Transition Services Agreement (TSA)

What is a Transition Services Agreement?

Transition Services Agreement (TSA, a contract for transitional services) is a contract in which the seller of a business unit undertakes to continue providing services to the sold business for a limited period. These are services that the business has so far obtained from the seller's group of companies. The services begin at closing, that is, on the day on which the business actually passes to the acquirer. The acquirer pays a fee for them and, during the term, builds up its own functions or migrates the business onto its own systems.

A comparison from everyday life: a self-contained flat in an annex has so far been heated by the main house's heating system. After the purchase, the buyer continues to draw heat from the seller for a few months, against a contribution to the costs, until the buyer's own system has been installed.

The occasion is almost always a carve-out, that is, the sale of a business division that was previously integrated into a group of companies. The service provider is the seller or one of its group companies, and the recipient is the sold company or the acquirer. The TSA is negotiated together with the business purchase agreement, usually attached at its signing as an agreed annex and signed at closing. Its signing is often one of the closing conditions, that is, the requirements that must be met before the transfer.

Occasion: dependencies in a carve-out

A business division that was part of a group for a long time shares the group's central functions. The data centre, the ERP system (the central software for accounting, purchasing and inventory management), software licences, accounting, payroll, purchasing and treasury (the management of accounts and liquidity) are run by the parent company or a service company. They are charged through group allocations, that is, internal cost contributions according to a fixed key. Before closing, these functions can rarely be rebuilt completely, because system separation, data migration and recruitment take months. The TSA bridges this gap. Services commonly covered are:

• IT: operation of ERP, CRM and email systems (CRM stands for the software for customer management), network and data centre, workplace support and the shared use of licences.
• Finance: accounts payable and receivable accounting (invoices from suppliers and to customers), payment transactions, monthly closings and input for tax returns.
• Personnel: payroll, time recording and the administration of the occupational pension scheme.

The reverse direction is called a reverse TSA: if systems or staff that the seller still needs pass with the sold business, the acquirer provides services to the seller for a transitional period. Comparable transitional arrangements also arise in a spin-off, in which the shares in the new company belong to the existing shareholders, although there is no external acquirer in that case.

Content and structure of the agreement

Description of services

The core of the agreement is the service schedules. For each service, they fix the content, scope, expected volumes, contact persons, fee and term. A common quality standard is that the seller provides the service in the same manner, to the same extent and at the same quality as in a reference period before closing, often the last twelve months. Services that were overlooked during the negotiation are caught by a catch-all clause (omitted services), under which they are added afterwards on comparable terms.

Express service levels with credits for failure to meet them (service credits) are rarer than in ordinary outsourcing contracts, because the seller is not a commercial service provider. For business-critical IT services, however, availability and response times are still often fixed, following the mechanics of a service level agreement.

Remuneration

The fee is usually based on the seller's costs, either at cost or at cost plus a mark-up. Billing is monthly, as a flat fee per service or by usage, for example per payroll case or user licence. For extensions beyond the base term, rising fees are common; the scale encourages the acquirer to become independent quickly. If the seller and the sold company were linked in a VAT group (umsatzsteuerliche Organschaft), they counted as a single business for VAT purposes, and internal services remained free of VAT. The VAT group ends at closing; the fees under the TSA are then generally subject to VAT.

Term, extension and termination

Terms are fixed per service and in practice often lie between 6 and 18 months. The acquirer usually receives the right to terminate individual services early on a notice period of a few weeks and to extend the term against a higher fee. The seller can generally terminate only for good cause, for example in the case of persistent payment default. With early terminations, dependencies must be observed: if the operation of the ERP system ends, the accounting and payment transactions that build on it often fall away too.

Liability

The seller generally demands a narrow liability clause. Customary are a cap at the fees under the TSA or part of them, the exclusion of indirect damage and lost profit, and priority of remedial performance. Liability for intent cannot be excluded in advance under Section 276 (3) of the German Civil Code (Bürgerliches Gesetzbuch, BGB). Liability under the TSA is regulated separately from the liability cap in the purchase agreement; the two provisions must be coordinated so that claims are neither covered twice nor not at all.

Data protection, information security and personnel

Many services involve personal data, for example payroll or the operation of a CRM system. Which role the seller assumes under data protection law depends on the individual service. If it processes data on instructions on behalf of the acquirer, this is regularly processing on behalf of a controller under Article 28 of the General Data Protection Regulation (GDPR), which requires a data processing agreement. If it also decides on purposes and means, separate or joint controllership under Article 26 GDPR may come into consideration. The classification must therefore be made and documented for each service.

Between the seller and the acquirer, the TSA allocates risk through indemnities, liability rules and information security obligations. This includes technical separation: the acquirer receives access to the data of the sold business, but not to the other data of the group. For the end of the term, the agreement regulates data export, formats and deletion.

As regards personnel, the boundary with temporary agency work (Arbeitnehmerüberlassung) must be observed. If the seller's employees work on the instructions of the acquirer and are integrated into its processes, this may amount to a secondment of workers, which requires a permit under the German Temporary Agency Work Act (Arbeitnehmerüberlassungsgesetz). The service description and management must therefore be designed so that the seller retains the power to give instructions to its employees.

Significance for valuation and purchase agreement

In due diligence, the acquirer determines which services the business obtains from the group and what it costs to run them independently. The historical figures of a carve-out contain group allocations, which rarely correspond to the actual costs of a standalone unit. The difference between the allocation and the future costs of running the functions itself (standalone costs) enters the adjusted EBITDA as an adjustment and thus the purchase price.

In addition there are one-off separation costs for building systems, data migration and new licences, as well as the fees under the TSA itself. Who bears these costs is regulated by the purchase agreement or the purchase price. A separation plan, which sets out by when each service is to be replaced, is common. It is also a basis for the acquirer's integration planning.

Worked example

A group sells a software division with a historical EBITDA of EUR 3.0 million. IT, accounting and payroll were previously charged through a group allocation of EUR 450,000 per year. A TSA with a term of nine months is agreed.

• Monthly fees: IT EUR 40,000, accounting EUR 15,000, payroll EUR 5,000, together EUR 60,000
• Base term: 9 × EUR 60,000 = EUR 540,000
• Extension of the IT service by three months with a 20% mark-up: 40,000 × 1.2 = EUR 48,000 per month, so 3 × 48,000 = EUR 144,000
• Total fees under the TSA: 540,000 + 144,000 = EUR 684,000
• For comparison, the group allocation for one year: EUR 450,000. One-off additional burden of the transition period: at least 684,000 minus 450,000 = EUR 234,000
• Standalone costs of the own functions after the end of the TSA: EUR 780,000 per year
• Permanent additional costs compared with the allocation: 780,000 minus 450,000 = EUR 330,000 per year
• Adjusted EBITDA: EUR 3.0 million minus EUR 0.33 million = EUR 2.67 million
• Effect on enterprise value at an EBITDA multiple of 8: 330,000 × 8 = EUR 2.64 million

The fees under the TSA are one-off transition costs and are usually negotiated separately, for example through a cost contribution by the seller. The permanent additional costs of running the functions independently, by contrast, reduce sustainable earnings: at a multiple of 8, every EUR 1 of permanent additional cost reduces enterprise value by EUR 8. It is therefore worthwhile for the seller to determine the standalone costs itself on a reliable basis before the acquirer applies its own, usually more cautious, estimate.

Distinction from related terms

• Long-term supply or service agreement: governs a lasting business relationship between the seller and the sold business, for example the continued supply of intermediate products. It is negotiated on market terms and is not designed to come to an end.
• Service Level Agreement (SLA): sets out quality commitments such as availability and response times for an ongoing service. In a TSA it is often a building block for the IT services, not the whole agreement.
• Integration Planning: plans the integration of the acquired business at the acquirer. The TSA provides the time for this; the separation plan and the integration plan must fit together.

Common mistakes

• Incomplete service schedule. Services that run unnoticed in everyday operations, such as certificates, domains, licence management or access to bank portals, are often missing and are noticed only after closing.
• Missing third-party consents. Software and framework agreements of the group often do not permit use by a company that is no longer affiliated. Without the consent of the licensors, the seller cannot provide the service in accordance with the agreement.
• Term too short without an extension option. IT separations regularly take longer than planned. Without an agreed extension, the acquirer has to renegotiate under time pressure.
• Data protection role fixed across the board. Classifying all services uniformly as processing on behalf of a controller overlooks services in which the seller pursues its own purposes or is jointly responsible with the acquirer.
• Standalone costs quantified too late. Anyone who determines the costs of independent operation only after signing has negotiated the purchase price on an earnings basis that will no longer exist in future.

Frequently asked questions

How long does a TSA last?

Often between 6 and 18 months, varying by service. Payroll and accounting can often be replaced after a few months; separating the ERP system and the data centre takes longer.

How is a TSA remunerated?

As a rule at the seller's own cost, often plus a mark-up of a few per cent. Billing is monthly per service; for extensions beyond the base term, the fees usually rise in steps.

Can the seller terminate a TSA early?

As a rule only for good cause. Because the acquirer depends on the services, ordinary termination rights for the seller are unusual.

Does a share deal also need a TSA?

Yes, if the sold company obtained services from the group. In a share deal, the shares are transferred together with the company, but the group's central services do not go with them. What matters is therefore not the form of the transfer but whether the business is able to operate independently on the first day.

Who is liable for a data protection breach by the seller?

That depends on its role. Towards the data subjects, it is mainly the controller who is liable under the GDPR; a processor is liable there only if it breaches its own obligations or acts against instructions. How the loss is allocated between the seller and the acquirer is determined by the indemnities and liability limitations in the TSA.

The Roemer Capital view

When a client sells a business division out of a group, we prepare an overview early in the process of all services that the division obtains from the group. We set realistic standalone costs against the group allocations. These figures belong in the financial model and the data room before bidders estimate them themselves and add risk discounts.

In the negotiation, we treat the TSA as part of the purchase price package: the term, fee scale and extension options have a value that can be quantified. The contractual drafting and the data protection classification lie with the parties' law firms. We supply the economic foundations and make sure that the separation plan and the purchase agreement fit together.