What Are Corporate Spinoffs and How Do They Impact Investors?

From tobacco producers to payment services and more, some major businesses have been spun off from their previous corporate owners. Why do corporations spin off subsidiaries, and what does this mean for investors?

What Is a Spinoff?

A spinoff occurs when a corporation divests itself of one or multiple divisions. The parent company often keeps a large ownership stake in the spinoff, but the new entity is an independent corporation with its own officers and board of directors, and its shares trade separately from those of the parent.

A spinoff is different than a corporation selling a subsidiary to another company. Shares in the new spinoff are allocated to existing shareholders of the parent company based on a predetermined exchange rate.

Why Pursue a Spinoff?

A company’s management might recommend a spinoff if they expect the combined value of the entities separately would be greater than if they continued to operate as a single company. In this case, they’re anticipating that the whole is currently valued less than the sum of its parts would be.

Here are some situations where executives might believe a spinoff makes sense:

Management expertise or focus: While executives of a company might be well-suited to overseeing most of its lines of business, perhaps there's a subsidiary that doesn't quite match their expertise. Or maybe a specific unit requires more attention than it's getting from upper management and its performance is suffering as a result. In either case, spinning off the unit and putting it under new management with responsibility only for this outfit might result in better performance at the newly independent company. Meanwhile, the parent company’s managers could put their entire focus on that firm’s remaining enterprises.

Separating growth trajectories and strategies: A mature business division that's growing slowly albeit steadily might prove a drag on a sister unit that's experiencing robust growth. Disparate operations like these could benefit from separate management that would tailor strategies to their different stages and goals. And separating them could enhance interest from investors who specifically seek out opportunities that are now better reflected by either the new entity or the slimmed-down parent.

Enhanced coverage from securities analysts: The same factors that help management improve its focus can impact securities analysts as well. It can be easier to assess the prospects and earnings of a more focused, less complex business. In addition, after a corporation narrows its focus, it might attract new coverage from analysts who specialize in that niche.

Unlocking shareholder value: Perhaps the biggest factor driving spinoffs is the idea that the parent company is undervalued—maybe because of management or strategy issues described above—and that its valuation would increase if it spun off one or more business units.

What Does a Spinoff Mean for Investors?

In a spinoff, a parent company typically distributes shares in the new company to current parent company shareholders on a pro rata basis, meaning the number of shares you hold in the parent company determines the number of shares you’ll receive in the new company.

Immediately after the spinoff, each parent company shareholder owns shares in the new company as well as the parent. Once the new company begins trading, the parent company's share price is adjusted lower to reflect the fact that its valuation no longer includes the spun-off unit. After the separation, the combined market value of the companies might trade close to the pre-spinoff value of the parent company but, since they trade independently, this isn’t necessarily the case.

Spinoffs can impact share prices even before the deal is executed. When a spinoff is first announced, the parent company's share price might rise if news of the transaction is greeted with enthusiasm. But if investors have their doubts about the wisdom of a spinoff, the parent company's share price might fall.

In addition, both parent companies and spinoffs can face significant challenges during and after a spinoff deal, ranging from how to deal with employment contracts and pensions for a soon-to-be-divided labor force to determining how to handle once-shared services such as human resources and information technology. This transition can prove smoother for subsidiaries that already enjoyed a good deal of autonomy in their operations prior to the spinoff.

Once a spinoff occurs, affected investors can choose whether to hold or sell shares of the parent company and the new company. Consider your investment goals and risk profile, as well as any opinions you might hold about whether the spinoff is beneficial, when making these decisions.

What Are the Tax Implications of Spinoffs?

Spinoffs are usually tax-free transactions for shareholders. A company is essentially breaking itself into smaller pieces while maintaining the same ownership. But you must plan for the possibility of capital gains taxes if you choose to sell shares of either the parent or the new entity after the spinoff. Talk to a tax or investment professional about how a spinoff could impact you.

Important information about corporate spinoffs, such as the company’s rationale behind the spinoff and the new company's strategies, is found in an SEC filing known as Form 10-12B, which is typically required of companies that are issuing new shares as part of a spinoff. A company might also file a Form 8-K—which is reserved for important announcements—with details about a proposed spinoff.

SEC filings related to spinoffs are available at no cost through the SEC’s Edgar database.