VLRE-15-05-01-Cover_Journal covers 6/5/15 5:49 PM Page 1

May/June 2015

After the Breakup— of Corporate Spinoffs and Divestitures Bret Tack VLRE-15-05-04-TACK_Layout 1 4/20/15 3:17 PM Page 22

pinoffs and divesti- ness strategy.2 Other reasons for spinoffs tures comprise a and divestitures include: large portion of the • The parent’s need to reduce debt or overall deal market.1 raise capital (this was a more preva- Independent valuations lent reason during the economic are often required in recession than it is today). these transactions, • Jettisoning an underperforming busi- for purposes that ness. include corporate • Monetizing a that has planning, fairness strong growth prospects but whose and solvency opin- current capital requirements are a ions, strategies, drain on the parent’s mature, prof- reporting, itable business. pricing, and litigation. Yet despite • Regulatory considerations. their prevalence, the valuation literature is practically non-existent when it comes to addressing the potential dangers for Relationship with Parent valuation professionals in performing The specific valuation considerations to spinoff and divestiture valuations. This be addressed largely depend on which of article seeks to draw on the present the following categories the spinoff or author’s experience in order to high- divestiture candidate falls in, relating to light some of the challenges associated its relationship with the parent compa- with these engagements, and suggest ny and their anticipated future dealings appropriate valuation treatments. following the transaction: A spinoff is a transaction in which a • Standalone. A corporate subsidiary, company distributes shares in a sub- division, or business unit that has sidiary to the shareholders of the parent. always operated autonomously from In a full spinoff, ownership of the spun- the parent company. off entity is identical to ownership of • Dependent. A corporate subsidiary, the parent company immediately after division, or business unit that has the transaction. However, in most spin- historically been dependent on the in the present author’s experience the offs it is expected that ownership of the parent company for services, sup- majority of spinoff and divestiture can- parent and the former subsidiary will port, or financing and will continue didates do not fall into this category. diverge on a going forward basis. This to require some level of support from Most have historically received some usually requires that any post-transac- the parent post-transaction. level of support from the parent. tion business dealings with the former • Transitioning from dependent to Dependent . It is common parent be on an arm’s-length basis. standalone. A corporate subsidiary, for a spinoff or divestiture candidate to A divestiture is the sale, , division, or business unit that has continue to receive services or use the or spinoff of a subsidiary or portion of historically been dependent on the of the former parent post-trans- the parent company’s business. Thus, a parent company for services, sup- action, at least for a period of time. When spinoff is technically a form of divesti- port, or financing but will need to this is the case, the following issues need ture. However, divestitures are typical- transition to full autonomy once it to be addressed in the valuation: ly referred to in the context of a full or has been spun-off or divested. • Which services will continue to be partial sale of a subsidiary, division, A standalone business will pose the provided by the former parent and business unit, or product line of the par- fewest spinoff or divestiture-specific val- for how long? ent. Such sales are also commonly uation issues. If the business already has • Are agreements in place between the referred to as carve-outs. its own dedicated management team; subject business and the former par- has its own general and administrative ent that spell out the terms by which infrastructure; owns its own intellectu- the parent will provide such services, Reasons for Spinoffs al property; occupies its own facilities; including management and general and Divestitures is self-financed; and has always had its and administrative (G&A) services? There are many reasons that a compa- own standalone financial statements, it These agreements are typically ny will spin off or divest a business unit. is possible that no valuation adjustments referred to as either shared services The number one reason is that the busi- specifically related to the spinoff or agreements or transition services ness is not part of the parent’s core busi- divestiture will be required. However, agreements (TSAs). In some cases they are temporary, though there are BRET TACK, ASA, is a managing director at Cogent Valuation and currently manages its Los Angeles office. transactions in which the shared ser- He has provided and related financial advisory services since 1985, managing over 1,500 valuation engagements involving businesses ranging in size from small closely held companies to multina- vices arrangement is expected to con- tional, publicly traded companies with in the tens of billions. tinue indefinitely.

22 VALUATION STRATEGIES May/June 2015 SPINOFFS VLRE-15-05-04-TACK_Layout 1 4/20/15 3:17 PM Page 23

required to reflect changes in the finan- cial and operating characteristics of the subject business resulting from the transaction. The transaction may also affect the subject business’s risk profile and growth prospects. These factors will be reflected in the valuation profes- sional’s selection of market multiples and required rates of return. Finally, val- uation indications from the market and income approaches may need to be adjusted for non-operating assets and liabilities, shortfalls (or surpluses), and contingent liabilities. In order to identify specific valua- tion considerations relating to the spin- off or divestiture, the areas of in- vestigation discussed below should be covered in the valuation professional’s . . Often the busi- ness being spun-off or divested will have been using intellectual property owned by the parent. This may include trade- marks and trade names; and technological know-how; copyrights; software code; or proprietary data and content. During the time that the busi- ness was a subsidiary or division of the parent, there may not have been any • Are license agreements in place for rely on it for services and support. This license agreements in place covering the the subject business to use intellectual poses a different set of issues that must usage of the intellectual property by the property ownedIt byis the parentcommon com- be addressed for in the spinoff valuation, including: business and no license fees being pany? • Is the management of the subsidiary charged by the parent. The valuation •candidates Are TSAs and license agreements to atcontinueor division capable to of runninguse the professional must first assess who will market rates? What are the relevant business on a standalone basis? own the intellectual property used by terms?the former parent’s• Will the subject assets. business be ade- the subject business post-transaction. • Will the former parent provide quately capitalized? If ownership will be retained by the par- financing and, if so, on what terms? • How will services formerly provided ent (as is common when the parent also • How does continuing to be reliant by the parent be obtained? uses the same intellectual property), he on the former parent affect the risk • What is the likely business impact of or she should determine whether license profile of the subject business? the transaction, including on rela- agreements will be in place post-sepa- • Will the divested business use the tionships with customers? ration from the parent and, if so, on former parent’s facilities? Are there what terms. lease agreements in place? While the subject business may Clean Break Scenario. An alternative Valuation Considerations receive a royalty-free license from the scenario is one in which the subject busi- Like all businesses, spinoff and divesti- parent as part of the spinoff or divesti- ness will be expected to make a clean ture candidates are valued based on con- ture, often it will be required to pay a break from the parent and no longer sideration of three distinct valuation license fee for the use of the parent- approaches, each of which has multiple owned intellectual property. The valu- variants or derivative methods. These ation professional may be called on to 1 According to Global magazine, spinoffs and divestitures accounted for 47% of world- are the market approach, the income determine a market royalty rate for the wide M&A activity in 2012. See Platt, “M&A: approach, and the net or cost intellectual property if establishing an Record Spin-Offs Boost Global M&A,” Global Finance (February 2013). It has been estimated approach. Primary emphasis in the val- arm’s-length basis for the license fee is that almost $600 billion worth of spinoffs and uation of operating companies is usually important. If the subject business’s his- divestitures were completed in the U.S. in the first nine months of 2014. See Dealogic, M&A given to the market and income torical financial statements do not Review (September 2014). approaches. include a license fee, historical earnings 2 This was cited as the number one reason for In spinoff and divestiture valuations, should be adjusted to deduct agreed divesting a business by 62% of respondents in Deloitte’s Divestiture Survey 2013. specific earnings adjustments may be upon license fees (typically as a per-

SPINOFFS May/June 2015 VALUATION STRATEGIES 23 VLRE-15-05-04-TACK_Layout 1 4/20/15 3:17 PM Page 24

centage of revenues) when calculating representative earnings. The valuation professional should also make sure that the company’s financial projections include the license fee. The present author has been involved in spinoff and divestiture valuations where the com- pany-provided financial projections did not include the royalty payments. It is also important to understand the breadth of the license for the intel- lectual property as an assessment of both the business’s risk and its growth potential. The narrower the license—in terms of either product line, customer population, or geographic territory— the more limited the ability of the busi- ness to expand into new areas using the intellectual property. Another consid- eration is whether the business’s rights to the intellectual property will be exclu- sive within its licensed fields or territo- ries and whether there is a significant risk of the subject business losing its rights to it in the future (for example, for failing to hit minimum sales targets). These are all factors that could affect the market multiple and required selections for the subject busi- ness. Finally, the valuation professional Management can add should understand whether there are issues include the amount of time for- division perceives that parent company any restrictions on transferring the mer parent company employees will management is adding minimal value license agreement to a subsequent buy- devotevalue to the subject by business; providing how the and may even be a hindrance to the sub- er, which could limit the marketability business will be charged for management ject business realizing its full potential. of the business. services;reliable and the duration ofhistorical the agree- Indeed, management of the subsidiary Management Services. The quality ment. An adjustment to earnings may be or division may be better positioned to and depth of management is an impor- requiredfinancial if the new arrangement statements. results identify growth opportunities and tant consideration in any business val- in a change in how management services unlock potential value than parent com- uation but it is especially so in spinoffs are charged to the subject business. pany management, that may be dis- and divestitures, because these often If the subject business will be transi- tracted tending to core operations. This involve a change in how the business is tioning away from any reliance on the is borne out by the many studies show- managed or how it is to be charged for parent for management services, con- ing that publicly traded spinoffs gener- management services. It is common that sideration should be given to whether ally outperform their former parents. many of the high-level management the management team at the division or When this is viewed to be the case, the functions of the business to be spun- subsidiary level is capable of running valuation professional should consider off or divested will have historically been the business on a standalone basis. Any whether the subsidiary or division-lev- provided by parent company employees perceived gaps in managerial talent el management team is properly incen- that devote only a portion of their time should be treated as either a risk factor tivized to remain with the business to the subject business. Often, the sub- to be reflected in the market multiple post-transaction. ject business will not have been charged and required rate of return selections or Sales, General, and Administrative Ser- for these services. an adjustment to earnings to reflect the vices. Prior to the spinoff or divestiture, If the former parent will continue to additional that will be required the subsidiary or division was most like- provide management services to the sub- to procure such talent. At the same time, ly obtaining G&A services from the par- ject business after the spinoff or divesti- any previously allocated for ent, including , strategic and ture, the valuation professional should parent company management services financial planning, legal services, human understand the parameters under which that will no longer be provided should be resources, information systems, insur- such services are being provided and added back to reported earnings. ance, and shared office space. It may whether they will be memorialized in a An alternative scenario is one in also have been relying on the parent management agreement. Key which management of the subsidiary or company’s sales force to market its prod-

24 VALUATION STRATEGIES May/June 2015 SPINOFFS VLRE-15-05-04-TACK_Layout 1 4/20/15 3:17 PM Page 25

such services will no longer be provid- exists in order to determine whether ed by the former parent, the valuation any valuation adjustment is warranted. professional should investigate how the Often the business to be divested will subject business plans to perform G&A be a division or an operating unit whose functions in the future. assets and liabilities are not held in a Intercompany Sales. Often the busi- separate legal entity. Thus, the contem- ness to be spun-off or divested has been plated sale will be an asset sale rather a supplier to (or customer of) the par- than a sale. In an asset sale, the ent. The transfer pricing used in such valuation professional should review the intercompany transactions is typically asset purchase agreement in order to dictated by where the parent wants prof- understand which assets and liabilities its to appear. However, once the business will be sold as part of the transaction is spun-off or divested market pricing is and which will be retained by the parent. likely to prevail. When the market price For example, it is common in such agree- is materially different from the transfer ments for the subject business’s and price formerly used for intercompany debt to remain with the parent. Pro for- sales, one of two things will happen: ma adjustments to the subject business’s either (1) the sales will cease because historical may be required the business cannot compete when the to reflect any assets and liabilities to be arrangement is subjected to market retained by the parent. competition, or (2) sales will continue Name on Key Agreements. Often the but under a new pricing structure. In subject business’s key agreements will either case, an adjustment to reported be in the name of the parent. The valu- earnings should be made to reflect either ation professional should inquire as to the loss of revenues (and cost of sales) the timing and potential hurdles or the new market pricing. involved with transferring or assigning Legal and Tax Considerations. When such agreements to the buyer. This issue subsidiary stock is transferred either in often causes significant delays in the a spinoff or in a stock sale, generally all close of the transaction. of the subsidiary’s assets and liabilities, Financial Statements. The quality of ucts. The issue of how the subject busi- including contingent liabilities, will be the subsidiary’s or division’s financial ness will procure these services post- indirectly assumed by the buyer. Thus, statements can be one of the most prob- transaction and the effect that it will the valuation professional should inquire lematic issues for spinoffs and divesti- have on its cost structure should be about the nature and potential finan- tures. In many cases, the parent has addressed in the valuation. cial effect of any significant contingent never deemed it necessary for the sub- In some instances, the parent may liabilities. If the contingent liability is ject business to have accurate, stand- have provided overhead services for a material, the liability may need to be alone financial statements because the subsidiary or division for which it was quantified and subtracted from the val- business has historically been viewed as either not charged or it was under- uation indications resulting from the an integrated part of the whole compa- charged relative to the true cost of such market and income approaches. Some- ny. Yet the parent’s inability to present services, resulting in the subsidiary or times the company or its potential buyers with reliable financial division’s historical earnings being over- will have made a determination as to statements for the divested business can stated. In other situations, the subject the magnitude of the contingent liabil- have several undesirable consequences. business was being unduly burdened by ity, which the valuation professional will At a minimum, it could delay the clos- corporate overhead charges that were be able to rely on. In rare cases, the val- ing of the transaction because of the either excessive or unnecessary resulting uation professional may be required to buyer’s need to perform more intensive in the subsidiary or division’s historical value the contingent liability as part of due diligence on the business’s finan- earnings being understated. In either his or her analysis (which could be the cial results and condition. More signif- case, historical earnings should be nor- subject of an entire separate article). icant consequences include lower offers malized to substitute the parent-allo- If the subsidiary is a C corporation, than would otherwise be forthcoming if cated overhead expense with the any unrealized gain in the company’s potential buyers had more confidence in estimated post-transaction cost of such assets will remain with the subsidiary. the financial statements and, in the services. The treatment of unrealized gains is extreme, disengagement by potential If G&A services will continue to be controversial in the valuation commu- buyers (this has been observed by the provided by the former parent, the val- nity and it is beyond the scope of this present author). The valuation profes- uation professional should determine article to advocate for any specific treat- sional can add value by emphasizing to whether shared service agreements will ment of the issue. Nonetheless, the val- parent company management and its be in place post-separation from the uation professional should be aware of advisors the importance of reliable his- parent, and understand their terms. If whether a substantial unrealized gain torical financial (Continued on page 47)

SPINOFFS May/June 2015 VALUATION STRATEGIES 25 VLRE-15-05-04-TACK_Layout 1 4/20/15 3:18 PM Page 47

Spinoffs • Eliminating and costs asso- Access to Financing. It is likely that the ciated with product lines or cus- subject business’s financing needs have (Continued from page 25) statements for tomers that will be retained by the historically been met by the parent, the business to be spun-off or divested. parent company. either in the form of direct loans or loan The considerations with respect to • Adding back parent company over- guarantees. The valuation professional historical financial statements are head allocation charges that will not should inquire as to how financing needs twofold: continue. will be met post-transaction. The financ- 1. Are the subject business’s financial • Adding back parent company man- ing issue is particularly relevant in the statements an accurate representa- agement fees that will not continue. case of start-up companies with ongo- tion of its historical financial results • Subtracting replacement costs for ing losses that have heretofore been and condition? services formerly provided by par- funded by the parent. 2. Are appropriate pro forma adjust- ent. ments being made to the historical • Subtracting license fees for intellec- financial statements to present a fair tual property that will be licensed Analysis representation of what the subject from the former parent. A component of the market approach business is going to look like post- • Reversing related party transfer is a financial ratio analysis, wherein transaction, as differentiated from charges for goods and services and the subject company is compared to what it has looked like in the past? substituting market rates or con- the guideline companies based on such The first issue will fall largely out- tracted rates going forward. financial measures as size, growth, side of the scope of the valuation pro- • Eliminating interest expense on debt profitability, , liquidity, and fessional’s role in the transaction. In fact, retained by the parent company. activity. In spinoff and divestiture the prudent valuation professional Working Capital. Because certain transactions, the subject company’s should always include language in the working capital assets may be retained financial ratios should be adjusted as valuation opinion that he or she has by the parent, it is possible that the sub- follows: relied, without independent verification, ject business will have a working cap- • Profi tability ratios should be based on the financial statements provided as ital deficiency post-transaction. As on pro forma earnings and include accurately representing the financial previously mentioned, often the busi- the earnings adjustments mentioned results and condition of the business for ness’s cash on hand will be retained by above. the time periods covered. Nonetheless, the parent. Although less common, • Leverage ratios should exclude any the quality of division-level financial accounts receivable and other working debt that will be retained by the par- statements varies widely and the valua- capital assets may also be retained by ent and include any new debt result- tion professional should inquire as to the parent, requiring the new owners to ing from the transaction (if the whether the business’s financial state- make an additional in work- valuation is on a post-transaction ments were prepared in accordance with ing capital post-transaction. In order to basis). generally accepted accounting princi- determine whether there is a working • Liquidity ratios should exclude cash ples (GAAP) and whether such state- capital deficiency, the post-transaction and other working capital assets and ments capture all of the revenues and level of net working capital (accounts liabilities to be retained by the parent. expenses, as well as assets and liabili- receivable, inventory, prepaid expens- ties, associated with the business to be es, and other working capital assets, spun-off or divested. Often such state- less accounts payable, accrued expens- Conclusion ments will be missing allocations of cer- es, and other working capital liabili- This article has sought to demonstrate tain operating costs. ties) should be compared to both the that there are many nuances to spin- The second issue is a primary subject business’s historical levels of offs and divestitures, and the risk of responsibility of the valuation profes- net working capital and the guideline overlooking important issues and sional providing an opinion related to a companies’ net working capital levels missing necessary valuation adjust- spinoff or divesture transaction. If pro (generally as a percentage of revenues). ments is high for the uninitiated val- forma financial statements giving effect If it is determined that the business will uation professional. On the other to the proposed transaction have not have a working capital deficiency hand, this can provide an opportuni- been prepared by the company or its requiring a capital infusion immedi- ty to add value by alerting clients and accountants (as is most often the case), ately post-transaction, the valuation their advisors to the need to address the valuation professional should make indications from the market and spinoff and divestiture-specific issues the appropriate adjustments to histori- income approaches may need to be early in the process. In particular, the cal financial statements to reflect antic- adjusted downward for the amount of need for reliable financial statements ipated changes in the subject business the deficiency (though to avoid double for the subject business should be resulting from the transaction. The fol- counting, beginning working capital in emphasized. Not only will this make lowing is a summary of some of the the model should for a better supported valuation, but it more common pro forma adjustments be adjusted to a normal level of work- may also help facilitate the closing of to the : ing capital). the transaction. G

SPINOFFS May/June 2015 VALUATION STRATEGIES 47 Bret Tack is a Managing Director at Cogent Valuation, and currently manages its Los Angeles Office. Providing business valuation and related financial advisory services since 1985, he has managed over 1,000 valuation engagements involving companies ranging in size from small closely held companies to multinational, publicly traded companies with revenues in the tens of billions.

Mr. Tack has extensive experience in corporate transactions, including resolving highly complicated securities design and allocation issues. He has also dealt with the Internal Revenue Service on dozens of valuation matters for income, gift and estate tax purposes with overwhelmingly positive results. He has provided expert testimony in various courts, including United States Tax Court.

Mr. Tack holds a Bachelor of Science in Business Administration from the University of Southern California and is an Accredited Senior Appraiser with the American Society of Appraisers in Business Valuation. He has written and spoken extensively regarding valuation issues, often for MCLE or CPA credit.

Cogent Valuation is a nationally recognized full service business valuation firm that has provided inde-pendent valuation and financial advisory opinions in thousands of situations since 1991. These include the valuation of companies ranging from small closely held businesses to those with market values in the tens of billions, covering almost every industry and all types of transactions.

With the collective backgrounds of our managing directors and professional staff, Cogent Valuation brings substantial large deal experience to bear on our middle market transaction opinions. Cogent Valuation utilizes proprietary research, intensive due diligence, and the experience and insights of its professionals to produce thoughtful, well-documented opinions that have consistently withstood the scrutiny of clients and their advisors, investors, regulators, and courts.

For additional information and/or questions, please visit our website at www.cogentvaluaton.com or contact Mr. Tack at [email protected].