts of a company have different market values. As a result, investors might be willing to pay more for certain assets rather than the entire company. 

Stock Value Stability

The stock share price is extremely important to public companies because it reflects the corporation's overall financial health. If an organization is involved in many industries through various business units, there could be instability due to market volatility. The company can choose to divest the asset involved in the volatile market to stabilize its stock price.

Regulatory Issues

Antitrust concerns can lead to divestitures during a stock deal where a company buys another one. The regulatory board can force an acquirer to divest one of its business units to allow the current transaction. This move ensures market competition, which is the sole purpose of the antitrust department. 

Examples of a Divestiture

IBM's Carve-out

On May 1, 2005, IBM sold its Personal Computing Division (PCD) to Lenovo, the largest PC manufacturer in the world. The move comes as IBM looks to focus on more lucrative areas of its business, such as software and services.

The deal makes sense for both companies as IBM is looking to offload a division that is no longer seen as a core part of its business, while Lenovo can gain access to IBM's patents and technology. 

eBay Spun off PayPal

Paypal Holdings, Inc. is an American company that provides payment processing and other financial services, including money transfers, through the Paypal digital wallet service. The company was founded in 1998 and became a wholly-owned subsidiary of eBay in 2002. In July 2015, eBay spun off PayPal into a separate publicly traded company. 

Both companies faced stiff competition in their respective markets, and PayPal wasn't operating at its full potential due to its association with eBay. Both firms were expected to be more profitable after the separation. PayPal will get the chance to innovate and grow, while eBay will get more cash to operate and invest in the company's main business. 

Google's Spin-off to Alphabet

On October 2, 2015, Google spun off its subsidiary, Alphabet. The creation of Alphabet was intended to allow Google to focus on its core business of search and advertising while providing more autonomy to other divisions like Nest (smart home devices), Calico (life extension), and Fiber (high-speed internet). 

This move comes as Google faces increasing pressure from regulators around the world. The European Union has fined the company multiple times for antitrust violations, and the US Federal Trade Commission is currently investigating it. However, the creation of Alphabet may help appease regulators by showing that Google is committed to separating its different businesses.

Executing Divestitures

What Makes Executing Distributions Hard?

What separates divestitures from traditional M&A is that the seller sells a business that has never stood independently from the parent company. For this reason, it will not have a standalone set of financial statements. Instead, the seller will now have to come up with a financial statement to satisfy the buyer's due diligence request. This process alone can make divestitures harder than M&A. 

Also, it will have shared services with the other functions of the parent company or even infrastructure. If the business unit for sale is inside the parent company's building, the buyer cannot simply cut a portion of the building and put it in their company. 

Lastly, there are many instances where employees wear multiple hats inside a company, and some of the people involved in the business unit must stay with the parent company. This is where a transitional service agreement (TSA) comes in.  

Transitional Service Agreements are essential but arguably the biggest complexities in divestitures. It is an agreement or contract entered by both parties where the seller promises to provide necessary services, people, or infrastructure to the buyer for business continuity up to a definite period of time. In exchange, the buyer agrees to pay the seller for the services at an agreed price. 

What makes all of this challenging is that the seller will want to get off the TSA as quickly as possible while the buyer is not. It is in the buyer's interest to take their time until they are fully prepared to operate the business independently. Negotiating this agreement can be a long and tedious process. 

When Should You Consider Divestiture?

However, despite all of its complexities, there are many reasons to consider divestitures. Here are five signs to look out for:

1. Overvalued Assets

As the saying goes, everything is for sale at the right price. If a buyer is willing to overpay for the asset, consider divesting. There are also industry factors where certain assets suddenly become overvalued for a short period of time. Constantly evaluating business units for divestment is an excellent strategy for any organization.

2. Better Opportunities

An effective company always looks for good investment opportunities to create long-term value. There are instances when better opportunities arise and the companies need more cash to invest. Consider divesting a well-performing asset if it could generate more value for the company. 

3. Industry Factors 

Outside factors play a huge part in running a business. For example, regulation changes or a pandemic can suddenly slow a company down where it can't stay competitive anymore. In this case, business owners should consider divesting as quickly as possible before things go from bad to worse. 

4. Change in Strategy 

Ideally, every company has a 5-year business plan which lays out its road to success. However, as mentioned before, outside factors take place in every business. Business strategy changes all the time, and certain assets that used to be an integral part of the strategy can be deemed irrelevant. This is often framed as "core" and "non-core" assets.

Consider divesting non-core assets, as they can be distracting and are not optimal in business operations. 

Divestiture Framework

M&A Science analyzed dozens of divestitures from the industry's best practitioners over the past years. We have compiled the overarching themes on how to execute divestitures once the decision to sell has been made and approved by the leadership team. 

Step 1 - Deal Perimeter

Deal perimeter is the process of clearly defining the asset for sale and what's not. The deal perimeter process can get complicated because of the shared resources with the parent company. For example, if company A sells one of its departments, they need to decide what equipment, furniture, and office supplies will be part of the transaction and what they want to keep. Therefore, the deal perimeter is essential to continue the following steps of a divestiture. 

Step 2 - Ring-Fencing

Next is to identify the people that will be a part of the sale process. While a core group of people is dedicated to running the business that is being sold, there are also employees who are doing multiple roles inside the organization. This is extremely common for any company, like an HR department that touches all business units. 

It is completely up to the seller who will be included in the deal, but the general rule is that any employees working 50% of their time on the business being sold will be included in the sale. 

Most importantly, sellers need to secure said people to the business by offering compensation and locking them in so they will not be eligible to apply for any roles within the company. 

Step 3 - Standalone Financials

As mentioned before, the business unit has no standalone financial statement. Buyers will want to look at the profitability of the business and its historical performance. The seller must work with the accounting department and create three years of standalone financial statements for the business. 

Sellers can even go as far as creating proforma financial statements. Then, find out more about the buyer and build projections on what they could do with the business unit. Showing buyers the business's potential under new ownership is one of the best ways to convince them to close the deal. 

Step 4 - Vendor Due Diligence

Buyers usually perform due diligence to understand the business value and risks of acquiring the target company. However, it is in the seller's best interest to conduct due diligence on their business. Vendor due diligence has been a growing trend in recent years due to its multiple benefits.

First, It reduces surprises the buyers might find out during their diligence. Detecting issues early will allow the seller to fix the problem before talking to any buyer. Usually, buyers get turned off if they find issues themselves and will either run away or reduce the purchase price. 

Vendor due diligence also includes creating a Quality of Earnings report (QofE). The concept of QofE is to remove one-time events or costs from the financial statements to get a clear picture of the average run rate of the business. This is usually done by an outside party to ensure parity and objectivity. It will bridge the gap between expectations and reality, as most sellers are expecting too high of a selling price.

Step 5 - Alignment

Communicate the deal properly and ensure everyone is on board with selling the asset. If there are people that don't want to sell, they can disrupt the entire process. If they are a part owner, they might not sign the documents, which will make selling the asset impossible. 

Step 6 - Look for Buyers

After every preparation is complete, it's time to look for buyers. At this point, the transaction is straightforward, just like any other stock deal. The best thing sellers can do is auction their business to maximize its value. Whether they hire an investment banker or not is totally up to them. But it is important to note that with much preparation, any seller can execute an auction process without bankers.

Step 7 - Transitional Service Agreement 

As mentioned before, the most significant difference between divestitures and traditional M&A is transitional service agreements. Often divestitures will only close if there is a guarantee that the newly acquired business will operate post-close. 

Fairly negotiate and find a middle ground where both parties can thrive and profit from the situation. To avoid losses from the transition period, the seller must charge for their services accordingly. Also, impose a strict timeline to force the buyer to be ready in the shortest time possible. 

If you want to learn more, M&A Science has a complete framework for executing divestitures, including playbooks. Read here.

How M&A Science Can Help

M&A Science can be a valuable resource for practitioners looking to improve their practice executing divestitures. Derived from real practitioners' knowledge and experience, M&A Science has constructed courses and materials that will help practitioners to better understand the divestiture process, identify potential issues and challenges, and develop effective strategies for addressing them. 

Additionally, the insights and experiences shared by M&A Science can provide professionals with valuable real-world examples of how successful divestitures have been executed in the past and can serve as a valuable source of inspiration and guidance for readers looking to improve their own divestiture practices. For further assistance, we also have an M&A advisory service. Learn more about it here.  

Overall, M&A Science can be an invaluable tool for practitioners navigating the complex and dynamic world of divestitures.

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