Let’s Make a Deal: Negotiating Transition Services Agreements

Business Briefing

Transition services agreements (TSAs) are used when one company is selling a product line, division, or other portion of its business to another. The agreement facilitates the transition of the acquired portion of a seller's business or division to the buyer after the closing of an acquisition.

When a buyer acquires a business in its entirety, TSAs are unnecessary because the buyer generally takes from the seller everything it needs to run the acquired business. In many cases, however, a buyer acquires a product line, division, or subsidiary that is incapable of acting independently. Implementing supply chains, separating information technology (IT) systems, and relocating manufacturing equipment can often delay the closing of an acquisition—a potentially bad result for both the buyer and seller.
TSAs often enable a transaction to close more quickly. They also allow longer-lead-time items to be dealt with on a postclosing basis. These agreements cover a wide variety of topics, and no two are alike. This article focuses on some of the issues relevant to medical device company buyers and sellers in arranging and negotiating TSAs.
How TSAs Work
TSAs are designed to transition an acquired entity or division from the seller to its buyer. In some cases, the buyer is unable to take on certain activities required for the operation of the acquired business or division. Under a TSA, the seller agrees to provide certain services to help run the business until the buyer can take over all aspects of its operation. Take, for example, a case in which the buyer is a medical device company that contracts with third parties for the manufacture of its product. The seller is a medical device company that manufactures its own product and is selling one of its product lines to the buyer. The buyer, however, doesn't have the immediate capability to manufacture the product. In addition, the seller isn't selling its manufacturing service because it is retaining the capability for its other product lines. In order to complete the sale, the seller and buyer enter into a TSA, whereby the seller will manufacture the product line for a specified time period until the buyer can internally develop or outsource the necessary manufacturing capabilities.

The business needs of the buyer dictate the scope of services to be performed by the seller. The TSA sets forth the nature, scope, and timing of the services and how they will be performed. It should also specify which party is responsible for any given task.
Some transition services, such as accounting and payroll services, human resources, customer order taking and support, and sales and distribution services, may be provided for a short term of 90 days or less. Examples of long-term services provided by sellers to buyers under TSAs include raw material acquisition, inventory management, IT services, regulatory compliance, engineering support, manufacturing and management services, private labeling, and supply-chain management and support.
The term of a TSA is typically between three and 12 months. The seller is usually involved for the period of time necessary to facilitate the transition, and the buyer works consistently to complete the changeover. There are times, however, when the term of a TSA is extended, such as when the buyer doesn't have the time or resources to quickly complete a changeover. In a long-term TSA, the buyer engages the seller in a manner similar to a third-party contractor and doesn't move aggressively to immediately transition the business. Long-term TSAs often require more specificity than their short-term counterparts, together with additional compensation to the seller.
Viewed on a spectrum, the shorter the term of a TSA, the more it functions as a truly transitional arrangement; the longer the term of a TSA, the more it functions as a service agreement with a third party. The issues and bargaining positions of the parties vary depending on where the TSA falls on this spectrum.
Completing the Transition
In the case of both long-term and short-term TSAs, the buyer is concerned with ensuring that the seller properly performs the services necessary to complete the transition. However, this part of the agreement is more important when dealing with long-term TSAs. In long-term TSAs, the buyer is relying more on the seller for the viability of the product line or business than it would in a 60-day TSA for immaterial service functions.
A buyer can ensure or encourage that the seller meets the needs of the buyer and works diligently for the benefit of the buyer in at least the following three ways:
•Establish criteria for the seller's actions. The TSA should clearly spell out the services to be provided, along with how, when, by whom, and the minimum required performance level. This includes listing activities and specifying which employees will be involved in providing the services, and possibly setting forth the amount of time that these employees will dedicate to the buyer. If the seller is not living up to its commitments, the TSA can specify what actions the buyer may take, and who pays for the cost of such actions. For example, the TSA may state that if the seller breaches its manufacturing obligations, the buyer may engage a third-party manufacturer with the seller being responsible for the related costs. •Provide oversight rights for the buyer. The oversight rights facilitate the chain of communication between the buyer and the seller, as well as the buyer's right to review the seller's operations.•Institute monetary incentives. The seller should have monetary incentives for providing quality transition services. The incentives can be in the form of payments from the buyer or of costs to the seller. The buyer can offer the seller payments for its services, or the seller can be required to make payments to the buyer or to a third-party provider if the seller fails to meet its obligations. This can take the form of product warranties or a reduction in cost reimbursements. For example, when the seller stipulates that the products will meet certain specifications in the TSA, the seller must replace the products at its own cost if the products do not meet the prescribed standard. The incentive for the seller is to properly manufacture the goods.
The buyer and seller negotiate which will bear the costs associated with transition services. Buyers argue that transition services should be borne by the seller as partial consideration for the purchase price, nothing that most sellers are not in the business of providing contract manufacturing or outsourcing services. Sellers argue that transition services are an additional benefit to the buyer and that the buyer should bear many of the costs.
In the case of short-term TSAs, the transition services are more likely to be viewed as part of the sale transaction, so sellers can be more easily persuaded to bear the costs. With long-term TSAs, sellers appear more like contractors and are usually unwilling to bear any substantial unreimbursed costs. Sometimes sellers require additional payment above and beyond actual costs, which usually is cast as a percentage of cost (e.g., the buyer will pay the actual cost plus 15–30%). This should be expected with long-term TSAs, considering that the outlays are more significant, and the seller is acting more like a contract provider.
In addition to cost, the buyer and seller negotiate which party will assume the risks associated with transition services. The seller's services typically directly relate to the operation of the newly acquired business or product line. The seller might argue that risks associated with the performance of those services should lie with the buyer, as if the buyer were performing the services. A buyer might argue that the seller has control over how it performs the tasks necessary to provide services and that the seller should be liable for its failure to properly perform those services.
Both the buyer and seller may request an indemnity from each other related to certain aspects of the relationship. Under an indemnity, one party holds the other harmless for claims of third parties related to certain activities or occurrences. The indemnifying party agrees to reimburse the indemnified party for costs, losses, and payments owed to third parties.
Take, for example, when a buyer purchases a medical device product line from a seller retaining the trademarks that were previously used on the product line. In this case, the buyer intends to ultimately sell the product line under its own trademark. However, due to timing issues, the parties may agree to have the seller manufacture and sell the product under the seller's trademark until the buyer can transition the product line for sale under the buyer's trademark.
The buyer will request that the seller indemnify it for claims of trademark infringement arising out of the use of the seller's mark during the transition period. In addition to indemnities, the buyer and seller may require that each maintain a certain amount of insurance to protect against third-party claims.
TSA Issues for Device Manufacturers
Although TSAs are used in acquisitions in many different industries, there are transition services that relate more specifically to the medical device industry. The processes for manufacturing medical devices are more complex and highly regulated than standard manufacturing. As a result, transitioning the manufacturing of medical products can be more complicated and time consuming. There are issues to consider when a buyer enters into a TSA in which the seller will manufacture one or more products for the buyer.
Compliance with Regulatory Requirements. Before instituting the transition services and completing the acquisition, the buyer and seller should determine what governmental approvals and permits are required of each party. The buyer will likely need certain approvals when the seller is acting as contract manufacturer for the buyer's recently acquired products. The buyer will want to ensure that its products are manufactured in compliance with FDA regulations and in accordance with GMPs and other applicable product quality and integrity standards.
Product Liability. Sellers are often reluctant to retain product liability responsibility for a product line that they have sold. Medical devices are used in the treatment of patients and can create a risk of harm to individuals, which can result in extensive liability. Although the nature of the medical device can heighten or lessen this risk, product liability is always a concern. Pursuant to the sale of a product line, the buyer may, among other things, purchase the product design and manufacturing specifications and engineering designs.
Product liability includes responsibility for design and manufacturing defects. A design defect is a flaw in the underlying product design that creates an unreasonable risk of harm to the product user. A manufacturing defect is a flaw in the product manufacturing process that creates an unreasonable risk of harm to the product user.
It is possible to divide the product liability risk when a seller is manufacturing the acquired product under a TSA. The buyer can assume the risk of design defects (subject to the indemnities in the purchase agreement that separately governs the sale of the product line or business to the buyer); at the same time it can have the seller assume the risk of manufacturing defects while it continues to manufacture the product. Such a division is reasonable because the buyer owns the product and its specifications, and the seller is in control of manufacturing the product in accordance with agreed upon specifications.
By allocating the risk so that the buyer is responsible for design defects and the seller is responsible for manufacturing defects, the seller will indemnify the buyer against third-party claims to the extent they arise out of the manufacture of the product. Similarly, the buyer will indemnify the seller against third-party claims to the extent that they arise out of the design of the product.
Sometimes, parties will argue for limits on indemnification. These limitations will include not indemnifying the other party for special, incidental, or consequential damages. This means that the indemnifying party will not be responsible for the devaluing of the business or lost profits arising out of the third-party claim. The indemnifying party will maintain that it should only be responsible for reimbursing payments and costs associated with third-party claims and not ancillary losses incurred by the indemnified party.
In addition, parties sometimes argue for limitations (caps or floors) on indemnification. The indemnifying party is only responsible up to a certain dollar amount or after a certain dollar amount of costs have been incurred. It is important that the buyer assess the product liability risk prior to purchasing the product line or business.
While under a TSA, a buyer may be responsible for design defects; however, the agreement that governs the purchase of the product line or business may include additional indemnities and warranties. These warranties can benefit the buyer with regard to the acquired product line or business. Under the purchase agreement, the seller may represent that the product hasn't been subject to claims of design defect or other product liability and indemnify the buyer only if such representation is inaccurate. However, the buyer may be liable after the acquisition for unknown or unanticipated claims of a design defect arising after the product line or business purchase.
The Details
In addition to the issues discussed in this article, TSAs can address many other important areas, including warranty claims, quality systems, record-keeping requirements, regulatory plans, product distribution and sales, and insurance and subrogation rights. When drafting and implementing a TSA, the devil is often in the details. One cannot anticipate each and every issue and, in many cases, it's not economical to negotiate every last detail. In most circumstances, the parties should avoid negotiating reimbursement of cell phone charges, company automobile allowances, and other immaterial items, and focus on the more critical issues.
Take, for example, if the buyer and seller are sued in connection with a products liability claim for products manufactured by the seller on behalf of the buyer, or FDA institutes a product recall during the term of the TSA. A well-drafted TSA will deal with the rights, duties, and obligations of each of the parties not only to each other regarding those matters but also to third parties.
Conclusion
The TSA should not be viewed as a value proposition by either party, but rather as a way to allow the buyer and seller to close a transaction more quickly and efficiently.
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