Enterprise software carve-outs: insights for success, distilled

The enterprise software industry is undergoing significant changes, as the race to turn the promise of continued product enhancement into reality for customers heats up. This requires the industry to innovate even faster than it has historically. 

To address these challenges, leading enterprise software businesses are repositioning themselves by using carve-out divestitures as a strategic enabler to recalibrate their portfolios, ignite innovation and enhance long-term shareholder value. In fact, in our CEO Survey, 48% of technology CEOs are planning a divestiture in the next 12 months.

Tech sector data shows divestments can turn TSR laggards into leaders

EY-Parthenon analysis shows that companies pursuing divestments significantly outperformed their S&P Global 1200 IT Index peers with respect to TSR, having previously been stragglers. They saw their median TSR outperform the S&P Global 1200 Information Technology Index by 9% two years after divestment, relative to pre-divestment (see Figure 1). The market is rewarding management teams that are pro-active about managing their portfolio.

Figure 1: TSR returns for divestors relative to the S&P Global 1200 IT Index

Carve-outs offer the opportunity to become a TSR leader but also pose challenges for achieving value. To overcome these potential obstacles, it’s even more important for businesses pursuing carve-outs to focus on planning and execution of the divestiture process, which requires thorough due diligence and a well-structured plan. Leading enterprise software businesses that are pursuing carve-outs are taking the following four actions to address their challenges and simultaneously enhance the attractiveness of the asset in the market.

1. Disentangle bundled software solutions

The intricate process of disentangling bundled software solutions is the paramount challenge in enterprise software carve-outs. Enterprise software companies frequently package their offerings into comprehensive bundles under enterprise license agreements (ELAs), which, when pulled apart, can create operational and financial complexities that require taking the following actions:

• Provide precise financials and valuation

A successful enterprise software carve-out hinges on isolating and accurately valuing individual software components. This involves meticulous financial analysis to offer transparency to buyers, establishing standalone selling prices (SSP) based on market value, and crafting tailored key performance indicators (KPIs) with a solid track record to enable accurate valuation and future performance projections.

• Navigate complex revenue attribution from ELAs

The “all-you-can-eat" nature of ELAs complicates the attribution of revenue streams, as customers' varied product usage blurs the lines of specific earnings. This complexity is exacerbated by the necessity to sidestep mid-cycle ELA renegotiations, which can lead to extended transitional services agreements (TSAs) and potential disruptions in customer service quality.

• Stay on top of contract renegotiations and customer communications

Divesting assets tied to significant client ELAs requires careful handling to preserve customer relationships and fair revenue distribution. Renegotiating contracts can unsettle customers, complicating renewals. Proactive communication is crucial to ease concerns about transitioning ELA pricing and terms, reducing uncertainty and maintaining trust during deal speculation.

• Lay out intellectual property (IP) considerations

Managing shared IP assets requires an adaptable, secure deal structure to protect both seller and buyer interests. This includes licensing costs, terms, rights to future developments and competitive edge protection. Valuing IP assets is complex, so both parties must be satisfied with the IP agreement and willing to collaborate.

• Focus on data separation and privacy compliance

After a divestiture, the segregation and protection of customer data are critical to comply with regulatory standards and preserve customer trust. Because data is a crucial asset for enterprise software companies driving revenue, particularly in the era of artificial intelligence (AI), any perceived diminution in data assets can significantly impact the seller's revenue potential. Furthermore, any shared use of customer data between the buyer and seller may necessitate regulatory notifications and customer consents.

2. Align the divestiture strategy with the evolution of the pricing model

The strategic shift from a perpetual license model to a subscription or consumption-based pricing model carries significant implications for carve-outs.

• Manage valuation amid cash flow changes

Transitioning to a subscription model changes cash flow dynamics. Assess the financial impact, recognizing gradual revenue realization and more predictable long-term cash flow. Incorporate the temporary cash flow dip into the valuation narrative, accurately representing the divested product's cloud future. Consider the cost of enhanced customer support needed for the subscription model.

• Navigate contractual revisions 

The shift of a pricing model necessitates the careful revision or replacement of existing contracts. Transitioning customers from perpetual licenses to subscription or consumption-based agreements is a delicate process that requires thoughtful negotiation and planning, aligning with the previously discussed challenges of preserving the divested business’s value and maintaining customer relations.

• Overcome customer hesitancy

To minimize customer attrition during the transition to a subscription model, proactively engage customers and communicate strategic benefits. This retains the divested business's attractiveness and ensures stable revenue streams. Aligning the divestiture strategy with the industry's shift toward subscription models is crucial for navigating enterprise software divestitures and maintaining momentum.

3. Enhance the value of the divested business

It’s paramount for sellers to maintain the allure of the business that is being carved out as they navigate how to convey the sustained value despite the loss of scale and the potential brand impact. 

• Resolve technical constraints

In a streamlined tech environment, making sure the divested product integrates seamlessly with a buyer’s ecosystem is essential. Address technical constraints and propose compatible solutions to expand the buyer pool and ease post-sale integration. Leverage long-term commercial agreements for shared platforms. 

• Clarify historical cost data

Accurately presenting the divested entity's value requires a meticulous breakdown of historical research and development (R&D) and general and administrative (G&A) costs. Benchmarking these costs is challenging due to the subjective nature of R&D investments and typical G&A allocation strategies. Transparent and justifiable historical cost data is essential, especially for financial versus strategic buyers. Addressing concerns about the loss of scale in historical costs is crucial for maintaining valuation attractiveness and facilitating a successful deal closure.

• Drive the diligence process

To prevent value erosion, sellers should proactively prepare key diligence artifacts, especially regarding ELA separation requirements for the carve-out. Conduct a current usage analysis, such as annual recurring revenue (ARR) evaluation and contract renewal metrics, to inform buyers about topline sustainability and growth potential. Develop these artifacts early to strengthen separation analysis and enhance buyer confidence.

• Retain and refine talent

To enable uninterrupted operations, retain critical staff and minimize turnover, especially in sales and R&D. Identify and secure key roles early to assure buyers of a stable workforce post-acquisition. Buyers should access key talent pools to counteract turnover. Align the sales team with product offerings and implement suitable compensation plans.

By focusing on these key areas, sellers can not only preserve but also enhance the value of the divested business, making it an attractive and viable opportunity for potential buyers.

Special thanks to the following individuals who contributed to this article: Daniel Kiczek, Amulya Puthige, Ni Lu, Shivangi Agarwal, Sean Patel, Caroline Wright, Divya Seshadri, Akrant Bhardwaj, Deepanshi Jerry and Shravan Davuluri.