Spin-Offs: Key Considerations
Many public corporations utilize traditional M&A transactions and strategic partnerships to streamline operations and maximize stockholder value. Sometimes, however, these transactions are not desirable for various reasons, such as not finding the right acquisition target or strategic partner, not being able to agree on the terms of the transaction, or adverse tax consequences in connection with the transaction structure. In these instances, a spin-off transaction can be a viable alternative.
A spin-off transaction typically involves the distribution by a parent company (Parent) of all of the stock of its subsidiary (Subsidiary) to Parent’s shareholders. After the transaction, Subsidiary would be owned by the same shareholders that own Parent, but would be an independent corporation, separate from Parent. Corporations pursue spin-off transactions for various specific reasons; however, the consistent theme across all spin-offs is a goal to maximize value for the shareholders of both the Parent and Subsidiary.
A successful spin-off can benefit both the original corporation and the spun-off corporation, and ultimately maximize stockholder value, by allowing them to focus on their respective principal businesses and allowing them to raise capital individually, thereby targeting certain investors that may not have invested in the prior consolidated entity.
This summary provides an overview of the principal legal issues and general timeline of spin-off transactions by publicly traded corporations.
Principal Legal Issues
- Director Responsibilities. Careful analysis should be conducted by Parent’s board of directors and its advisers to analyze the business reasons for the spin-off transaction to fulfill its fiduciary duties.
- Engagement of Third Parties. Because of the complexities of a spin-off, it is often beneficial to engage a financial adviser. In addition, outside auditors for Subsidiary will need to be engaged. Depending on the nature of the business and structure of the transaction, other third party experts may be required.
- Capital Structure. Tax considerations are often the driving force behind decisions about capital structure. In addition, a solvency opinion may be required. Consideration should be given to post-separation liquidity of Parent and Subsidiary.
- Asset Allocation and Transition Services. Parent will need to determine how to allocate assets and liabilities between Parent and Subsidiary, and whether any contractual arrangements or licenses will be required. Similarly, any intellectual property that Subsidiary will use post-spin-off will need to be assigned to such Subsidiary. A transition services agreement may set forth the responsibilities of Parent to provide services to Subsidiary for a period after the separation. Care should be given to evaluating which services will be provided, as well as the pricing, time frame and tax consequences.
- Tax Issues. In order for a spin-off to qualify as tax-free to both Parent and its shareholders for U.S. federal income tax purposes, it must qualify under Section 355 of the Internal Revenue Code (IRC). Section 355 aims to provide tax-free treatment only to transactions that separate two operating businesses and not to transactions that resemble either distributions of cash or other liquid assets or corporate-level sales.
Attempting to summarize the numerous requirements of a tax-free spin-off runs the risk of not capturing the breadth of the requirements nor the technical nature of many of them. Nonetheless the following is a list of some of the major requirements:
- Control—Parent must own stock possessing at least 80 percent of the voting power and at least 80 percent of the shares of any non-voting class of stock.
- Active Trade or Business—Immediately after the spin-off, each of Parent and Subsidiary must be engaged in an “active trade or business” that was actively conducted throughout the five-year period before the spin-off.
- Business Purpose—There must a real and substantial non-tax purpose germane to the business of Parent, Subsidiary or both that is the motivation, in whole or substantial part, for the spin-off.
- Device—The spin-off must not be carried out as a device to distribute earnings and profits.
Even if all of the requirements of a tax-free spin-off are met, transfers of control of either Parent or Subsidiary after the spin-off can cause the spin-off to be taxable to Parent, but not to Parent’s shareholders. Parent and Subsidiary should work with their tax advisers to structure the transaction to be in compliance with Section 355.
- Contract Review. Contracts with third parties, such as vendors, suppliers and customers, should be reviewed to determine whether they should be assigned to Subsidiary or if new agreements will need to be entered into. In addition, existing financing arrangements should be reviewed to determine whether any of the terms need to be renegotiated.
- Employees and Compensation. Parent must determine which employees will remain with Parent and which will be transitioned to the spun-off entity. Parent must also arrange for the transition of any benefits (including stock option plans, health plans, retirement plans, etc.) provided to employees that will work for Subsidiary. In addition, existing employment agreements should be reviewed, particularly to identify any change-of-control provisions that might be triggered by a spinoff.
- Corporate Governance. As a separate entity, Subsidiary will need to have a separate board of directors from the Parent. Consideration should be given to potential director independence issues and any potential overlaps between Parent and Subsidiary’s post-spin-off board members.
- SEC Filings. A spin-off transaction typically requires the following filings with the United States Securities and Exchange Commission (SEC):
- Form 10 registration statement and related information statement;
- Form 5-8 registration statement to register the issuance of equity under Subsidiary’s employee benefit plan;
- Section 16 and Section 13 filings for directors, officers and significant shareholders; and
- Forms 8-K, in connection with announcing the transaction, the closing of the transaction and other material events.
- Ongoing SEC Reporting and Stock Exchange Compliance. Subsequent to the spin-off, Subsidiary will be required to comply with the reporting requirements under the Securities Exchange Act of 1934, as amended. If stock exchange listing is desired, a listing application with the New York Stock Exchange, Nasdaq Stock Market or other desired stock exchange would need to be completed.
- Communications Plans. Communications with key audiences should be considered to maintain relationships and comply with SEC reporting obligations. Audiences may include investors, suppliers, employees, lenders, regulators, and licensors or sub-licensors.
Illustrative Transaction Timeline
- Month One through Month Three. Generally, during this period, the following actions should be taken:
- Assess the historical performance of both companies;
- Evaluate the post-separation financial viability and corporate governance structures of both Parent and Subsidiary;
- Evaluate contracts with outside parties and consider the specific property, employees, contracts, intellectual property and other assets that would be spun off with Subsidiary;
- Retain independent financial advisers and auditors for Subsidiary;
- Obtain solvency opinions from an appraisal firm in order to avoid fraudulent conveyance concerns;
- Work with tax advisers to analyze requirements under Section 355 of the IRC, and decide whether to pursue an Internal Revenue Service private letter ruling, if available, and if so, prepare and file a private letter ruling request;
- Prepare communications plans and begin communications;
- Draft and file a Form 8-K, announcing intention to conduct a spin-off;
- Prepare Subsidiary corporate governance documents; and
- Begin drafting Form 10 and information statement.
- Month Four through Month Five. The board of director focus during this period should be on the preparation of the necessary documents to effectuate the spin-off and execute asset transfers between Parent and Subsidiary. Typically, the documentation for a spinoff includes:
- Separation and distribution agreement;
- Transition services agreement;
- Tax matters agreement;
- Employment and benefits agreement;
- Management services agreement;
- Intellectual property agreements;
- Form 10 and information statement;
- Subsidiary’s amended and restated certificate of incorporation;
- Subsidiary’s amended and restated bylaws;
- Subsidiary’s committee charters; and
- Subsidiary’s company policies.
- Month Six through Month Seven. During the final stages of the spin-off process, the following actions should be taken:
- Finalize the spin-off agreements;
- Finalize Subsidiary corporate governance documents;
- Finalize the Form 10 and information statement
- Comply with technical requirements for listing Subsidiary’s stock on a stock exchange;
- Prepare road show materials if necessary or desirable;
- Continue communications plans;
- Obtain IRS private letter ruling, if applicable;
- Execute completed spin-off agreements; and
- Distribute the Subsidiary’s stock to shareholders to effect the spin-off.
A spin-off transaction involves complex tax, securities and corporate governance issues. While this article identifies several key issues, it does not address all of the issues that would need to be addressed. A spin-off transaction involves significant planning, analysis and resources to complete and should be pursued only after extensive consultation with legal, tax, financial and business advisers.
For more information, please contact a member of our Early Stage & Emerging Companies practice group.