A spin-off is a distribution of the stock of a subsidiary to shareholders of a parent company in proportion to their original holdings. Spin-offs are tax free transaction if they meet certain requirements. The initial ownership of the spun-off company and the parent private company is the same. However, the goal of the spin-off is to relieve the parent management from the operating and controlling responsibilities of the spun-off subsidiary.
Spin-offs have been used extensively as a method for increasing shareholder value. transactions have Specifically, returns to shareholders of companies that spun-off unrelated businesses were higher than those to shareholders of companies who did not. Academia literature has reinforced the precept that the market rewards private companies for focusing on their core businesses. In addition to immediate shareholder benefits upon announcement, spin-offs provide considerable and sustainable long-term benefits. According to the IRS, creating shareholder value through spin-offs is not a valid business purpose. Though not explicitly stated, spin-offs nevertheless create value indirectly for both parties.
For an example, a small, high growth subsidiary of a larger company will greatly expand in market capitalization once it is spun-off and able to secure funding for its specific needs.
A spin-off transaction deconsolidates the financial statements of the parent and the subsidiary. The stand-alone performance of the parent and the subsidiary allows the market to value each individually. Poorly performing subsidiaries that are spun-off will help the overall performance of the parent company by not dragging down the financial statements while strongly performing subsidiaries will be valued positively by the market and shareholders will realize gains from the distribution of equity.
Balance sheets of the subsidiary and the parent will also be deconsolidated. The subsidiary will be able to finance itself using its own cost of capital, creating more capital efficiency. In addition, a dividend may be paid by the spun-off company to the parent, most likely a tax-free distribution to shareholders who are otherwise taxed on capital gains from dividends.
For balance sheet, spin-offs can alter leverage ratios, earnings per share, and ownership. For income statements, spin-offs can alter revenue growth rate, earnings per share and the multiples applied to them.
In the case where a parent private company spins off a faster growing subsidiary, different multiples are applied to the spin-off and the parent private company to offset the differences in growth rates. It is also important to understand that increased shareholder value may not be realized until the market prices-in all changes within the private company.
Finally, announcements of spin-offs signal that the parent company is focusing more on its core businesses by getting rid of poor performer or acknowledging a strong performer. The break-up of a larger private company allows for easier valuation of its parts.