Spin offs are an important topic for executives and investors in today’s entrepreneurial economy. A powerful trend is enhancing the supply of spin outs: public companies face pressure from activist investors to spin off operations that, in the view of the activists, depress the stock price because they are not synergistic with the company’s other lines of business. Activists typically claim that these operations represent a misallocation of capital and management time and attention. As for demand to invest in spinoffs, private equity and other financial investors often see a promising upside in the business that--as a standalone, with its own strategy and investment and an intensified focus--can realize its potential better than it could as part of a larger entity. For their part, strategic investors may think they can better unlock synergies with other businesses than the former owner could.
My partners in Newport Board Group, an advisory firm of CEOs that assists emerging growth companies and helps private equity evaluate and execute investments, have extensive experience on both sides of spin off transactions—across industries including oil and gas, wireless and industrial equipment. We suggest six key areas for the management team responsible for the new entity to consider in executing a spin off transaction.
1. Negotiate What Is Needed to Run an Independent Business
Some of the most critical decisions on a spinoff take place during the negotiations to set the terms of the separation. The key is to ensure that, in separating it from its former parent company, “Newco” gets the employees and assets it needs to run an independent business. There should be employment contracts to ensure that key employees stay with Newco as it ramps up. If there is potential business overlap between Newco and its former parent, there also needs to be clear definition of who gets what business. Non-compete agreements should be considered.
2. Identify Specifically What Is Being Carved Out
In today’s economy, a company is a complex combination of tangible and intangible assets, strategy, people, products, processes, systems, relationships and culture. In its prior life Newco was dependent on its parent company for many of these. Newco’s board and executive team must rigorously define what the company will need to operate on a standalone basis. It is essential to map existing processes and tools to the operations of the new entity, deciding what is and isn’t needed.
3. Address Separation of Operations
Complex separation of operations may be required particularly where there will be ongoing transactions between Oldco and Newco. Among issues that may need to be addressed: supply contracts, sharing of common facilities, environmental and legal issues, employee compensation and obligations and transition of books and records and back-office functions. IT, accounting and other systems of Newco are often interlinked with its parent’s and can be hard to unwind. Rigorous analysis of historical costs is required to create the initial balance sheet. Future access to historical records must be assured, for example if the spinoff eventually wants to execute an IPO or other transaction and must prepare financial statements going back a number of years.
4. Be Ready to Run the Company as a Separate Entity from Day 1.
Where feasible, Newco’s management should approach the new entity as if it were a startup—by designing processes and systems that fit a business plan for stand-alone operations. Some operating areas may need to be rebuilt from scratch.
For example, there is often a need to establish a free standing corporate finance function capable of coordinating and overseeing the spinoff’s operations—including controllership, forecasting, treasury, tax and compliance. New management reporting, consolidation and forecasting model methodology and processes may be needed. Standards must be designed and implemented to provide reports and performance measurements to Newco’s investors and lenders.
Management must mitigate customer and employee “flight risk.” Communicating a plan for continuity of operations and explaining how both groups will benefit from the new ownership is essential. Continuity of vendor relationships also requires attention. A good way to start is to designate a leader for each function or operating area to coordinate a designated set of vendors. Once the company is up and running independently, new priorities and a new cost structure will dictate changes. The company can then systematically consolidate vendors or replace them with in-house staff.
5. Consider the Need for Transitional Systems
Often the spinoff doesn’t yet know what it needs or doesn’t have time to implement processes and systems from a “clean sheet of paper.” The prudent approach to mitigating operational risk may be to “borrow” processes and systems from the divesting entity. This will require a Technical Services Agreement (TSA) with the prior parent company for a delimited period. Over time Newco should then modify processes and systems to meet the needs of the new management team and operations. There must be controls in place to verify that rates charged by the former parent do not involve Newco in effect paying for other units’ expenses. Conversely, Newco will have to address Oldco concerns to make sure they aren’t providing services to Newco for free or at below market rates—and that ties are cut in a timely manner.
6. Address IT Needs
There typically needs to be a plan for IT infrastructure to facilitate management of Newco on a global basis.
The extent of the IT transition depends on how many IT services are being provided by the parent, are used right now and the length of the transition. Assuming that the goal is total independence at some future point there are at least three approaches for key IT components, such as its ERP system:
- Acquire a license for the same software the parent used.
- Acquire a new, probably more up to date and slimmer module.
- If Newco is intended to be the platform for a PE rollup: wait until a roll-up occurs and use the software of the new company.
Continuing to use the same software as the parent could be expensive and cumbersome to operate and support--but conversion costs should be minimal. Switching to a new module can ensure a better fit and will probably be less expensive to license and operate. But conversion costs must be considered. In the case of a spinoff purchased by a private equity firm as part of a rollup strategy, the new PE owners must assess whether a roll-up of systems is possible—even then, conversion will likely be required.
Realize the Potential
The new owners of a company spun off from its prior owner have the opportunity to create considerable value —including through better alignment of managerial incentives and more streamlined decision making. As management is freed from the parent’s control, decision making can become less complex and more effective.
Yet Newco’s management team may be too preoccupied with their “day jobs” to give execution of the spinoff plan the attention it requires. The demanding agenda outlined above requires resources and experience that Newco’s management team may lack in house. A dedicated project team, supplemented by outside advisors who have experience in making spin offs work, may make sense. Following the principles outlined above and providing the required focus and expertise will increase the chance of realizing the spinoff’s full potential.
About the Author
Mark brings to Newport expertise in an important, growing industry: business information services. Mark’s career in Financial, legal and medical information started with a 13 year career at Bloomberg Financial Markets. Hired as the company’s fifth sales person and a direct report to Michael Bloomberg, Mark went on to a number of important positions with Bloomberg, including General Manager roles for North Asia, Singapore and New York. In these positions he had P&L accountability for multinational, cross-border organizations. He was credited with contributions to creating, growing and holding Bloomberg’s leading presence in Asia – a primary driver of corporate-wide growth and profitability. Click here to learn more about Mark Dailey or contact him
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