What is Spin-off | Working, Types, Advantages vs Disadvantages

Various corporate actions, like acquisitions, mergers, buybacks, bonus shares, and the like, tend to influence market operations by bringing in drastic changes in the market shares.

Therefore, market participants and investors need to be aware of the meaning and outcomes of these corporate actions to avoid encountering market risks.

One such corporate action that tends to affect market operations significantly is a corporate spin-off.
A spin-off is a form of operational maneuver that entails the dissolution of an existing subsidiary of a parent company and the establishment of a new independent company.

The resultant company is termed the Company Spun-off and is created with an eagerness to generate more value than the parent company. As such, a spin-off can also be considered a form of divestiture.

Key Takeaways

1. A spin-off is a type of corporate restructuring where a company creates a new, separate entity out of a division or business unit.
2. The new entity is formed by distributing subsidiary shares to the parent company’s existing shareholders.
3. Spin-offs can provide a way for a company to unlock the value of a business unit that may not be getting the attention or resources it deserves and create opportunities for investors.

How does Spin-off work?

First, it is crucial to note that a spin-off is a form of mandatory corporate action. It follows that the board members can decide to venture for a spin-off. The shareholders have no right to vote in this context.

When a parent company ventures for a spin-off, it dispenses a hundred percent of its holding interest in the company spun-off in the form of a stock dividend to the extant shareholders in proportion to their ownership in the parent company.

The parent company can also give its extant shareholders discount offers to swap their shares in the parent corporation for a holding in the spin-off. For example, the parent company can offer its shareholders to barter their $100 of the parent corporation’s stock for $200 of its spun-off stock.

Generally, it takes six months to more than two years for a spin-off to take off. Once the decision to establish a spin-off has been taken, significant steps will likely follow.

1. Identification and selection of a team of competent leaders for the spin-off company.
2. Generating a suitable operating model.
3. Chalking out an appropriate financial plan.
4. Informing and explaining the terms and conditions of the spin-off to the extant shareholders.
5. Completing all the required legal procedures.
6. Taking other vital steps to enable the spin-off company to create a distinct identity unless the company spun-off finally takes off.

Generally, the company spun-off assumes a new name and a separate management structure. However, it inherits its intellectual properties, assets, and human resources from the parent company.

Besides that, in most cases, the company spun-off may continue to receive technological and financial support from the parent corporation.

Types of Spin-offs

Based on the proportion of holdings the parent company retains, a spin-off can be classified into two types.

1. No ownership: The parent company does not retain any shares in the company spun off. All the shares are dispensed among the extant shareholders. Consequently, the company spun off and became autonomous upon taking off.
2. Partial ownership: The parent company can acquire up to 20 percent of the company spun-off, leaving the rest distributed among the extant shareholders. In this case, the parent company retains the power to regulate the company’s spun-off operations and have some say in the decision-making process.

Advantages of Spin-off

A corporation may choose to go for a spin-off for various reasons. Among them are the most significant reasons to venture for a spin-off.

1. For better focus: Certain subsidiaries of a parent company may have different yet promising business goals and strategic priorities. To unravel the full potential of these divisions and streamline its management and financial operations, the parent company may turn these subsidiaries into independent companies.
2. Lack of success in selling off a subsidiary: Spin-off is the last option a parent company chooses to separate itself from its sick subsidiary.
3. To lessen agency costs: To diversify its business interests, a company may sometimes acquire or establish divisions that starkly contrast its core capabilities. Consequently, the investors may either show zero interest or oppose those new subsidiaries. To lessen the agency costs incurred from resolving these disputes, the parent company may choose to get separated from the new divisions by turning them into independent companies.
4.  To eliminate risks and debts: A company may opt for creating a spin-off if it finds that one of its subsidiaries has long-term potential but is currently going through losses and is becoming a burden for the parent company. The company spun off may or may not inherit its debts based on the parent company’s decision.
5. To lessen overhead: A company can eliminate the overhead of its subsidiary by turning it into an independent company.

Disadvantages of Spin-off

Although a company ventures for a spin-off hoping for lucrative returns, the process has disadvantages. 

1. Volatile share price: The share price of spin-offs tends to be extremely unstable. It may dip in the short term despite having long-term potential.
2. Dependent on market trends: Turbulent market trends influence spin-offs. If the market is strong, the spin-offs can outperform. Conversely, if the market is weak, the spin-offs can underperform.
3. Costly process: The cost of venturing into a spin-off is quite extortionate as too many legal and other institutional matters are involved.
4. Shareholders’ discomfort: The parent corporation’s shareholders may not want the company’s shares spun off because of its incompatibility with their investment standards.
5. Employees’ distress: The subsidiary employees may become uncomfortable with the idea of a spin-off as they may have joined that division due to its connection with the parent corporation. Besides that, they may become distressed in the face of spin-off-related uncertainties.

References

1. https://www.sciencedirect.com/science/article/pii/S0304405X99000173
2. https://journals.sagepub.com/doi/abs/10.2307/4131471