Estimating, classifying and allocating M&A IT costs

Several factors can place considerable pressure on IT executives to provide a reliable estimate of M&A-related costs:

• Typically IT executives provide a cost estimate at an early stage in the M&A process, and this estimate is not expected to vary as the transaction progresses.
• IT costs are often one of the largest items in the total costs for the transaction. This makes re-statements and modifications highly visible to internal and external stakeholders, and may lead to (often lengthy) discussions being re-opened.
• Usually the IT-related activities required to operationalise an M&A transaction have the longest lead time, with the IT team supporting the process long after the conclusion of the transaction. Consequently, IT costs associated with the transaction can easily be misjudged for business-as-usual (BAU) expenses leading to unnecessary IT budget discussions.

In order to ensure constructive discussions during the sales and purchasing agreement (SPA) process, improve the resulting valuation and reduce post-deal disputes, we suggest breaking down the approach to costs into a three-step process:

• Estimating: Obtaining a picture of the total IT costs for the transaction, without specifying which party, buyer or seller, will be paying for each of the cost items
• Classifying: Categorising the costs as integration-, separation- or migration-related costs
• Allocating: Deciding (through agreement between buyer and seller) who will pay for which cost item.

Estimating the IT costs

Estimating the IT costs involved in an M&A transaction contributes to the assessment of deal value and should therefore be a priority task for IT executives. The objective should be to obtain a complete picture of the expected IT costs, ensuring that all costs are captured. There should not be any question about who is going to pay for which costs, as this will come at a later stage. The initial estimation exercise should avoid any contamination with either thoughts about classification or allocation of costs, in order to avoid inaccuracies in cost estimates.

There are several approaches to cost estimation:

• ‘Meet in the middle’. This approach consists of both a top-down and a bottom-up analysis, and reaching a cost estimate somewhere in the middle of the two. The top-down analysis leverages experience from similar transactions in the past, and provides a basis for comparison. The bottom-up analysis should be performed by the seller’s IT management team, while ensuring confidentiality during negotiations. To the extent that is possible, the seller’s top management in the negotiations should consider involving the IT management team in the estimation process, to increase their sense of ownership in the estimate.
• ‘Bite size it’. In this approach, the focus is on the key cost components (e.g. hardware, software, networks, labour, IT services), in order to confirm cost categories (capital expenditure, operating expenditure) with Chief Financial Officers and auditors, minimising the likelihood of re-opening these discussions in the future. Identifying the cost categories and associated costs is important, as this is the basis for the classification stage where it is established which IT costs should be considered as transaction costs (which are reported to financial analysts and other external parties) and which will be ongoing operational costs post-completion of the deal.
• ‘Benchmarks and due diligence’. This approach uses the due diligence phase to focus specifically on IT costs to obtain an estimate of the costs (independent if external advisers are used). It is recommended to include industry benchmarking for the cost base in the scope of the due diligence to enable not only a picture of the relevant cost items themselves, but also how they stack up against competitors of similar size or in similar industries.

In preparing an estimate of IT costs for an M&A deal, consideration should be given to the points below, as some types of cost may not be on the radar of businesses because they are not budgeted for on a regular basis:

• ‘Be aware of particularities’. Specific cost items not typical in the normal course of business, such as IT TSA-related or stranded costs, can significantly affect the overall cost estimate, and these need to be included in the cost exercise.
• ‘Account for the unexpected’. Mitigate unexpected expenses that may emerge during deal execution by factoring in an additional estimate for these costs beforehand, so that they do not affect the deal negotiations once they become apparent. In addition, it is a best practice for detecting required cost baseline adjustments to document (and frequently revisit) the assumptions that were made to produce the cost estimates.
• ‘Leverage independent opinions’. It is recommended that external consultants should support the validation of cost baseline estimates. Assumptions can be pressure-tested to increase the reliability of estimated costs and help secure buy-in from various stakeholder groups on both sides of the transaction.

The result expected from the estimation phase is a validated baseline of IT costs that sets a common ground on which both the IT management and the deal teams can develop their thinking about how to classify and allocate the IT-related costs between the parties.

Classifying the IT costs

The IT costs typically involved in an M&A transaction can be divided and allocated to three categories of cost: separation, integration and migration costs. These categories are as follows:

• IT separation costs (or ‘perimeter set-up costs’): These are the costs required to prepare the target entity for the valuation process and the transaction. The goal is to ensure the entity being sold is ready to be presented to the market. This does not necessarily translate into a requirement for the entity to operate autonomously, should it require separation from a parent company divesting it. In case of separation, it is often too complicated to separate certain IT assets and therefore could be deliberately excluded from the perimeter of the transaction, e.g. IT infrastructure. Other examples of separation costs include building up a newly-created IT function that may require new dedicated resources for key functions such as network connectivity, and the costs of implementing new access rights for users of shared systems.
• IT integration costs: These are the costs required to incorporate the IT landscape of a divested entity into the buyer’s IT systems. These can be divided into two sub-categories:
  • Costs required to optimise the new operating model, such as rationalisation of the application, development and implementation of new IT processes and workflows, and the costs required to transform the service delivery.
  • Costs required to add additional capacity, for example providing support to an increased customer base by purchasing additional licences or connectivity capabilities.
• IT migration costs: These are the costs of transferring IT assets from the seller to the buyer. These costs are not required for business-as-usual IT operations, but are ‘one-off’. An example is the cost of establishing an interface between a buyer’s data centre and that of the seller, where the connection is decommissioned after the transfer of IT assets between the parties is completed.

Typically these costs are paid by the buyer, but a seller may contribute to them, for example to speed up the deal settlement process.

Allocating the IT costs

The third step to manage the IT costs involved in an M&A transaction is to allocate each of the different types of cost to the relevant party. The objective is to agree on an allocation method satisfying the deal-related goals of both the seller and buyer.

It is common practice that sellers pay for separation costs and buyers pay for integration costs, while migration costs are shared by the parties.

Nevertheless, there could be situations where buyers participate in the migration or separation costs; for example in the case of limited availability of resources from the seller that could impact the deal execution, the buyer may decide to deploy its own resources and bear the separation costs with the intent of speeding up the deal and outpacing competition.

In other cases, sellers may be willing to bear a relatively larger portion of the migration costs or participate in the integration costs, for example by supporting the buyer through allocating its own resources to buy-side activities, when specific IT expertise is required that the buyer has not yet obtained. Sellers may also engage an external advisory party to assist the buyer with migration-related activities, attempting to speed up the process.

Finding the most appropriate method for allocating M&A IT costs, once properly estimated and classified, allows IT executives of both parties to reach a common understanding about how to manage both IT costs and the IT activities required to execute the transaction. IT executives can thus move faster and more constructively to other aspects of the deal, such as the functional separation of the IT systems and IT TSA-related discussions.

Conclusion

Estimating and managing the one-time IT costs is vital to the effective implementation of an M&A transaction. When preparing for an M&A deal, IT executives should manage the topic of IT costs carefully, as it is typically one of the highest costs in an acquisition. The steps laid out in this article should be followed in sequential order without rushing towards completion.

If you would like to find out in more detail how this cost estimation, classification and allocation approach could work as part of your M&A strategy, please let us know.