M&A IT Playbook & Integration Checklist

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“Stranded IT costs,” quite simply, equate to money left on the table for the remaining entity during the course of a carve-out. They’re IT costs that the seller is forced to pay, after the fact, yet should have avoided in the first place.

That’s a cautionary tale right there for M&A professionals.

In this article, we’ll dive deeper into the topic of “stranded IT costs.” We’ll cite numerous examples. And we’ll show you ways to avoid them.

What are “stranded IT costs”?

Technically speaking, a stranded IT cost is a recurring IT expense which a company is obligated to pay... after it sells a portion of itself (e.g., a particular line of business) to another company.

It’s an IT 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 purchased a huge order of laptop computers, 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 all those laptops, it’s a one-time factor into the profitability of the sale.

In other words, that particular hardware purchase is not “recurring.”

But what if you’re Company B, and you operate ten server 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 server centers 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 IT costs. In other words, that sexy $2 million sale was just drained by half, from those “gray area” recurring expenses.

Here are numerous other IT 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 the acquiring Company A, being bigger, may well have a better deal with Microsoft already. So that’s a painful stranded IT cost, waiting to happen.
  • Other recurring IT 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 an 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, simply 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 the remaining portion of Company B 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.

Why does this happen?

Some stranded costs are unavoidable. Assuming you spot them during due diligence, they simply become points of negotiation, typically within the context of the transition services agreement, or TSA, between buyer and seller.

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 IT-support 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 B—added millions of dollars, not to mention time, complexity, and risk, to the divestiture.

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 billions 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 line of business” 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 IT cost like this gets buried—and thus harder for Company B’s internal deal team (or 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 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 avoiding 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. 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 deal 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.
  • Visit the facilities—either in person, or more likely these days, virtually (be sure to check out Ensunet’s blog about “How to Perform M&A Due Diligence for IT... Remotely”). 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.”

Avoid “stranded IT costs” before they negatively impact deal value

Ensure that your M&A transaction is poised for success: Ensunet specializes in M&A IT diligence and transaction lifecycle integration and optimization, helping you to maximize business outcomes for your digital enterprise. Serving private equity and corporate M&A leaders since 2008, we tackle  the complexities which span the M&A transaction lifecycle with a focus on technology and operations—from strategy, analysis, diligence, and planning all the way to hands-on integration and optimization.

Avoid stranded IT costs. Download our free M&A IT Playbook & Integration Checklist, or contact us today to book a no-obligation call with one of our friendly subject-matter experts.

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