Spin-Offs

In a spin-off, the parent company (ParentCo) distributes to its existing shareholders new shares in a subsidiary, thereby creating a separate legal entity with its own management team and board of directors. The distribution is conducted pro-rata, such that each existing shareholder receives stock of the subsidiary in proportion to the amount of parent company stock already held. No cash changes hands, and the shareholders of the original parent company become the shareholders of the newly spun company (SpinCo).

Strategic Rationale
Divesting a subsidiary can achieve a variety of strategic objectives, such as:

Unlocking hidden value Establish a public market valuation for undervalued assets and create a pure-play entity that is transparent and easier to value Undiversification Divest non-core businesses and sharpen strategic focus when direct sale to a strategic or financial buyer is either not compelling or not possible Institutional sponsorship Promote equity research coverage and ownership by sophisticated institutional investors, either of which tend to validate SpinCo as a standalone business Public currency Create a public currency for acquisitions and stock-based compensation programs Motivating management Improve performance by better aligning management incentives with SpinCo's performance (using SpinCo, rather than ParentCo, stock-based awards), creating direct accountability to public shareholders, and increasing transparency into management performance Eliminating dissynergies Reduce bureaucracy and give SpinCo management complete autonomy Anti-trust Break up a business in response to anti-trust concerns Corporate defense Divest "crown jewel" assets to make a hostile takeover of ParentCo less attractive

Transaction Structure
In general, there are four ways to execute a spin-off:

Regular spin-off Completed all at once in a 100% distribution to shareholders

Majority spin-off Parent retains a minority interest (< 20%) in SpinCo and distributes the majority of the SpinCo stock to shareholders Equity carve out (IPO) / spin-off Implemented as a second step following an earlier equity carve-out of less than 20% of the voting control of the subsidiary Reverse Morris Trust Implemented as a first step immediately preceding a Reverse Morris Trust transaction ParentCo's existing credit agreements may impose restrictions on divestitures that are material in nature. It is important to determine if any credit terms will be violated if ParentCo spins off a subsidiary that materially contributes to its business.

Tax Implications
A spin-off is usually tax-free under Internal Revenue Code (IRC) Section 355, meaning that no taxable gain is recognized by either the parent entity or the parent's existing shareholders. To qualify for favorable tax treatment, the spin-off must meet the requirements of Section 355:

The parent and subsidiary must both have been engaged in an "active trade or business" the entire 5 years preceding the spin-off, and neither entity may have been acquired during that period in a taxable transaction. ParentCo and SpinCo must continue in an active trade or business following separation. ParentCo must have tax control before the spin-off, defined as ownership of at least 80% of the vote and value of all classes of subsidiary stock. ParentCo must relinquish tax control as a result of the spin-off (< 80% vote and value). The spin-off must have a valid business purpose, and cannot be used as a "device" to distribute earnings (dividends). The parent's shareholders, collectively, must retain continuity of interest in both parent and subsidiary for a 4year period beginning 2 years before the spin-off by maintaining 50% equity ownership interest in both companies (a change in control of either ParentCo or SpinCo during this period could trigger a tax liability for the ParentCo). This is the anti-Morris Trust rule. If the unusual event that a spin-off does not qualify for tax-free treatment, there are two levels of tax:

Ordinary income at the shareholder level equal to the FMV of subsidiary stock received (similar to a dividend) and Capital gain on the sale of stock at the parent entity level equal to the FMV of subsidiary stock distributed less the parent's inside basis in that stock. Any cash received by shareholders in lieu of fractional shares of SpinCo is generally taxable to shareholders.

Accounting for Spin-Offs

From the announcement of the spin-off until the date it is completed, the parent accounts for the disposition of its subsidiary in a single line item on its balance sheet called Net Assets of Discontinued Operations, or similar. The parent also segregates the net income attributable to the subsidiary on its income statement in an account called Income from Discontinued Operations, or similar. The spin-off is recorded at book value on the transaction date as follows:

Parent's Journal Entry

dr. Retained earnings cr. Net assets of discontinued operations Subsidiary's Journal Entry dr. Assets cr. Liabilities cr. Equity

Monetization Techniques
The parent company will often extract value from the subsidiary before spinning it off by levering up SpinCo and siphoning the cash proceeds as a special tax-free dividend (courtesy of the 100% DRD) or pushing down debt to SpinCo. The special dividend and amount of debt pushdown are both limited in size to ParentCo's inside basis in the subsidiary's assets. If either exceeds the inside basis, the spin-off is taxable to the extent of the excess. The amount of debt ParentCo can push down to SpinCo is also limited by SpinCo's ability to service the debt. Exhibit A Monetization of Verizon's Spin-Off of Idearc The following is excerpted from an Idearc 8-K filing detailing its spin-off from Verizon, and outlines how Verizon monetized the spin-off: On November 17, 2006, Verizon Communications Inc. ("Verizon") spun off the companies that comprised its domestic print and Internet yellow pages directories publishing operations. In connection with the spin-off, Verizon transferred to Idearc Inc. ("Idearc") all of its ownership interest in Idearc Information Services LLC and other assets, liabilities, businesses and employees primarily related to Verizon's domestic print and Internet yellow pages directories publishing operations (the "Contribution"). The spin-off was completed by making a pro rata distribution to Verizon's shareholders of all of the outstanding shares of common stock of Idearc. In connection with the spin-off, on November 17, 2006, and in consideration for the Contribution, Idearc (1) issued to Verizon additional shares of Idearc common stock, (2) issued to Verizon $2.85 billion aggregate principal amount of Idearc's 8% senior notes due 2016 and $4.3 billion aggregate principal amount of loans under Idearc's tranche B term loan facility (collectively, the "Idearc Debt Obligations") and (3) transferred to Verizon approximately $2.4 billion in cash from cash on hand, from the proceeds of loans under Idearc's tranche A term loan facility and from the proceeds of the remaining portion of the loans under Idearc's tranche B term loan facility. Creative monetization techniques such as debt-for-debt and debt-for-equity swaps, or exchanges, allow ParentCo to extract value in excess of its basis in SpinCo's stock without affecting the tax-free nature of the spin-off.

Debt-for-Debt Swaps
In a debt-for-debt swap, the parent company (ParentCo) uses an investment bank as an intermediary to retire debt in connection with a spin-off. Generally speaking, a debt-for-debt swap is executed as follows: 1. 2. ParentCo contributes assets to SpinCo in exchange for all of SpinCo's common stock and SpinCo notes An investment bank purchases previously-issued ParentCo debt securities in the market

3. 4.

ParentCo swaps with the investment bank its SpinCo notes for a like amount of its own debt securities, which it then retires The investment bank sells the SpinCo notes

A debt-for-equity swap is mechanically similar to a debt-for-debt swap, except that ParentCo swaps its SpinCo notes for ParentCo stock. Thus, the debt-for-equity swap resembles a stock repurchase rather than debt retirement.

Capital Markets Implications of Spin-Offs

The separate business entities created in a spin-off sometimes differ in many ways from the consolidated company, and may no longer be suitable investments for some original shareholders. Spun-off companies are often much smaller than their original parents, and are frequently characterized by higher growth. Institutional investors committed to specific investment styles (e.g. value, growth, large-cap, etc.) or subject to certain fiduciary restrictions may need to realign their holdings with their investment objectives following a spin-off by one of their portfolio companies. For example, index funds would be forced to indiscriminately sell SpinCo stock if SpinCo is not included in the particular index. As institutional investors "rotate out" of, or sell, their parent and/or new subsidiary stock, the stocks may face short-term downward pricing pressure lasting weeks or even months until the shareholder bases reach new equilibriums. Shareholder churn and the corresponding potential for short-term pricing pressure can affect timing of a spin-off when CEOs are sensitive to stock price performance. On the other hand, spin-offs are commonly executed in response to shareholder pressure to divest a subsidiary, perhaps because the hypothetical sum-of-the-parts valuation exceeds the current value of the consolidated enterprise. In these cases, the parent and/or new subsidiary stock may experience upward pricing pressure following a spin-off that mitigates downward pressure due to shareholder rotation. In the long run, stocks of the individual companies should theoretically trade higher in aggregate than stock of the consolidated company when the spin-off is well-received by investors. Also, when SpinCo is highly levered as a result of debt pushdown or loans incurred prior to spin-off, shareholder returns receive a boost when SpinCo generates returns in excess of its cost of capital. The effect is identical to how the use of leverage in LBO transactions magnifies returns to financial buyers.

Sponsored Spin-Offs
In a sponsored spin-off, a financial sponsor (e.g. private equity fund) generally makes a pre-arranged "anchor" investment in a newly spun company (SpinCo). Participation by a sophisticated investor is viewed favorably by the market because it validates SpinCo as a standalone business and serves as an endorsement of SpinCo's management team. The mechanics of a sponsored spin-off are similar to those in Morris Trust transactions. To qualify for tax-free treatment, the transaction must meet the conditions of Section 355 described above. Additionally, Section 355(e), known as the anti-Morris Trust rule, limits the sponsor's investment to less than 50% of the vote and value of SpinCo's outstanding stock when the investment is made in connection with the spin-off. In general, if the sponsor's participation is arranged prior to or within 6 months after the spin-off, the sponsor can acquire no more than a minority interest in SpinCo without compromising the tax-free nature of the transaction.

As a result of the Section 355(e) restriction, the sponsor will not have legal control over SpinCo following the investment. Also, unlike traditional privately held portfolio companies, SpinCo will be a public company subject to SEC reporting requirements whose share price will fluctuate in market. The sponsor has several exit options. If the sponsor's equity stake appreciates in value, it can readily sell the appreciated SpinCo shares in the market. If the shares decline in value and the sponsor continues to view SpinCo as a good investment, the sponsor may acquire additional shares at a low price and gain control of SpinCo following the 2-year waiting period, possibly even taking SpinCo private. The sponsored spin-off may be alternatively structured as an investment in ParentCo, rather than SpinCo. In this case, ParentCo would spin off assets not wanted by the sponsor prior to the sponsor's investment in ParentCo. Since any subsequent event compromising tax-free treatment of the original transaction would create a tax liability for ParentCo, the sponsor would be sure to include a tax indemnification clause in the transaction agreement. You can learn more about sponsored spin-offs in articles posted on TheDeal.com andAltAssets.com.

Split-Offs
In a split-off, the parent company offers its shareholders the opportunity to exchange their ParentCo shares for new shares of a subsidiary (SplitCo). This tender offer often includes a premium to encourage existing ParentCo shareholders to accept the offer. For example, ParentCo might offer its shareholders $11.00 worth of SplitCo stock in exchange for $10.00 of ParentCo stock (a 10% premium). If the tender offer is oversubscribed, meaning that more ParentCo shares are tendered than SplitCo shares are offered, the exchange is conducted on a pro-rata basis. If the tender offer is undersubscribed, meaning that too few ParentCo shareholders accept the tender offer, ParentCo will usually distribute the remaining unsubscribed SplitCo shares pro-rata via a spin-off. A split-off is viewed as a sale for accounting purposes with a recognized gain or loss equal to the difference between the market price of the new SplitCo stock issued and ParentCo's inside basis in SplitCo's assets. Because the split-off is tax-free, provided that it meets the requirements set forth by Section 355, there is no corresponding gain or loss recognized for tax purposes. The split-off is a tax-efficient way for ParentCo to redeem its shares. However, since split-offs require shareholders to tender their ParentCo shares to receive new shares of the subsidiary, they suffer from lower certainty of execution and are mechanically more complex relative to spin-offs. Another notable disadvantage of split-offs is the potential for shareholder lawsuits if the exchange ratio (premium) offered by ParentCo is deemed unfair by activist shareholders. On the other hand, shareholder churn may be lower for a split-off than for a spin-off because the subscription feature of a split-off better aligns shareholders' preferences with their equity holdings than does a pro rata spin-off. An equity carve-out is typically executed ahead of a split-off to establish a public market valuation for SubCo's stock. Although the split-off can be conducted without a preceding carve-out, execution is more challenging given the difficulty in measuring the appropriate premium without an established market value for SubCo. The preceding carve-out therefore all but eliminates the possibility of shareholder lawsuits related to the premium.

Fraudulent Conveyance

When SpinCo incurs a loan and dividends the proceeds to the ParentCo, as described above, creditor claims of fraudulent conveyance may arise if SpinCo later declares bankruptcy because it is unable to service its debt. Similar creditor claims may also arise if the spin-off leaves ParentCoinsolvent. Therefore, it is necessary to ensure that both SpinCo and ParentCo are adequately capitalized following the spin-off.

Equity Carve out

In an equity carve-out, also known as an IPO carve-out or a subsidiary IPO, the parent company (ParentCo) sells a portion or all of its interest in a subsidiary (SubCo) to the public in an initial public offering. The carve-out creates a new legal entity with its own management team and board of directors, and provides a cash infusion with proceeds distributed to the parent, subsidiary, or both.

Strategic Rationale
In addition to the strategic rationale for corporate restructuring outlined in our lesson on spin-offs and split-offs, equity carve-outs can be used to achieve the following additional strategic objectives:

Cash infusion Cash proceeds can be distributed to ParentCo, SubCo, or both Preparation for complete separation Establish a public market valuation for SubCo in preparation for a subsequent spin-off or split-off of ParentCo's remaining interest

Transaction Structure
ParentCo's stake in SubCo sold in a carve-out may consist of primary and/or secondary shares. Primary shares are issued by SubCo, and secondary shares are sold by ParentCo. Although secondary shares are sometimes sold alongside primary shares in a carve-out, they usually represent a small portion of the total shares sold in the transaction.

Similar to monetization techniques employed in spin-offs and split-offs, ParentCo may push down debt to SubCo prior to the IPO, and/or extract a special tax-free dividend from SubCo up to ParentCo's outside basis in SubCo's stock. Cash proceeds from the stock sale might be distributed to ParentCo to pay down debt, to SubCo for growth capital, and/or used by SubCo to repay an intercompany loan from ParentCo, for example. Equity carve-outs are commonly followed by a tax-free spin-off or split-off of ParentCo's remaining interest in SubCo.

Tax Implications

Whether primary or secondary shares are sold in the carve-out has tax implications. If ParentCo sells secondary shares of SubCo, it recognizes a capital gain or loss equal to the cash proceeds less its outside tax basis in SubCo's stock. However, if primary shares are issued, the transaction is considered a non-taxable event to raise capital. Therefore, selling primary shares is generally preferable to selling secondary shares. Carve-out do not usually exceed 20% of ParentCo's equity interest in SubCo for several reasons:

If ParentCo divests more than 20% of its voting interest in the subsidiary, ParentCo would lose tax control of SubCo and any subsequent spin-off would fail to qualify for tax-free treatment under IRC Section 355. So long as ParentCo retains at least 80% of SubCo, dividends from SubCo to ParentCo are tax-free under the Dividends Received Deduction. If more than 20% of ParentCo's voting interest in SubCo is sold, ParentCo may no longer consolidate SubCo for tax purposes. Tax deconsolidation may result in a tax liability to ParentCo to the extent of any negative basis in SubCo. By using a dual-class stock structure, however, ParentCo may be able to divest greater than 20% of the value of SubCo, while still retaining at least 80% of its voting interest in the subsidiary.

Accounting for Equity Carve-Outs

The accounting treatment of a carve-out depends on whether or not ParentCo maintains legal control of SubCo following the carve-out, where legal control is generally defined as ownership of at least 50% of SubCo's voting common stock. If ParentCo does not lose legal control, as is most often the case, the accounting gain or loss from the carve-out is recorded either on the consolidated income statement or as additional paid-in capital (APIC) on the balance sheet, depending on whether primary or secondary shares are issued. If secondary shares are sold for an amount exceeding ParentCo's book basis in the shares and ParentCo maintains legal control, ParentCo makes the following journal entry to record the carve-out:

ParentCo Sells Secondary Shares dr. Cash cr. Minority interest cr. Gain on carve-out
If primary shares are sold for an amount exceeding ParentCo's book basis in the shares, ParentCo makes the following journal entry:

SubCo Sells Primary Shares dr. Cash cr. Minority interest cr. Additional paid-in capital (APIC)
If ParentCo does lose legal control of SubCo, it recognizes a gain or loss on its consolidated income statement regardless of whether primary or secondary shares are issued. Also, ParentCo will be required to account for its investment in SubCo using the equity method of accounting rather than the consolidation method:

ParentCo Loses Legal Control of

SubCo dr. Equity investment in SubCo dr. Minority interest cr. Net assets of SubCo cr. Gain on carve-out
Note that when primary shares are sold, regardless of whether or not ParentCo loses legal control, ParentCo recognizes a gain or loss for accounting purposes, but not for tax purposes. This temporary difference gives rise to a deferred tax liability (DTL) that reverses when ParentCo ultimately sells its secondary shares. On the other hand, if ParentCo sells the shares, a gain or loss is recognized for both accounting and tax purposes and no DTL is created. ParentCo makes additional journal entries when SubCo sells primary shares as follows:

Accounting for Tax Effects dr. Income tax expense cr. DTL

Timing Considerations
Like a regular IPO, the equity carve-out must be prepared, filed with the SEC, marketed to investors, and priced. The entire process typically takes approximately 4 to 6 months to complete.

Equity Carve-Out vs. Spin-Off

An equity carve-out achieves separation of a subsidiary without losing complete control, and is especially useful when a capital infusion is desired. When SubCo operates in a thriving industry, such as the Internet sector in the late 1990s, it may be preferable to monetize a portion of SubCo in a carve-out transaction to take advantage of high market valuations. However, equity carve-outs are mechanically complex suffer from a lower degree of execution certainty relative to a spin-offs