What is a spin-out

A spin-out occurs when a company takes a division or a business unit or a related group of properties and separates it from the parent by creating a new free-standing corporate entity. In many cases, special warrants of the new entity are created and dividended to the shareholders of the parent in order to create a large shareholder base and to permit shareholders of the parent to participate in the success of the new entity. The parent then promotes the new entity and raises capital for the new entity by private placement (optional) and/or by a prospectus offering. Whether directly by way of an initial public offering or indirectly by way of a reverse take-over, the spin-out entity can be taken public and given a publicly traded life of its own.

Possible scenarios

The most typical rationale for the creation of a spin-out is where the value of certain assets of the parent is not fully reflected in the trading prices of the parent’s shares. Spinning-out assets into a separate new entity creates value for the existing shareholders of the parent and a new investing opportunity for the public. Some atypical scenarios may include cases where a non-core business unit requires separation from the parent so that the market can better appreciate the investment potential in the newly formed entity. Also, an underperforming business unit may warrant separation from the “good” business unit so that the “good” business unit can grow and prosper without the burden of the underperformer. Occasionally, in the context of take-overs, a spin-out is a defensive tactic to salvage assets in the face of a take-over. In other friendly scenarios, an undesirable business unit may be separated from the parent because the acquirer is only interested in the core business unit and does not wish to carry the cost of a secondary “undesirable” business unit.

Management’s point of view

From a management’s point of view, there are three main criteria for embarking on the spin-out path. Firstly, the division or business unit requires the leadership of a strong management team. Secondly, the potential for aggressive growth of the division or business unit as a stand-alone venture and its ability to absorb external capital to create shareholder value can signal a potential for a successful spin-out. Thirdly, by industry example, the company should be able to predict the ability to attractively price the shares of the spin-out entity in order to suggest to the investing public the potential of future value and have the ability to attract investors.

How to best prepare for a spin-out

It is important to note that a spin-out needs to be carefully planned and staged in order to minimize its launch time and cost associated with the process of taking the spin-out entity public.

For example, the prospectus disclosure rules in Canada prima facie require three years of financial history in order to take a private company public. If the new entity cannot provide financial statements for a period of at least 12 months and there is no other information concerning the business conducted or to be conducted that is sufficient to enable an investor to make an informed investment decision, a receipt for a final prospectus may be denied. As a preparation strategy, it is best to separate a division or a business unit into a subsidiary and allow the subsidiary to exist for at least a period of three years before it is taken public. This strategy will allow the company to minimize the regulatory review time and improve its chances of being receipted for a prospectus offering.

Supplementing financial information is possible in situations where there is a parent entity that has maintained separate accounts for the assets or business unit being spun-off. Supplementing information in situations where the corporation has existed for less than three years may become a major issue and a major expense in a situation where the parent has not maintained separate accounts for the assets being spun-off. In this case, the securities regulatory authorities may impose additional disclosure requirements, such as carve-out financial statements or statements of assets acquired, liabilities assumed and statements of operations of the parent in order to show the potential viability of the division or business unit. The process of preparing carve-out financial statements is time consuming and burdensome. Time and expense are not factors considered by the securities regulatory bodies, should the applicant wish to apply for a discretionary relief with respect to this requirement.

Secondly, staging the spin-out may require that a certain percentage of the shares of the newly formed entity are placed with private investors in order to create interim funding and/or to create a wider shareholder base. However, in setting up the terms of such private placements, one should be mindful of the possible application of seed share restrictions imposed by certain stock exchanges. Two basic rules can be followed in that respect: (i) shares should not be issued for under five cents per share and (ii) issuances for prices that are likely to be below 75 per cent of the possible initial public offering price per share should be carefully pre-planned in order to allow the company to avoid a possible exchange escrow on the seed share capital.

As a final example, principals of the spin-out entity (i.e. directors, senior officers or promoters) that hold securities carrying more than one per cent of the voting rights attached to the company’s outstanding securities, will be subject to escrow immediately after its initial public offering pursuant to National Policy 46-201 – Escrow for Initial Public Offerings. Depending on the spin-out’s entity exchange listing, the escrow period can run from a minimum of 18 to a maximum of 36 months. Principals need to be aware of this requirement in order to avoid frustration and in order to allow them to make informed investment decisions with respect to the company they wish to promote.

Alternatives to a spin-out

Another choice for a company that wishes to separate an asset or a business unit is to conduct an equity carve-out by issuing and selling a portion of its equity in the subsidiary to the public and keeping a majority stake in the new company. Alternatively, the company could create a tracking stock. A traded tracking stock allows for the creation of a separate class of the parent company’s stock that has a claim on the cash flow generated by the tracked unit and is intended to reflect that unit’s performance. In the tracking scenario, no separate legal entity or governance structure is created. Thus, the original board can continue to effectively control the division or business unit and the company can preserve certain operating synergies especially with respect to interdivisional allocation of resources and investments.

Conclusion

A spin-out allows the market to price a subsidiary, division or a business unit based on its fundamentals as a “pure-play” investment opportunity. A “pure-play” company usually has a single business focus with an objective to specialize in a particular area to the exclusion of other business opportunities. After the public offering establishes a visible stock price, the spin-out subsidiary can take a life of its own and may even outperform the parent. In fact, past studies have shown the beneficial effects of creating public offsprings—businesses which tend to outperform the market indexes.

The content of this article is based on the laws having application in the Province of Ontario and is intended as general information only and is not intended nor shall be construed as legal advice.

Lucie Kroumova practices in the areas of securities and corporate law with the securities group of McLean & Kerr LLP, Toronto.