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

Split Off

Generally, companies tend to have four options when it comes to 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 that, companies do not opt for split-offs very frequently 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.

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 which it intends to divest.

However, the shareholders can own shares in the resultant new company only 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 shares of the new company are not dispensed on a pro-rata basis among the participating shareholders.

However, the parent corporation may provide its shareholders with 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 generally tend to 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 in fixing the exchange ratio of the split-off.

It is crucial to note that most split-offs are classified as a Type D reorganisation. Therefore, it is vital for companies venturing for this kind of split-offs to follow section 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 enables companies to get rid of the dues and risks concerning one of its subsidiaries.
  2. Enhancing core operations: Sometimes, too much diversification often deviates a company’s focus from its core operations. To restore its focus on its core competencies, the company may opt for a split-off.
  3. Lessens 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 restructuring of the business by rationalising workflow, increasing focus on core competencies, permitting judicious capital allocation and providing tax protection. All of these factors play a significant role in raising the profit margins of a company.
  5. Prevents stock dilution:  A split-off is just like repurchasing stocks without the use of 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.
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Disadvantages of Split-off

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

  1. Complicated process: So far, the procedure is concerned, split-offs tend to be far more intricate in comparison to other divestiture methods like spin-offs. 
  2. Costly process: Divestitures are always more expensive than acquisitions as there are too many legal and institutional matters involved. Split-off as a divestiture method is no deviation from this rule.
  3. Difficult to execute: The provision of exchanging shares often 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 a lot of 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