Corporate demergers

Demerger is a form of corporate restructuring in which the entity’s business operations are segregated into one or more components. It is the converse of a merger or acquisition.

A demerger can take place through a ‘spin-off’ (also known as a ‘spin-out’) by transferring the shares in a subsidiary holding the business to company shareholders carrying out the demerger. The demerger can also occur by transferring the relevant business to a new company or business to which that company’s shareholders are then issued shares. Under a spin-off, the company splits off sections of itself as a separate business.

The spin-off is when a division of a company or organisation becomes an independent business. The spin-off company takes assets, intellectual property, technology, and/or existing products from the parent organisation. Shareholders of the parent company receive equivalent shares in the new company in order to compensate for the loss of equity in the original stocks; therefore, at the moment of spin-off, the ownership of the original and spun-off companies is identical.
In other words, spin-offs occur when the equity owners of the parent company receive equity stakes in the newly demergered company. For example, when Agilent Technologies was separated from Hewlett-Packard (HP) in 1999, the stockholders of HP received stock in Agilent.

Demergers can be undertaken for various business and non-business reasons, such as government intervention, by way of anti-trust law, or through decentralisation.
Many times the management of the new company is from the same parent organisation. Often, a spin-out offers the opportunity for a division to be backed by the company but not be affected by the parent company’s image or history, giving potential to take existing ideas that had been languishing in an old environment and help them grow in a new environment.

In most cases, the parent company or organisation offers support by doing one or more of the following:

• Investing equity in the new firm,
• Being the first customer of the spin-out (helps to create cash flow),
• Providing incubation space (desk, chairs, phones, Internet access, etcetera)
• Providing services such as legal, finance, technology, etcetera.

All the support from the parent company is provided with the explicit purpose of helping the spin-off grow. Shareholders can benefit from spin-off by having the ability to then buy and sell stocks from either company independently; this potentially makes investment in the companies more attractive, as potential share purchasers can invest in only the portion of the business they think will have the most growth.

The other type of spin-off is a firm formed when an employee or group of employees leaves an existing entity to form an independent start-up firm. The parent entity can be a firm, university, or another organisation. Spin-offs typically operate at arm’s length from their parent organisations and have independent sources of financing, products, services, customers, and so on. In some cases, the spin-out may license technology from the parent or supply the parent with products or services.
Spin-offs are important sources of technological diffusion in high technology industries. Research oriented employees accept lower wages at firms with better technological expertise in exchange for the implicit opportunity to learn about their employer’s technology and capabilities.

Employees who successfully learn can leave their employer and start their own firms using some of their former employer’s knowledge. As this opportunity has high future value, employees are willing to accept lower wages today in return for the chance to ‘spin out’ tomorrow.
Technologically advanced firms are more likely to survive and more likely to generate spin-outs, as long as the spin-offs succeed in learning their parents’ strengths. The fact that spin-offs are important in the evolution of high technology industries during the initial take-off stage, challenges the previous conventional wisdom that forces outside the industry itself drive progress and entry early in the evolution of an industry.

The accounting impact of a spin-off is the necessity of determining whether the transaction represents transferring of assets or business, the fair value of considerations exchanged at the spin-off company level and the gain or loss to be recognised under the International Financial Reporting Standard.On the other hand, determining whether the transaction represents a business combination at the spun-off company level, the fair value of the considerations exchanged, and the goodwill or the gain from bargain purchase transaction is a necessity.

Luay Hanania is a senior manager at KPMG in Qatar.