What are IT “stranded costs” in a carve-out or acquisition? - Ensunet

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What are IT “stranded costs” in a carve-out or acquisition?

We were recently on a call with a highly-placed professional who lives in the world of mergers and acquisitions, or M&A. During the conversation, we casually mentioned the issue of “stranded costs,” at which point, this person asked us, “What are those?”

We were surprised to be faced with what seemed to be a basic question from someone with so much M&A experience.

It also made us realize, He’s not the only one. There are lots of people who toil in M&A who aren’t familiar with “stranded costs,” and there’s an important reason why.

In this article, we’re going to define “stranded costs.” We’ll cite numerous examples, focusing on Ensunet’s realm: IT. We’ll show you ways to avoid them. And we’ll explain why that guy on the phone—and so many others like him—aren’t familiar with this term, when they really should be.

What are “stranded costs”?

Technically speaking, a stranded cost is a recurring expense which a company is obligated to pay… after it (or a portion of it) has been sold been sold, via an acquisition, to another company.

Simple as that.

It’s a cost that doesn’t go away once the acquisition is consummated. Thus it’s left “stranded” in the deal.

The big word here is “recurring.” If you’re Company A, and you’re buying Company B, and they just bought a big box of widgets, that’s a one-time cost that 1) you should detect, pre-deal, during due diligence, and 2) factor into your negotiations.

Similarly, if you’re Company B, looking to make a nice profit by selling off a line of business to Company A, and you just bought that box of widgets, it’s a one-time factor into the profitability of the sale.

In other words, that box of widgets is not “recurring.”

But what if you’re Company B, and you operate ten facilities—and have signed long-term leases on them? And what if the acquisition stipulates folding those assets into Company A, to the point where, say, five of your buildings are no longer needed, but you’re still obligated to pay the rent on those now-vacant facilities? Those leases are classic stranded costs.

Stranded costs in IT

A lease on a building is pretty obvious. In IT, the potentially stranded costs can be trickier to find. Indeed, many will hide in a “gray area”: Let’s say you’re Company B, and you recently expanded your IT assets to support additional revenue at a cost of $5 million. Then you sell a line of business for $2 million—but now your IT vendor won’t right-size the contract from $5 million down to the $2 million it’s now really worth.

That leaves an effective $1 million in stranded costs. In other words, that sexy $2 million sale was just drained by half, from those “gray area” recurring expenses.

Here are whole bunch of other examples, to get you thinking in the right direction:

  • Licensing agreements. Let’s say that Company B just signed a five-year (remember: “recurring”) licensing deal with Microsoft in order to reduce costs. But Company A, being bigger, may well have a better deal with Microsoft already. So That’s a painful stranded cost, waiting to happen.
  • Other recurring contracts. The Microsoft licensing agreement we mentioned above is just the tip of the long-term-contract iceberg. There are support contracts. Managed service providers. Outsourced cybersecurity monitoring. The list goes on and on.
  • Custom system support. Many companies eschew COTS (commercial off-the-shelf) solutions for customized, one-off/homegrown systems. (We wrote a great article on this exact subject, entitled “Pride Before The Fall: How to Overcome Homegrown IT Systems During M&A.”) Such a custom system will often come burdened with a whole retinue of vendors and locked-in contracts, to try and keep this invariably creaky system up-and-running.
  • Mobile costs. This isn’t about hardware. It’s about recurring telecom costs. What if Company B just renegotiated the contract for all their company phones with one of the big wireless carriers? The instant the ink dries on that agreement, that cost is locked in. Think that that telecom will want to break that contract, just because a big chunk of Company B was just acquired? Think again.
  • MPLS/WAN costs. MPLS (multi-protocol label switching) and WAN (wide area network) setups allow for a fast, secure, non-internet connection among Company B facilities, typically using technology such as fiber-optic transmission. And those deals typically include—you guessed it—long-term contracts.

The tale of the duplicative data center

We know of a Company B which made what seemed to be a smart IT decision: They realized they could reduce operating costs by nearly 50 percent—along with improving reliability and security—by physically moving all of their on-site data servers to a secure colocation facility, with its locked-down premises, always-available power, redundant cooling systems, and so on.

Halfway through the migration—as some of the devices were on the trucks and/or being re-wired—Company B was acquired by a Company A. And Company A, as you’ve surely guessed by now, had sufficient data-center capacity of its own, and had zero need for what would have been cost-saving rack space for Company B. And so Company A was on the hook for those long-term colocation contracts—effectively paying for empty racks in a secure building. The colocation facility, understandably, had zero interest in breaking the lease.

Think of it another way: If Company B was selling just a portion of itself to Company A, then it would be on the hook for its portion of those stranded costs.

Why does this happen?

Some stranded costs are unavoidable. Assuming you spot them during due diligence, they simply become points of negotiation. The bad ones are the surprises—the ones you didn’t spot. You don’t want to assume that Company B has, say, a $100 monthly water bill… only to learn, post-acquisition, that it’s more like $3,000 a month. Surprises like the colocation contract we noted above—and yes, it was a surprise to Company A—added millions of dollars, not to mention time, complexity, and risk, to the acquisition.

So why does this happen? Why are we, at Ensunet, often called in to remediate issues that result from stranded IT costs during an acquisition? (And having supported more than $4 billion in M&A activity globally, we’ve seen more than our share.)

It often boils down to trust. Think of that colocation story. Company B’s senior IT team made what seemed to be a brilliant call: move the servers offsite and save the company a ton of money. But they weren’t trusted, enough, by the company’s senior leadership, to give them a seat at the table when the “We’re looking to sell this company” conversation began. You know that the IT team would’ve held off on that colocation contract. Many IT directors and CIOs, unfortunately, have been unable to cross the chasm and communicate more effectively with the C-suite.

This is also why a stranded cost like this gets buried—and thus harder for Company A’s due-diligence team to find. The irony is that the C-suite is ostensibly all about harvesting synergies and increasing shareholder value, but when an acquiring enterprise fails to account for all of its IT costs, pre-deal, it’s doing exactly the opposite.

Seller-side obligations

Many “Company B’s” get blinded by dollar signs when a spin-off or carve-out looms. Yet they must plan ahead: You don’t want your assets stranded on the wrong side of the deal. Two keys to this problem are 1) creating an “elastic infrastructure,” which effectively makes pieces of the IT underpinnings modular; and 2) use of the cloud, which is custom-made for elasticity. You can dial up, or down, your needed capacity, at will.

Red flags and other warning signs

As noted above, the time for finding potentially stranded costs is pre-deal, during due diligence. Here are some guidelines to help:

  • Bring your IT leaders in early, and often. Explain to them the goals of the deal.
  • Make sure your due-diligence team asks the right kinds of questions at Company B. “What kind of contract-management process do you employ?” “Show us an inventory of IT contracts for the past five years.” If they get you a clear spreadsheet, with a smile, that’s a good sign. If they give you piecemeal information and excuses, that’s a warning.
  • If you’re Company B, seeking a carve-out, ask those same questions of yourself!
  • Visit the facilities—either in person, or more likely these days, virtually (watch for Ensunet’s new blog on “Remote Due Diligence”). Ask, for example, “When was the last time this data-center equipment was refreshed?” If you’re told, “Hey, we just did this three months ago!”, that’s a warning. It suggests a recently-inked long-term contract. In other words, “recurring costs.”

Why don’t more M&A professionals know about “stranded costs”?

Remember that M&A professional we mentioned at the beginning of this article? He was neither unintelligent nor inexperienced. Why, then, wasn’t he familiar with a basic term like “stranded costs”? And why are so many other M&A professionals in the same leaky boat?

It all comes back to our original thesis: Only one-percent of the companies in the world are true strategic acquirers. The other 99 percent are more reactive, and thus never gain the experience and insights required to make “acquisition” an integral part of their “A Game.”

There is a way around this shortcoming: Bring in dedicated experts. Like Ensunet. We specialize in M&A for IT, with proprietary protocols and run books, honed over the course of more than $4 billion in acquisition support. Download our free pre-/post-merger integration IT checklist, or contact us today to minimize the impact of stranded IT costs.