Using a Spin-Out to Maximize Shareholder Value

May 4, 2018

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What is a Spin-Out?

A spin-out is a type of corporate reorganization involving the separation of business assets or operations from the Parent Company (“ParentCo”) to a newly formed independent company (“SpinCo”). The SpinCo takes the assets or operations being transferred, as well as any associated liabilities. In exchange, the SpinCo will usually issue shares to the ParentCo shareholders (in proportion to their percentage interest in ParentCo) to compensate them for the decline in the ParentCo’s equity value after the spin-out. Depending on the situation, this can usually be accomplished in a fairly tax-effective manner.

Spin-out Method

Reasons to Consider a Spin-Out

Using a spin-out can unlock the value of an embedded division or any underutilized assets, such as newly created intellectual property, that might have a different risk-reward profile than the ParentCo’s core business.

Often the assets being transferred will require new management talent and financing to fully exploit the business opportunity. Such capital and human resources may not be available to the ParentCo, and therefore the asset would remain unexploited if kept within the ParentCo.

Secondly, the spin-out allows the ParentCo to focus on its core business without the diversion of resources to a segment that could have different needs. The ParentCo will often provide support to the transferred business by signing contracts for the supply of products or services from the SpinCo.

Spin-outs also provide a mechanism to bridge a valuation gap that may exist in an M&A transaction. A purchaser interested in acquiring the ParentCo may place little or no value on the ParentCo’s non-core assets. A spin-out avoids the need to sell the asset prematurely (i.e., thereby losing out on any long-term gain) and distributing the proceeds to the ParentCo’s shareholders (possibly triggering negative tax consequences). This way, the acquirer only pays for the core business of the ParentCo that it wants. The shareholders of the ParentCo get paid full value for the ParentCo’s core business, plus they get to participate in the upside potential of the SpinCo.

Some Drawbacks of a Spin-Out

Shareholders are usually in favour of a spin-out, as it makes sense for a promising new business with diverse needs and growth prospects to go at it alone. More importantly, the combined value of the separated parts is usually much higher, as public company spin-out transactions have often demonstrated.

However, the spin-out process can be costly and time consuming due to one or more of the following issues:

Financial Reporting Issues

If the property being transferred to the SpinCo is not an operating business, but rather an asset such as intellectual property or a mineral property, the financial reporting requirements are straight forward[1]. However, if the assets being transferred represent an operating business, there is often a need for divisional carve-out financial statements to be prepared. If the SpinCo’s shares are to be listed on a public stock exchange, the divisional statements must be audited for a number of years, which can be a very expensive proposition.

Taxation Issues

Some of the most complex issues associated with a spin-out transaction are tax related. Generally, the goal is to minimize the tax consequences at both the corporate and shareholder levels.

There are a variety of ways to structure a spin-out. Invariably, it involves a distribution of the SpinCo shares by the ParentCo to its shareholders, either as a return of capital or a dividend in kind. Other, more complicated, techniques may also be available. The relative advantages and disadvantages of each technique will depend on the specific facts of the situation, including the extent of accrued gains at the corporate and shareholder levels, the ParentCo’s tax attributes (including any loss carryforwards which may be utilized), the make-up of the ParentCo’s shareholder base and other issues which are beyond the scope of this article.

Needless to say, a detailed review of the facts and a thorough assessment of alternative structures (and their respective tax effects), should be completed before settling on a specific tax plan.

Valuation and Financing Issues

Potential investors considering an equity investment in the SpinCo will be interested in the value assigned to the assets transferred in, as it will impact the price they are willing to pay for their interest and the implied dilution they will accept. An independent valuation report or fairness opinion can often be helpful in bridging any differences between the parties’ perception of the fair market value of the SpinCo’s assets.

Any of the above activities are likely to require a significant time commitment from management and will also act as a distraction for a number of months. Management’s focus may shift from running the ParentCo’s core business to executing the spin-out.

Notwithstanding the significant planning needed for a successful spin-out, the benefits in terms of maximizing shareholder value can make it worth the effort.

If you would like to explore how we can assist you in planning your proposed spin-out transaction, or explore other strategies to maximize shareholder value, please contact one of our trusted Smythe Advisors.

[1] For example, if the asset is being transferred between private entities under common control, Canadian accounting standards for private enterprises (“ASPE”) generally require the asset to be recorded on SpinCo’s books at its carrying amount (as recorded on ParentCo’s books) unless there is some independent evidence that supports an exchange value. See ASPE Section 3840.04 for further details.

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