At your best friend’s birthday party, she told you about an interesting spin-off company. She lists all the benefits of her investment but makes no mention of the downside. What are the cons of a spin-off? Read on and find out what she’s not telling you …
What are the Cons of a Spin-Off?
The cons of a spin-off are execution risk, transaction costs, company disruption, synergy absence, adverse market sentiment, increased competition, capital structure implications, and tax treatment. Here’s what your friend didn’t tell you:
Execution Risk – The divesting of a portion of a company into an independent entity is a challenging execution. The associated risks are managerial, operational, regulatory, legal, and potential shareholder disapproval. The time-consuming transaction mechanisms are complex.
Transaction Costs – Spin-offs are expensive corporate events and can adversely impact the fiscal health of the parent company and spin-off firm. Typical transaction costs are financial and legal advisory, restructuring, regulatory compliance, and transaction mezzanine financing.
Company Disruption – Spin-offs ignite uncertainty among suppliers, customers, and banking relationships. Employees are fearful of tentative job security which lowers morale and productivity. The spin-off entity and the parent company expend time affecting the split which takes resources away from their day-to-day operations.
Synergy Absence – The corporate fabric between the parent firm and the spin-off is woven with synergy. The spin-off creates two independently operating companies, however, each has lost the shared managerial expertise, research, technology, and sector network of the other. The price to duplicate these dissipated resources is reduced operational efficiency and increased capital.
Adverse Market Sentiment – What are the cons of a spin-off? Here’s a hard-to-anticipate externality. The intention of the parent firm to spin off its undervalued subsidiary may be to unlock shareholder value, but the market may harbor a different view. Unpredictable investor sentiment may temporarily shun the parent company’s stock unsure about its prospects, minus the loss of spin-off revenue.
Increased Competition – The spin-off is a standalone company with its own vision, mission, and functioning operations – and is a potential competitor of the parent company! This adversarial association can deteriorate market share thus earnings for both firms.
What are the downsides of a spin-off? Competing with a firm that literally knows your company inside and out is a major downside.
Capital Structure Implications – Spin-offs can be mutually disruptive to the capital structures of the parent firm and the spin-off company. Ill-allocated assets, liabilities, equity participation, and debt can damage credit ratings, trigger finance covenants, and erode access to capital.
Tax Treatment – Spin-offs can trigger a taxable event for the parent company and the spun-off firm if specific conditions are not met under the Internal Revenue Code’s Section 355D. Spin-offs are jurisdiction and transaction structure-dependent. Tax and legal advice must be sought prior to making any special situations investment.
What are the cons of a spin-off? The cons of a spin-off are the inherent risks associated with an event-driven corporate action. Spin-offs can be accretive under certain conditions but potential capital gains are not intoxicating enough to ignore the risk profile of a spin-off company.
Read next: Do Spin Offs Create or Destroy Value?
