A stock spin-off is the formation of a new, independent company via the distribution of shares from the Parent Company. In the majority of cases, the new company was formerly a subsidiary or segment of the Parent Company.
Corporations execute these transactions for many different reasons, including improving strategic focus, closing a valuation discount, removing conflicts of interest, differing capital allocation priorities, and better-aligning investor bases, among other reasons.
The timeframe from the spin-off announcement through the distribution of shares is a long process but can be monitored by investors through SEC filings and press releases from the parent company.
This article investigates all the important aspects of a stock spin-off, including:
- Outlining a stock spin-off transaction
- The main reasons companies execute spin-offs
- The timeline of events and key regulatory filings
- The difference between non-taxable and taxable spin-offs
- Initial listing and trading terminology
The article also goes through an example from 2015, highlighting all the important steps and information investors need to consider – all the way from the initial spin-off announcement through the distribution of shares.
In a traditional spin-off transaction, the Parent Company distributes shares of the SpinCo to Parent Company shareholders on a pro-rata basis. This means that Parent Company shareholders will have the same proportionate interest in the SpinCo as they have in the Parent Company (also termed the “RemainCo”).
However, in certain circumstances, the Parent Company could retain a minority interest in the SpinCo. In this case, the Parent Company shareholders will own the portion of the SpinCo not owned by the parent company on a proportional basis, rather than the entire SpinCo.
The Parent Company does not receive any capital from outside investors in a spin-off transaction. Nevertheless, the Parent Company can get value out of the business prior to the spin-off by having the SpinCo take out debt and then transferring the cash to the Parent before separating.
For example, prior to spinning off from TEGNA, Cars.com (CARS) issued debt and transferred a substantial amount of proceeds to the parent. They entered into $900 million of senior secured credit facilities, consisting of a $450 million revolver and a $450 million senior secured term loan facility. They used these borrowing to make a cash transfer of $650 million to TEGNA prior to the spin-off.
There are two main reasons for the Parent Company to have the spin-off transaction contingent on a cash transfer:
- To monetize a portion of the SpinCo, and/or
- To maintain a consistent leverage ratio post-transaction
Monetize a Portion of the SpinCo
A cash transfer from the SpinCo to the Parent is a way for the Parent Company to effectively monetize a portion of the SpinCo by taking out equity.
The illustrative example below shows the impact to the SpinCo when the Parent Company receives the cash transfer. Notice the enterprise value doesn’t change, but the equity value declines by the amount of cash transferred to the Parent.
Maintain Consistent Leverage Ratios Pre-and-Post Spin-Off
Another reason the Parent Company could want to transfer cash from the SpinCo to the Parent pre-spin-off is to maintain a consistent leverage ratio after the transaction. After all, the Parent will lose revenue and profits with the spin-off. Therefore, it could be important to transfer the cash to ensure a proper capital structure post-spin-off.
In the illustrative example below, the Parent Company loses $15 in EBITDA in the spin-off. In order to maintain a constant net debt/EBITDA ratio of 1.4x, they need the spin-off to transfer $21 in cash to the parent (1.4 x 15). By doing this cash transfer, the Parent company can continue to execute their capital allocation strategy and stay within an appropriate leverage range.
In many ways, a spin-off goes against a corporate executive’s self-interest of running a larger company and getting paid more. However, companies continue to announce spin-offs every year. There are a wide variety of reasons for executing these transactions, which could be driven by the management team, an activist investor, or regulatory considerations.
Improves Strategic Focus
Many large companies have a wide variety of businesses selling different products and services to many different end markets across the globe. The operations of such companies are extremely complicated and difficult to oversee. As a result, senior management could become distracted and lose focus on the opportunities that create the most value for the overall company.
Therefore, separating off dissimilar businesses could improve the company’s focus and execution.
More Efficient Capital Allocation
In the large, sprawling companies described above, the major capital allocation decisions are made at corporate headquarters which can be multiple layers removed from interacting with customers and running the actual businesses. Therefore, the people who make the decisions on where and how much to invest in internal projects and acquisitions aren’t necessarily the people who are in the best position to make that decision. However, when a company spins-off a business, it moves that ultimate decision-making responsibility down to executives who are closer to the business itself.
Investments Have a Much Larger Impact
Attractive, high returning investments made by a small subsidiary will only have a very small impact on the overall company’s consolidated results. For instance, a subsidiary that is able to invest their capital and generate 20%+ returns won’t have a large impact on the overall company if that subsidiary is only 5% of the company’s profits. However, if the subsidiary is a standalone company, then these attractive investments will have a very large impact.
Better Aligns Each Company with a Natural Investor Base
Depending on where a company is in its corporate lifecycle and its potential investment opportunities, a company should adopt a capital allocation strategy that makes sense. This could mean returning capital to shareholders through dividends or buybacks, investing in organic growth opportunities, and/or making acquisitions.
There are many different types of investors in public equity markets. There are investors who focus on companies that pay a large percentage of earnings out dividends, are rapidly growing revenue, making acquisitions, etc. By aligning a company’s strategy with a natural investor base, the company will be more efficiently valued.
Potential to Reduce Conflicts of Interest
There are situations where a subsidiary’s business conflicts with the parent company. For instance, eBay owned PayPal from 2002 through the spin-off in 2015. Over the years PayPal’s business evolved to the point where many of their new customers were retailers. However, many of these retailers were in direct competition with eBay. As a result, some retailers were hesitant to allow PayPal as a payment method on their website for fear of giving eBay material information on their business. This conflict of interest went away when PayPal was spun-off.
Close a Valuation Discount
Many companies have multiple segments, each of varying business quality. Each of these segments also has their own unique key drivers. In any given year, some of the businesses could be strong while others are weak. As a result of this dynamic, the market places a valuation on the consolidated company.
In many of these instances, the current market value is less than what the company is worth on a ‘sum-of-the-parts’ basis.
Therefore, a spin-off of a higher quality or lower quality business could create value by allowing the market to assess the individual segments on their own as standalone public companies.
For example, let’s assume that a company is comprised of two separate segments, a Cyclical Co and a High-Quality Co. The Cyclical Co generates $100 in revenue and $7 in earnings and deserves to be valued at 10x earnings ($70 valuation). The High-Quality Co generates $50 in revenue and $10 in earnings and is such a great business that it deserves to be valued at 20x earnings ($200 valuation). However, the market currently values the consolidated company’s $17 in earnings at 12x ($204 valuation). It partially credits the company for not just being a capital-intensive cyclical business, but not all the way.
If the company spun-off High-Quality Co (or Cyclical Co), then the market would be able to value each company on its own. The valuation of these two individual segments would combine to be worth more than the former consolidated company.
There are many situations where a business might need to separate off a subsidiary for regulatory reasons. This could be because a spin-off is required to get a merger/acquisition through anti-trust or because a business is running up against regulatory thresholds in their business (e.g. capital ratios for a bank).
Alignment of Incentives
When a company is comprised of many different subsidiaries, it can be difficult to align the employees’ incentives (increase revenue, EPS, ROIC, etc) and rewards (cash bonuses, stock options, etc) with activities that are directly within their control.
For example, let’s say a manager of a subsidiary at a large conglomerate receives stock in the overall company based on the company’s performance (revenue growth, EPS, ROIC, etc). However, if the business he or she manages only contributes 20% to the overall company’s profits, then the company’s other businesses matter a lot more in terms of hitting performance targets than the business they directly work within. Similarly, the stock they receive and own will be driven more by the performance of the company’s other businesses than their own responsibilities.
These incentives could be realigned if the subsidiary is spun-off. Now the incentive targets are directly aligned with the performance of the business. Also, the market value of stock owned by executives will be driven, over the long-term, by the decisions they make and the success of the business rather than the success of the larger Parent Company.
The announcement that a company plans to spin-off a subsidiary is just one step in a long and very complicated process towards the ultimate separation. The timeline from announcement to completion can be anywhere from 6 months to years. The ultimate timeframe depends on a wide variety of factors, including the level of business integration, tax treatment, capital market conditions, audits, board recruitment, SEC/IRS approvals, and finalizing corporate governance.
Below is just a brief overview of some of the key events and filings a company needs to make during the process to spin-off a subsidiary.
In order to stay well-informed, investors need to monitor and analyze the following major events and filings:
- Initial public announcement
- Finalization of the executive team
- Filing of the Form 10
- Finalizing the board of directors
- Establishing the record data and distribution date
- Closing of debt offerings and/or credit facilities
Spin-offs can be structured as a tax-free distribution under Section 355 of the U.S. Internal Revenue Code. This is important because the transaction won’t trigger a gain at either the corporate or shareholder level which makes the spin-off tax-free for both the parent company and its shareholders. On the other hand, some spin-off transactions could be taxable to either the company and shareholders or to both.
In order for the distribution to qualify for tax-free treatment, the company needs to satisfy a handful of requirements, including but not limited to:
- The parent company must distribute “control” of the spin-off to shareholders. This means that the parent company must distribute at least 80% of the total combined voting shares and 80% of any non-voting shares.
- The spin-off must be for a corporate purpose. Some of the corporate purposes approved by the IRS include: saving costs, improving performance, or resolving competitive concerns, as well as many others.
- The parent company must establish that the SpinCo is not used as a “device” for the distribution of profits. This requirement is to ensure that shareholders cannot convert dividend income to capital gain by selling the shares of either the Parent or SpinCo after the distribution.
- Both the Parent and SpinCo have conducted active business within the five-year period before the distribution and must continue to conduct active business immediately after the distribution.
Also, the company needs to satisfy a requirement to maintain the tax-free treatment post-transaction.
- The SpinCo cannot be acquired for two years after the spin-off. They can only be acquired if there have been no “substantial negotiations” regarding the SpinCo or a “similar acquisition” within two years prior to the spin-off.
Although rare, some spin-off transactions are not structured as tax-free, but taxable as they do not meet all the requirements under Section 355 of the IRS Code. In these transactions, the company must pay capital gains on the distribution and the shareholders typically pay taxes as well.
Taxable spin-offs are common when a spin-off is part of a plan or series of transactions (thus disqualifying it for tax-free treatment under Section 355). For instance, in May 2018, La Quinta spun-off their real estate assets through a taxable distribution into a REIT, CorePoint Lodging, followed by the merger of the remaining franchise and management businesses with Wyndham Worldwide.
Spin-offs are distributed to the Parent Company shareholders on the distribution date. After this date, the SpinCo trades like any other stock on the exchange. However, it is possible for investors to purchase/dispose of the RemainCo and/or SpinCo prior to the distribution.
“When Issued” Market
Stocks trade on a “when issued” basis when they have not yet been issued (distribution hasn’t occurred), but trade as if they have already been issued. Also, they typically have a different settlement cycle than a standard “regular way” trade.
A “when issued” market is a temporary market which allows holders of the Parent Company common stock who are expecting to receive shares of the SpinCo to separately trade each of their Parent Company shares and/or the SpinCo shares.
This market enables Parent Company investors who hold the shares past the “Record Date” to sell their shares of either the Parent Company or the SpinCo prior to the distribution at which time the SpinCo begins trading “regular way”.
Investors need to be careful when purchasing or selling shares in the “when-issued” market because volumes are typically low which can create large price swings.
“Regular Way” Trading
Stocks traded on a “regular way” basis trade with the right to receive the SpinCo distribution. Also, purchases/sales follow the standard settlement cycle.
Initial Listing and Trading Example: Dover spin-off of Apergy
On April 18th, 2018, Dover’s board of directors approved the Apergy Corporation spin-off as well as announced details surrounding the record date, distribution date, and when issued market.
Record Date: April 30, 2018
- Any Dover shareholders who sold their shares “regular way” through the close of trading on the day prior to the distribution date also sold their right to receive shares of Apergy in the distribution
Dover (DOV WI) “When Issued” Trading
- The “when issued” public trading market for Dover common stock began on April 27, 2018 on the NYSE under the symbol “DOV WI” and continued through the close of trading on the day prior to the distribution date.
- This is also known as trading “ex-distribution”, which means “DOV WI” traded without the right to receive shares of Apergy common stock in the distribution
- Investors who wished to only own Dover post-spin-off could sell their Dover shares in the “regular way” market and purchase Dover shares in the “when issued” market.
Apergy (APY WI) “When Issued” Trading
- The “when issued” public trading market for Apergy common stock began on April 27, 2018 on the NYSE under the symbol “APY WI” and continued through the close of trading on the day prior to the distribution date.
- Investors who wished to only own Apergy post-spin-off could sell their Dover shares in the “regular way” market and purchase the Apergy shares in the “when issued” market.
- On May 9, 2018, the “when issued” trading of Apergy (“APY WI”) ended and Apergy began to trade “regular way”.
- On May 9, 2018, Dover investors received a pro rata dividend of one share of Apergy common stock for every two shares of Dover common stock held.
- Apergy (APY) “Regular Way” trading: May 9, 2018
The distribution ratio is used to calculate how many shares in the SpinCo the Parent Company investors will receive in the spin-off.
In the Dover/Apergy example above, a Dover shareholder who owned 10 shares would’ve received 5 shares of Apergy.
The best way to learn about all the key aspects in a spin-off transaction is to go through a real example to highlight and explain the actual press releases, SEC filings, and presentations.
On November 13, 2014, Graham Holdings Company (GHC) announced the separation of Cable One, a Graham Holdings subsidiary, from Graham Holdings. The transaction was structured as a tax-free spin-off.
- Allow Graham Holdings to pursue their unique growth opportunities
- Enable Cable One to focus entirely on its video, Internet and voice services and to attract a more natural shareholder base.
Form 10 Registration Statement Filing
On February 27, 2015, Cable One filed its Form 10 Registration statement with the SEC. This is an important document for investors to read and analyze to understand the business. It includes a lot of important information, including:
- Business Overview
- Risk Factors
- Financial Statements
- Background of the spin-off and rationale
- Agreements between the Parent Company and SpinCo
Throughout the spin-off process, they filed four amended Form 10 statements which disclosed incremental information concerning the business, executive team, board of directors, and initial compensation, as well as details surrounding the capital structure and timing of the spin-off.
Cable One’s final amended Form 10 Registration statement was filed on June 4, 2015.
Board of Director Approval and Final Distribution Announcement
On June 4, 2015, the board of directors at Graham Holdings also approved the distribution ratio and declared the pro rata dividend of Cable One stock to shareholders.
Record Date: June 15, 2015
Graham Class B (GHC WI) “When Issued” Trading
- The “when issued” public trading market for Graham Class B common stock began on June 11, 2015 on the NYSE and continued through the close of trading on the day prior to the distribution date.
- This is also known as trading “ex-distribution”, which means Graham traded without the right to receive shares of Cable One common stock in the distribution
- Investors who wished to only own Graham post-spin-off could sell their Graham shares in the “regular way” market and purchase Graham Class B shares in the “when issued” market.
Cable One (CABO WI) “When Issued” Trading
- The “when issued” public trading market for Cable One common stock began on June 11, 2015 on the NYSE under the symbol “CABO WI” and continued through the close of trading on the day prior to the distribution date.
- Investors who wished to only own Cable One post-spin-off could sell their Graham shares in the “regular way” market and purchase the Cable One shares in the “when issued” market.
- On July 1, 2015, the “when issued” trading of Cable One (“CABO WI”) ended and Cable One began to trade “regular way”.
- On July 1, 2015, Graham investors received a pro rata dividend of one share of Cable One common stock for each share of Graham Class A and Class B held.
- Cable One (CABO) “Regular Way” trading: July 1, 2015
On June 15, 2015, Cable One filed an investor presentation with the SEC. The presentation discussed many important details such as the spin-off transaction, business overview, future strategy, historical financials, and capital allocation priorities.
Finalizing the Capital Structure and Special Dividend
On June 17, 2015, Graham announced the closing of Cable One’s private offering of $450 million of 5.750% senior unsecured notes due 2022.
Also, they took out a $100 million term loan at 1.50% + LIBOR.
Cable One used the proceeds from the debt offerings to pay a $450 million special dividend to Graham Holdings as well as for general corporate purposes.
Completing the Spin-Off
On July 1, 2015, Graham Holdings announced the successful spin-off of Cable One.
Executing a spin-off is a long, complicated process that involves many steps, but has the potential to create significant value for shareholders as well as the company’s employees.
It takes a lot of time and effort for investors to stay well-informed of all the different the spin-off opportunities. However, investors can keep up-to-date by reading through company press releases, SEC filings, and thoroughly researching the pro forma Parent Company and Spin-Off to determine if either could be compelling investments.
Investors have historically been rewarded for their hard work as spin-offs delivered attractive, market-beating returns.