Introduction
Divesting assets, no matter what strategy is used, helps increase shareholder value. Sometimes, people interchange the terms divestiture and spin-off, as spin-off involves divesting assets through the formation of a new company separate from the parent company. However, divestiture does not only include spin-offs; it includes split-offs and carve-outs, too. Now, somebody who has never heard these terms before is bound to be more bewildered. Fear not, like all jargon, these terms have not-so-complex meanings.
Spin-offs and split-offs involve forming a new company whose management is not dependent on the parent company. However, the existing shareholders get to keep the shares from the parent and the new company when the parent company spins off part of its business, whereas, in the case of a split-off, the existing shareholders have to pick the shares of the parent or the new company. Carve-outs refer to the sale of shares to the public. So, why do companies divest their assets or businesses? To increase profitability and maximize shareholder value (i.e., increase dividends and capital gains).
Spin-Off Vs. Divestiture
Divestiture refers to a company’s disposal of its assets or business units. Spin-off is a divestiture technique in addition to split-off and carve-out. Therefore, divestiture is a broader concept than spin-off.
Difference Between Spin-Off And Divestiture In Tabular Form
| Parameters of Comparison | Spin-Off | Divestiture |
| Meaning | A subsidiary is formed as a new independent and distinct entity with a separate management. | It is the partial or complete disposal/discarding of assets or a subsidiary through sale, closure, exchange, or bankruptcy. |
| Distribution of Shares | The existing shareholders (parent company shareholders) receive shares of the spun-off company on a pro-rata basis. Therefore, they have shares in the parent and the spun-off company (a win-win situation). | The existing shareholders have to choose between the parent and the split-off company’s shares (when the subsidiary is split off). Therefore, they will have shares in either the parent or the split-off company (tough to know which share will pay off, right?).The parent company offers part or all of the shares to the public if it chooses to carve out the subsidiary. |
| Cash inflow | The parent company does not experience cash-inflow when a subsidiary is spun-off. | A carve-out generates cash inflow for the parent company. |
| Reasons for divesting/spinning off | A parent company may spin off its subsidiary to focus on a particular product line. This process facilitates increased profits, as the new management only needs to concentrate on the split-off company’s problems, and the parent company can focus on its affairs. | A company predominantly divests its assetsDue to a merger or acquisition. It spins, splits, or carves out a business unit that has a duplicateDue to the subsidiary’s underperformance (hmm, like cutting off a beyond-saving limb?). |
| Performance | Spin-offs are preferred to split-offs and carve-outs as they are generally more successful. | Split-offs and carve-outs are good divestiture techniques but are comparatively less successful than spin-offs. |
What Is Spin-Off?
Spinning off part of a parent company’s business and forming a new company often improves the performance of both companies. The spun-off company’s success is attributed to increased focus on a particular business or product line. DreamWorks Pictures spun off DreamWorks Animation in 2004, and Fairchild spun off Intel. Both companies are successful and almost more famous than the parent company (this is the reason why spin-off is preferred to other divestiture strategies.). Sometimes, a company resorts to the spin-off strategy if it does not get a good offer for a part of its business it is looking to sell.
After the assignment of equivalent shares in the newly independent company, the shareholders can buy and sell the shares of the parent and the new company freely. Fortunately, the shareholders face less risk, as they are not required to exchange their shares in the parent company for the new company’s shares. Spin-offs usually go smoothly as the independent company’s management consists of employees from the parent company. As such, the management knows what is expected to be done and focuses on making the company as successful as possible.
Spin-offs, though popular, are not resorted to lightly. The parent company thinks long and hard before deciding to spin off a business unit or segment. It spins off a business segment only if it thinks that the business segment no longer fits into its core competency or the business unit will perform better as an independent entity.
Sometimes, a company grows so much that it has multiple product lines and business units, making it challenging to manage them all (imagine being that successful. Not many companies can boast such a feat). In such scenarios, the company can do nothing other than spin off a division, subsidiary, or business unit. Some other causes for spin-offs are:
- Financial duress, need for reconstruction.
- The subsidiary is holding back the parent company from maximizing profit.
- The parent company believes a particular business unit will be more lucrative as a standalone entity.
- Active investors/shareholders pressure the parent company.
- Government regulations.
Spin-offs are expected to act as tax shields and reduce costs for the parent company. Advocates of this divestiture strategy believe that the sum of the parts is greater than the whole. That is, a company will perform better than it will if it stays as a part of the larger/parent company (love something set it free?). Since, in most cases, this has proven true, companies have no scruples using this strategy. Tax implications, regulations, market conditions, how a spin-off will affect the company values, etc., should be considered before adopting the spin-off strategy.
The parent company continues to offer strategic and technological support to the spun-off company even though it is, in theory, an independent entity. A problem with spin-offs is that the shareholders may not want the new company’s share and start selling it. This increasing sale will make the share price dip in the short run (which does not instill confidence in a potential investor). However, spin-offs are more often successful in the long run than not. At times, spin-off may seem like the best strategy; however, a split-off or a carve-out may be a better option.
What Is Divestiture?
Divestiture is a complex strategy involving the sale of a part of an entity and not the whole. A company may divest its assets or business units through any of the following strategies:
- Spin-off
- Split-off
- Carve-out
Split-off
Split-off is a type of divestiture similar to spin-offs; however, the shareholders have to relinquish their shares in the parent company to receive the new/split-off company’s share. Most people are wary about investing in a new company they cannot predict. Therefore, some parent companies offer a premium to the shareholders who decide to exchange their parent company shares for the split-off company shares (it is difficult to motivate people to take an action without some sort of incentive, right?).
However, the shareholders do not need to exchange their shares (that is, it is not mandatory); they can stick to their parent company shares resolutely if they are unwilling to part with them. Split-offs, unlike spin-offs, are not always beneficial for both companies. Spin-offs take place when the parent company is sure that the spun-off company will operate better independently.
On the other hand, split-offs may take place when the parent company feels that a business unit is underperforming or dragging the parent company down with it. Of course, that is not the only reason a split-off takes place. Sometimes, a subsidiary is split off to defend it from hostile takeovers. The other reasons for splitting off a business unit are similar to the reasons for spinning off a company. Splitting off a division or a subsidiary leaves the parent company to pursue more profitable opportunities.
Carve-out
Carve-out refers to the parent company’s sale of some of a subsidiary’s shares through an Initial Public Offering (IPO). The parent company retains its controlling interest/holds the majority of the shares in the carved-out subsidiary, as typically, only 20% of the shares are offered to the public. Carved-out companies have a better chance of sourcing finance and forming strategic alliances that were not possible before. In short, those who have a bone to pick with the parent company may deal with the carved-out subsidiary, as it becomes a separate entity.
Unlike a spin-off, carve-outs generate cash, meaning the parent company enjoys increased and improved cash flow. An equity carve-out also aids the company in circumventing capital gains taxes (but to avail of this benefit, the company must sell only 20% of the shares to the public.). Sometimes, the parent company divests the entire subsidiary if underperformance persists. Usually, a spin-off or split-off succeeds carve-outs. Therefore, people considering investing in carved-out companies must ponder what caused the carve-out and what will happen if the parent company relinquishes its control in the future (which may not be for several years).
No matter which type of divestiture strategy is used, there are bound to be uncertainties and, at least initially, chaos. Divesting an asset or a business unit seems easy in theory, but the actual process takes months to end. An equity carve-out process goes on for about 8 – 24 months. Spin-offs and split-offs are more complex processes and need additional time compared to carve-outs (once, just once, can’t there be a process that takes mere weeks to complete?).
Reasons For Divestiture
The following are some of the common/predominant reasons for divestment:
Bankruptcy – A company facing bankruptcy uses divestment strategies to reduce costs. After all, bankruptcy is no joke! A company will find it extremely challenging to come out on top once it is named a bankrupt company. To avoid shattering its well-earned reputation, any company will find ways to combat the situation.
Increase Cash Inflow – A company may need to generate more cash to pay off debts, achieve liquidity, or strengthen its balance sheet (most people hone in on a company’s balance sheet to determine how it is performing). Potential investors will want to check a company’s solvency ratios, creditors turnover ratio, and fixed assets turnover ratio before investing – all of which are related to cash inflows.
Underperforming/Non-Core Assets – Sometimes, a company will be better off selling an asset that underperforms or has become unnecessary. Such a move will reduce the cost of managing the assets, and the organization will have time to concentrate on much more pressing matters.
Main Difference Between Spin-Off And Divestiture (In Points)
- Usually, a spin-off follows the carve-out strategy. For the spin-off to be tax-free, 80% of control should be in the hands of the existing shareholders. Therefore, 20% of the shares are offered to the public through carve-out, and later the remaining 80% is spun-off.
- A spin-off involves providing the shareholders with 80 – 100% of the new company’s shares. A carve-out divestiture strategy involves only partial divestment. Therefore, only a part of the shares are sold to the public (the company can sell all the shares, but it is a rare occurrence).
- A spin-off aims to provide tax-free returns to shareholders, increase performance standards and focus, and attract more investors. Divestiture (as it is a broader concept) is a strategy used to reduce costs, focus on core (primary) business, and repay debts.
- Divestiture involves selling off parts of the business or underperforming assets, closing off certain operating locations due to increased cost, and disposing of assets due to political or ethical obligations. On the other hand, spin-offs involve focusing resources on business areas that show potential but are different from the direction the parent company is heading.
- Spin-offs may create new job opportunities or facilitate employee transfer from the parent to the spun-off company, whereas divestiture, in general, may result in several lay-offs.
Conclusion
Spin-off is a narrow concept encompassed by a much broader concept – divestiture. Divesting assets helps the parent and the new company function better. However, all divestiture strategies have their drawbacks. A spin-off or split-off company’s shares are volatile (at least in the short-run) as people cannot bring themselves to trust easily a company they know nothing about. Will it perform well financially and become a steady competitor in the market? Does it have the same strengths people love about the parent company? People have other similar questions that only time can answer. Still, divestiture strategies are popular because the benefits outweigh the drawbacks.
References
- https://www.linkedin.com/pulse/divestiture-mindset-sale-vs-spin-off-prashant-sopory/
- https://www.wallstreetprep.com/knowledge/spin-off/
- https://corporatefinanceinstitute.com/resources/valuation/spin-off-and-split-off/
- https://corporatefinanceinstitute.com/resources/valuation/divestiture-overview/
- https://en.wikipedia.org/wiki/Corporate_spin-off
- https://www.ansarada.com/mergers-acquisitions/divestiture/carve-out
- https://www.linkedin.com/advice/3/how-can-you-choose-between-spin-off-carve-out-skills-restructuring
