Spin-Offs: Key Considerations | QuickLaunch

A corporate action is an event or action taken by a publicly traded company which can impact some of its stakeholders, including its shareholders, bondholders and employees. There are many types of corporate actions which, under the scope of corporate governance, are initiated some with great fanfare and others within the ordinary course of business. Some actions are compulsory, while others provide for the elective participation of the shareholders. Some actions, like spin-offs, stock splits and share repurchases can offer good opportunities for the investor.

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A spin-off is a corporate action intended to restructure a company. A spin-off is a sale or divestiture of a subsidiary company or division to create a new, independent entity.

Valuation for Corporate Spin-Offs

Shares of the new company are distributed to the shareholders of the parent company in accordance with a specific ratio. The new shares, just like the shares owned in the parent company, may be kept or sold by the shareholders at their discretion. The theory behind most spin-offs is that they can unlock hidden value, which value is not fully reflected in the parent company valuation.

These estimates were used by management and tax counsel to select a transaction structure which was appropriate to the situation. In this case, the indexing product line was determined to have the smaller value of the two, so the assets for it were placed in a subsidiary and then the shares of that subsidiary were distributed as a dividend to existing shareholders to complete the spin-off.

Treating the transaction as a dividend worked in this case, because the parent company had a large reserve of net operating losses, because many of the venture capital shareholders were tax-exempt entities, and because the tax basis of the indexing product line was low.

Another transaction structure and tax treatment might be more appropriate in different circumstances. Although selecting the right structure was important, there were other significant problems to be solved, including how to allocate the liquidation preferences and how to set stock option strike prices.

Why Spin Offs Rock

Each of the companies — call them Oldco and Newco — would be taking some portion of the liquidation preferences of the existing preferred stock. But this could not be accomplished by simply splitting the preferred stock in two or even assigning a dollar weight to each entity in line with the relative values of Oldco and Newco.

In a similar vein, the spin-off has an effect on the stock options of the company. Our client had been following this regulation for years, but now the fair market value of the underlying common stock was about to be radically adjusted down to reflect the movement of value in the spun-off unit. How should the strike prices of existing stock options be modified?

What should be the strike prices of new options at both Oldco and Newco? And should employees of Oldco be given options exercisable into stock of Newco as part of the spin-off process? To illustrate the complexity of this sort of change, consider the following simplified example.

Each strike price was based on the fair market value and the capital structure of the company at the time that series of options was issued. Part of that value on each of those dates was access to the future potential of both product lines and another part of that value was the burden of preferred stock liquidation preferences and participation features. Change either or both of these and, clearly, the option strike prices also should change in the interest of fairness to the employees.

Spin-Offs: Key Considerations

In a similar vein, the capitalization table of Newco might include 2. Fortunately, the corporate change created by a spin-off is one of those circumstances.

In the case of the video advertising and monetization company, there was a happy outcome to the whole process. Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers.