What is Split-off? | Complete Guide, Pros vs Cons

Generally, companies tend to have four options for structuring a divestiture. Split-off is one of them (the other three being split-ups, carve-outs, and spin-offs).

What distinguishes it from other divestiture methods is the allotment of shares. Besides, companies do not frequently opt for split-offs, like spin-offs.

As it follows from the appellation and the above discussion, a split-off is a method of divestiture that entails the division (split) of the stockholders from the parent corporation. As such, it can also be termed as a business restructuring method.

Key Takeaways

1. Split-off refers to the separation of a segment of a company to form a new independent entity.
2. Split-off aims to create two independent entities that can operate more effectively.
3. A split-off is tax-free for the parent company and the new independent entity.

How does Split-off work?

When a company ventures for a split-off, it extends its extant shareholders an offer for owning shares in a subsidiary that it intends to divest.

However, the shareholders can only own shares in the resultant new company if they give up their stocks in the parent company. In this context, the shareholders may have two choices before them.

1. Continue to own shares in the parent corporation.
2. Give up a portion or whole of their parent company shares for shares in the resultant new company.

As a split-off doesn’t require compulsory participation by the shareholders, the new company’s shares are not dispensed on a pro-rata basis among the participating shareholders.

However, the parent corporation may offer its shareholders lucrative offers to encourage them to participate in the split-off. For example, it can offer them a premium or some incentives for trading their parent company shares with the divesting company’s stocks.

Before venturing for a split-off, companies sell the deprived/divesting subsidiary through a carve-out in an initial public offering (IPO). This step generates a specific market value for the deprived subsidiary, which helps fix the split-off exchange ratio.

It is crucial to note that most split-offs are classified as a Type D reorganization. Therefore, it is vital for companies venturing into this kind of split-offs to follow sections 355 and 368 and the Internal Revenue Code.

Adherence to these codes will enable companies to conduct tax-free transactions, which, in actuality, is a feature of the Type D split-off as only shares are traded.

Besides that, a Type D split-off also entails a transfer of the parent corporation’s assets and resources to the newly formed company.

Advantages of Split-off

The motivations behind a company opting for a split-off are many, as the method has several advantages. The following are the most significant among them.

1. Debts and Risks: Divestitures like split-offs enable companies to eliminate the dues and risks concerning one of its subsidiaries.
2. Enhancing core operations: Sometimes, too much diversification deviates a company’s focus from its core operations. The company may opt for a split-off to restore its focus on its core competencies.
3. Lessons agency costs: A company may opt for a split-off to reduce the agency costs acquired from the disputes among its shareholders regarding one of its subsidiaries.
4. Increases profitability: Split-offs allow business restructuring by rationalizing workflow, increasing focus on core competencies, permitting prudent capital allocation, and providing tax protection. All of these factors play a significant role in raising a company’s profit margins.
5. Prevents stock dilution:  A split-off is just like repurchasing stocks without using cash. Instead, the shares of the division company are used for a buyback by the parent company. Consequently, there remain no apprehensions of share dilution.

Disadvantages of Split-off

Although, like all other divestiture methods, split-offs are opted for by companies in the hope of favorable returns, the procedure is not without its share of disadvantages.

1. Complicated process: So far, the procedure concerned with split-offs tends to be far more intricate than other divestiture methods like spin-offs. 
2. Costly process: Divestitures are always more expensive than acquisitions, as too many legal and institutional matters are involved. Split-off as a divestiture method is no deviation from this rule.
3. Difficult to execute: The provision of exchanging shares acts as a turn-off for the shareholders who are less willing to give up their stocks in the parent company.
4. Employees’ discomfort: As a business restructuring method, split-off generates several job-related uncertainties, which can cause much distress to the employees.
5. Probability of shareholder lawsuits: If the shareholders participating in a split-off find that the premium (exchange ratio) offered by the parent company is not up to the mark, there is a high chance that they may file a lawsuit against the parent company. 

References

1. http://www.etd.ceu.edu/2008/kovacs_veronika.pdf
2. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=241226