Understanding Transition Services Agreements in SMB M&A
Transition Services Agreements (TSA) are an essential part of the deal making process. They set out how the seller trains the buyer to operate the business post close; they ensure that the business doesn’t flounder while the buyer is learning the ropes.
But despite their importance, they’re often uneventful. In SMB M&A, you will never spend less time negotiating such an important agreement.
There are good reasons for this contradiction. So let’s look at what makes TSAs important, and why the parties usually don’t care.
What is a Transition Services Agreement?
In the typical SMB deal, the TSA is a contractor agreement: A legally binding agreement between business and service provider, outlining the terms of a working relationship.
Just like any contractor agreement, the TSA may include terms relating to:
Contract length (its “term”)
Scope of seller’s services
Seller’s compensation.
Transition services agreements are often shorter than typical contractor agreements. And unlike a typical contractor agreement, they’re not standalone documents; they’re incorporated into the purchase agreement (either directly, or as an exhibit or schedule). But apart from that, there’s not much to distinguish them.
From the buyer’s perspective, the goal of the TSA is to ensure that the seller does all she can post close to make sure that the business continues to run smoothly and that the buyer is fully prepared to take control once the TSA ends.
From the seller’s perspective, she doesn’t want to be on the hook to provide transition services for too long. And neither does she want to commit to working long hours. Like all things M&A, it’s a negotiation.
Why Do Searchers Need TSAs?
I’m an M&A lawyer. Unsurprisingly, I write about SMB M&A rather than SMB operations.
But let’s be honest, deals are a small part of the searcher’s journey. Buying a business is a big undertaking. Operating a business is something more.
You will never feel as overwhelmed as you do on the day after closing.
You may own the business, but you don’t own the business. On day one, you will be 100% reliant on the seller to show you how things work.
In fact, my advice is to let the seller come into work on day one as if nothing has happened. You need the seller to continue to operate the business, and to start transferring her knowledge about the business to you.
At this critical time, you need to be best friends with the seller so that she will freely share this information. But just in case friendship fails, you need something binding to commit the seller to this task.
That something is the TSA.
Why Do Searchers Often Not Care?
Here’s where it gets (less) interesting.
Given how critical a TSA is to the success of the buyer as SMB operator, you would think that the parties always negotiate a detailed agreement, describing the exact services that the seller will provide.
And sometimes they do.
But often the TSA amounts to a single paragraph in the purchase agreement setting out the:
Term of the agreement (most often in months)
Seller’s hours and location
Seller’s compensation, if any.
There are two reasons for this:
The TSA is being negotiated at the same time as the purchase agreement. And the buyer may not fully understand what the seller needs to do to transition the business at that point.
The seller may not want to sit down and talk detailed transition planning prior to signing the purchase agreement. And that’s a fair take. The best time to transition plan is arguably after signing the purchase agreement (assuming a sign-then-close structure), when the parties can put the stress of negotiations behind them and collaborate.
As a lawyer who represents searchers in M&A deals, I’m okay with this.
I’m okay with it.
At first glance, a limited TSA may leave the buyer exposed to unnecessary risks. Without a detailed agreement, what’s to stop the seller from checking out—adhering to the high-level terms but not the spirit of the TSA?
Two words: seller financing
Every searcher deal should include a material amount of seller financing, preferably on standby for the first 2 years. Seller financing is the carrot ensuring that the seller is there for you during the transitional period.
It’s about aligning incentives: The seller is likely to work towards a successful transition if 10-20% of the purchase price is contingent on that success.
After all, if the business fails, the primary lender will wipe you out; the seller will receive little of the debt owed against the seller note (regardless of personal guarantees or security interests).
If the seller has sufficient skin in the game in the form of a material seller note, a single paragraph in the purchase agreement documenting the material terms of the TSA may suffice.
It’s not ideal. But it regularly happens. Detailed transition planning is a must. Yet under the right circumstances, it can wait.
Key Components of a TSA in SMB M&A
Although detailed transition planning can sometimes wait, material terms must still be agreed up front and included in the Letter of Intent (LOI). Here’s what I see in the market:
Term. Sellers normally commit to between 60-90 days, with the option to continue consulting on an hourly basis. The services should be at Buyer’s discretion (i.e., the buyer can instruct the seller to stop at any point).
Location. Can the seller provide the transition services remotely, or does she need to be there in person? Is it a little bit of both?
Compensation. Seller’s services during the initial 60-90 days are often (although not always) included in the purchase price. The seller’s hourly rate following the initial 60–90-day period is up for negotiation.
Avoiding TSA Pitfalls as a Self-Funded Searcher
Think carefully about compensation
When negotiating the seller’s compensation, err on the side of more rather than less. The seller may have decades of experience running the business. But there is only so much you can learn in the space of a few months. Having the seller engaged and happy to help is a smart investment.
Include the TSA in the purchase agreement
No matter whether the TSA is a single paragraph or a complete document, include it in the purchase agreement, either directly or by incorporating it as an exhibit or schedule. If the seller promises to take certain action, and that promise is included in the purchase agreement, it becomes a covenant. Indemnified losses arising from the breach of a covenant are often uncapped. If seller financing is the carrot, this is the stick.
Make sure the right party stands behind the TSA
In asset purchases, the business, not the owner, is the seller (you’re buying the company’s assets not the seller’s personal property). Accordingly, in the asset purchase agreement, make sure that the owner, not the business, is standing behind the TSA.
What language should I include in my LOI?
You can describe the transition services agreement in your LOI using the following language:
Owner will provide Buyer reasonable consultation services for no additional consideration to assist in the transition of ownership of the Business. Owner agrees to be present as often as reasonably requested by Buyer during the first three months after the Closing to provide these services. Owner agrees to provide additional consultation services as reasonably requested by Buyer.