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5 Factors for a Successful Transitional Service Agreement (TSA)

Whether the business case of an M&A deal or divestment is successful or not depends on numerous factors. One often underestimated aspect is the design of the Transitional Service Agreement (TSA). Due to complex processes and company-specific dependencies, especially in the areas of IT, HR and finance, the outsourced unit (target) is usually not able to act independently from the beginning (Day1). Especially in the case of group spin-offs, it still needs support from the seller side for a transitional period in order to maintain the business operation. What this support should exactly look like is specified in the Transitional Service Agreement, which is concluded between the seller and the buyer and which usually has a term of about six to twelve months. Anyone who thinks that the parties will surely agree as the transitional time is so short, is mistaken. Our experience shows that a regular transition period, during which the outsourced unit can access the usual services as long as necessary in order to establish their own processes in parallel, in line with the new challenges and goals, is decisive for the successful start into independence and prevents time- and cost-consuming disputes between the parties. So, what shall be considered when designing a successful TSA?

1. Completeness and level of detail

A successful TSA should be complete and describe the required services as detailed as necessary and as concisely as possible. If the seller is not a company in the service sector, it’s usually hard to act as one. In the spirit of diplomatic negotiations, the buyer should be considerate and avoid a catalogue of services that is too extensive.

The elaboration of the TSA is carried out during the due diligence phase. At this stage, the buyer is not yet aware of all the details about the target, which makes it difficult to claim the completeness of the service description. The parties could therefore agree initially on general approaches, such as providing all services “to the same extent and quality as in the past 12 months” and add later the explicitly required services to the TSA.

Similarly, strict confidentiality rules usually still apply during the due diligence phase, and only a small group of people on both sides of the party is involved. Depending on the level of hierarchy and technical knowledge of the negotiating team, this group of people often knows only a few details about the operational processes. This can not only have a concrete negative impact on the creation of the TSA but can also affect the entire business case if relevant information is not included due to lack of knowledge. In order to counteract this, we recommend including a defined group of people from both parties from departmental levels at an early stage. They know their processes best and can estimate, based on the integration capacity of their department, which services are needed for which period from the seller side before either the independent takeover or integration into existing group services of the buyer can take place.

2. Term and termination

The contract must include terms of duration and termination. Depending on the structure of the deal, TSAs are valid as per date of signing, but at the latest as per closing (change of controls/ legal transition) or day1. Their duration is usually between six and twelve months, depending on the scope and complexity of the project.

Experience has shown that the receiving unit can assess very early on which services can be taken over quickly and which, due to their complexity or, if necessary, due to dependencies, will only be transferred to their own company later. Especially in the cost-intensive area of IT, it has proved worthwhile to structure the individual services and to put them together into packages, each of which can be cancelled independently. Investing some time at this point and already thinking about the next phase of integration during the due diligence phase, will lead to cost-optimized results. Of course, it is necessary to find an appropriate middle way between too small-scale packages, which involve a high administrative burden in implementation and billing, and too little structured performance blocks, which lead to unnecessary additional costs.

3. Compensation and payment methods

Every service has its price. The clearer and more detailed the amount and conditions of the payments to be made are regulated in the TSA, the lower the risk of subsequent differences between the parties. In any case, the TSA should include the mode of settlement as well as other terms of payment. There are different criteria for setting prices. The prices the seller has previously charged internally for the operation of the target can serve as a basis, or to simplify performance lump sums according to current market prices. If the parties choose to use service package models as above mentioned, it makes sense to determine the prices for each package, considering the following aspects: complexity/effort for the performance of the service, estimated duration of use of the service, as well as dependencies on other service packages. Besides conventional approaches of billing according to related services, there are also payment models that schedule the payment of a certain amount of costs at the beginning and to pay the remaining costs at the end of a successful TSA term as a bonus for the seller. In this context, accelerated implementation procedures of e.g. standalone activities are often rewarded.

4. Legal review

From two perspectives, it makes sense to have the TSA legally reviewed, just like other contractual documents, before it is submitted to the negotiations: specialized M&A law firms often already know the legal parties involved in companies that regularly execute deals and are able to check the TSA before it is submitted to the other party for review and, if necessary adjust accordingly with regard to the choice of wording and the legal acuteness of the demands. This will simplify the negotiation. In addition, the law firm shall ensure that the wording chosen is valid in the event of a dispute between the parties.

5. Compliance

The TSA has been formulated, reviewed, negotiated and is now signed by both parties. Unfortunately, it is a mistake to think that we can now check off the box and turn our attention to the “important” aspects of the deal. The TSA now contains all decisive factors for success. However, to be successful, it is necessary to ensure its correct application and compliance during the agreed period. It is recommended to appoint a TSA manager on both sides of the contract to control and evaluate the course of the services to be provided from the outset and to maintain a regular exchange of information. Once more, the involvement of the operational level should not be ignored, as it is able to provide information on the quality and status of the integration capability. Depending on the relationship between the parties, it may be helpful at this point to include explicit warranty and liability clauses in the TSA.

Conclusion

Even if the negotiations are harmonious and the deal is satisfactory for buyer and seller, the parties have conflicting interests after the conclusion of the contract: the seller wants to repel the target immediately and is not motivated to carry out any further effort, whereas the buyer still has to rely on the services of the seller for a certain period of time before he can operate the acquired unit himself. The TSA serves to regulate this conflict of interest and is therefore an elementary building block for a M&A or divestment deal. Our checklist shows that, in the end, there are not many points to consider for a successful TSA. Nevertheless, the devil is in the detail. We therefore recommend to think thoroughly through the points mentioned and to invest some time here, also with the involvement of specialized advice.

Christoph Pscherer

Christoph Pscherer
He has been working in the IT environment for almost 20 years, gaining experience in a wide variety of roles and areas. Through his years of experience as a service manager, he knows the challenges and needs on the customer side. He has been applying this deep understanding and knowledge at digatus for over two years. As a project manager, his main focus is on IT M&A, where he mainly manages carve-out projects.

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