What are “transitional services”?
Many businesses transferred in the course of M&A transactions (“Target Businesses”) are dependent on intra-group services such as information and communication technology (“ICT”) services (eg, regulatory reporting tools, telecommunication), HR-services (eg, payroll services), infrastructure-services (eg, office space, machinery) and other services (eg, canteen, car fleet management, sales support, trademark licenses). The providers of such services (ie, the seller or other group companies) commonly service only other group companies but no third parties, including, in particular, former group companies that are carved-out as a consequence of the M&A transaction.
Whereas the seller of a Target Business usually wants a clear out from the target business at the closing of the transaction, a buyer obviously seeks the seamless continuation of the Target Business. This creates a dilemma, as most of the services described above are not replaceable within a short time (eg, between signing and closing).
The solution to the dilemma
This dilemma is commonly solved by the provision of selected intra-group services by the seller (or its relevant affiliate) for an interim period in order to allow the buyer and the Target Business to find a replacement and to accomplish a smooth transition to the new service provider. The services provided during this interim period are commonly referred to as “transitional services” and are regularly governed by “transitional services agreements” (“TSA”).
Key elements of a TSA
Transitional services are often provided between multiple parties on each side (eg, by the HR entities of a group to multiple target companies that are being carved out). In such cases, framework TSAs are concluded between the seller and the buyer as principals of the M&A transactions. On the basis of such framework TSAs, the service providers and recipients enter into service level agreements (“SLAs”) that specify the services and other relevant details.
Scope of services
The scope of transitional services is the most critical element for the TSA. A scope that is too broad may be burdensome on the service provider; a scope that is too narrow may cause the interruption of the target business.
The scope should be as detailed as possible, avoiding generic descriptions (eg, not “IT services” but “provision of the following software applications: [x], [y] and [z] for up to [x] users”).
Since the risk of missing (crucial) services lies with the buyer, the buyer may request a “missed services” provision, which allows the Target Business to request services that are not specified in the TSA (ie, which were missed) but that have been provided in the past.
In many cases (depending on the negotiating power of the parties), transitional services are rendered without separate consideration. However, in most cases, a separate consideration (charges) will be charged for the services. Common mechanisms to determine charges include (i) fixed pricing, (ii) “at cost” or “cost plus” (cost plus a specified mark-up) and (iii) time and material. In many cases, no benchmark for the pricing exists, so the parties will have to carefully consider which pricing mechanism works best.
In larger TSAs, a buyer will request a “most favoured nation” clause, which forces the service provider to offer to the service receiver the best terms that the service provider offers to other parties for the same services.
For each transitional service, the TSA should specify the relevant service levels that must be met and which key performance indicators (“KPIs”) apply to test if and to what extent a service level has been met. Again, in many cases, no benchmarks on service levels and KPIs exist and must thus be developed. The services levels and KPIs should again be specified in as much detail as possible, avoiding generic descriptions (eg, “existing service levels apply”). Examples of service levels include (i) delivery within a certain timeframe, (ii) responsiveness of IT support (eg, within [x] hours in case of a critical IT disruption and within [y] hours in other cases) and (iii) no interruption of functionality.
The TSA should then further define what happens if a KPI is not met, from what time a default occurs, whether minor defaults qualify as “defaults,” and which default categories exist (eg, “minor”, “major” and “critical” defaults), which may be relevant for the applicable remedy.
Since the flawless provision of transitional services is often crucial for the seamless continuation of the target business and since the disruption of a target business may cause damages that cannot be compensated with money (or at least the damage may not be easily determinable), a Buyer will want to specify appropriate remedies that are available in case of a default. Depending on the category of default, the remedies may include (i) restitution-in-kind, (ii) monetary compensation of damages, or (iii) contractual penalties.
Common legal issues
The provision of transitional services must be thoroughly analysed from a legal perspective. In our experience, the following legal issues are most likely to arise:
- Third party rights / right to sublease: Transitional services are sometimes sourced in turn from third party providers (this is particularly often the case for ICT service and licences). The underlying legal arrangements may prohibit the service provider from servicing non-affiliated parties. The explicit consent of the third party is therefore required for the provision of transitional services.
- Employee rights: Employees of the seller who (exclusively) provided services to the target business may claim that they have a right to be employed with the target business under applicable labour laws (particularly laws implementing the European Union Business Transfers Directive).
- Regulatory requirements / restrictions: Transitional services may be subject to applicable regulatory requirements if the target business itself is regulated (eg, banking or insurance businesses). The outsourcing of certain core-functions to non-related persons may thus require approvals by the competent regulator.
- Data protection / banking secrecy: The provision of services itself may be subject to applicable data protection and banking secrecy limitations that must be considered when drafting and negotiating the TSA.
A key element to successfully carving out a target business is the detailed preparation for, and thorough implementation of, transitional services. Such preparation and implementation must cover not only the operational aspects, but also the legal aspects of transitional services.