Spin-offs
Matthew Semadeni
A spin off is formally defined as the ‘‘divestment of a business division to shareholders through a distribution of the subsidiary’s common stock in the form of a dividend’’ (Miles and Woolridge, 1999: 1). While a notable body of research exists on corporate spin offs, very little has examined the spin off event from the spin off’s perspective. To date, much of the extant research on corporate spin offs has focused on either the parent firm or the market value created by the spin off, with little attention given to the spin off’s performance, whether market or otherwise (see Woo, Willard, and Daellenbach, 1992, for a notable exception).
Rationales and Motives for Spin-Off
Tax implication is the overarching criterion governing the distribution of shares to share holders through corporate spin offs (the tax regulations governing spin offs are found in Section 355 of the Internal Revenue Code). The distribution will be deemed tax free to both the parent firm and its shareholders if the spin off meets certain conditions. For example, for the distribution to be considered tax free, the parent must divest 80 percent or more of the subsidiary, the parent and subsidiary must be engaged in active business for at least five years before the distribution date, and the transaction must have a legitimate business purpose (e.g., addressing anti trust issues, increased focus on core businesses by the parent, enhanced capital market access, etc.). It is curious to note that ‘‘increasing shareholder value’’ does not constitute a legitimate business purpose per the In ternal Revenue Code guidelines (Miles and Woolridge, 1999).
Several motivations for spin offs exist. First, the spin off could be required to comply with regulatory rulings, including regulations sur rounding a merger or acquisition or to address antitrust charges. Second, the spin off could be motivated by a renewed focus on the parent’s core businesses. Third, spin offs could be motivated by a CEO succession event, where the organizational attachment to a particular division is low. Fourth, spin offs may occur to remove excessive volatility from the corporation’s performance. Fifth, conflict may arise between the corporation and the subsidiary or between the subsidiary and a key customer of the corporation. Sixth, a spin off may be pursued if the parent believes that the combined value of the parent and child (under the corporate structure) is less than that which could be obtained if the two operated as independent entities.
While the motivations for undertaking a spin off are varied and diverse, it is important to note that the motivations do not always favor the spin off, but rather are generally done in line with the parent firm’s best interests. This is not surprising, given that corporate managers control the fate of the subsidiary and will generally make decisions based on what is best for the corporation rather than the subsidiary. This point is noteworthy because the conditions under which the spin off event occurs may not be optimal for the business that is spun off, possibly placing it in a precarious position from the outset of its existence as an independent, publicly traded firm.
Research Perspectives on Spin-Offs
The transformation from corporate subsidiary to independent, publicly traded firm generates interesting conditions from several theoretical perspectives, namely agency theory, transactions cost economics, and most recently upper echelons theory. Some cross theoretical perspectives have also emerged. Each of these are treated separately below.
Agency theory. Two points are worth noting regarding the relationship between agency theory and spin offs. First, spin off affects the information asymmetry between shareholders 226 spin-offs and managers by changing information disclosure requirements and managerial monitoring (Krishnaswami and Subramaniam, 1999). (It is important to note that size does become a factor in determining whether or not analysts would follow a given spin off, with larger spin offs more likely to receive coverage than smaller spin offs.) Second, spin off allows for better managerial incentive arrangements, given that as an independent market entity, the board of directors can draft market performance contingent contracts that will better align the interests of owners and top managers (Seward and Walsh, 1996). This is noteworthy because subsidiary managers often have incentives to manipulate accounting performance to their best advantage (see Aron, 1991). Hence, from an agency theory perspective, the spin off event, taken by itself, should lead to positive market performance.
Transactions cost economics. Three points are worth noting regarding the relationship bet ween transactions cost economics and spin offs. First, transactions cost logic is a dominant rationale for diversification (Jones and Hill, 1988) and applying it to spin offs suggests that there will be severance effects when a spin off separates itself from its corporate parent. This logic suggests that these severance effects (i.e., the loss of financial economies, economies of scope, or economies of integration) will vary according to the spin off’s diversification relationship to its corporate parent, with more closely related spin offs suffering the most severe effects. Second, spin off eliminates any corporate cross subsidies that the spin off may have been paying to or receiving from other divisions of the firm (Powers, 1999). Third, the spin off has the opportunity to negotiate its own contracts, which has been identified by researchers as beneficial in some instances (Hite and Owners, 1983). Con tract negotiation autonomy presents an opportunity to the spin off if it was required to use a sub optimal contract negotiated at the corporate level by its former parent; however, it is import ant to note that in general the spun off firm’s bargaining position is usually weakened post spin off, given its smaller size and independent status separate from its corporate parent. Over all, from a transactions cost perspective the performance implications for the spin off are somewhat equivocal.
Upper echelons theory. Three points are worth noting regarding the relationship between upper echelons theory and spin offs. First, top management characteristics will have a significant impact on the perspective taken by top management, with top management vision often being colored or constrained by characteristics and past experiences and existing mindsets and dominant logics (Prahalad and Bettis, 1986; Bettis and Prahalad, 1995) having an important framing effect on actions taken post spin off. Second, in addition to their perspectives, the combination of human capital talent held by top management is important in determining future returns given that as a separate, independent entity, the spin off will face a new set of challenges in addition to (or sometimes in the place of) those it faced as a division of a corporation (Hambrick and Stucker, 1999; Wruck and Wruck, 2002). Third, the spin off event creates a significant change in organizational discretion (Hambrick and Finkelstein, 1987), providing spin off managers far greater latitude of organizational action. In sum, upper echelons theory argues that the com position of top management will affect spin off performance.
Cross theoretical perspectives. Two cross theoretical perspectives are particularly noteworthy. First, using both agency theory and transactions cost perspectives, Woo, Willard, and Daellen bach (1992) found that although spin off announcements are generally met with a significant positive reaction (to both the parent firm and the spin off), the expected performance gains for the spin off are not always realized. Second, using upper echelons and agency theory, Seward and Walsh (1996) found that spin offs facilitate the implementation of efficient internal governance and control practices, but that other factors must influence the value created by the spin off announcement. These cross theoretical perspectives provide interesting insights not available through the application of a single theoretical approach, but also revealed the need for further cross theoretical work, with both sets of researchers noting their inability to go beyond their initial findings, calling for a spin-offs 227 deeper examination of many of the issues that they broach.
Most recently, Semadeni (2003) has integrated agency, transactions cost, and upper echelon perspectives on spin off to generate a model of spin off actions and performance. Using a seven year window (two years prior to and up to five years post spin off) of managerial, ac counting, and market data, Semadeni examined the spin off as an entrepreneurial opportunity and proposed that certain strategic, financial, or institutional actions would occur post spin off due to the designation of new management, new monitoring/incentive arrangements, and severance effects from leaving the corporate parent. He found, however, that in large measure the strategic, financial, and institutional actions that would be expected according to upper echelons, agency, and transactions cost theories did not occur. In other words, although the spin off event should motivate the firm to act in a more entrepreneurial fashion, the actions expected from being freed from corporate oversight did not occur. Moreover, there was little connection between the expected strategic, financial, and institutional actions and performance post spin off. All this suggests that these traditional theoretical perspectives may not be appropriate in dealing with the dynamics of firm spin offs. Thus, Semadeni’s (2003) findings are important not only for what they found, but for what they did not. Although the three perspectives have been applied to spin offs individually or partially together in the past, they had never been brought together in one set of empirical tests, and when they were, the results were equivocal. This suggests that none of the three perspectives provides clear insight into what affects firm performance post spin off, implying that new theory needs to be developed to understand this significant organizational event.
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