Divestitures (#295)
/In this podcast episode, we discuss corporate divestitures. Key points made are as follows:
The Need for Divestitures
First of all, why engage in a divestiture? Most companies are more concerned with acquisitions, not getting rid of existing business units. There are a lot of good reasons. First, you might need the cash, and some business units can sell for quite a bit of money. Second, a business unit might not be doing all that well, and it’s taking up too much management time. And third, the company strategy might be heading in a different direction, so you need to shed some business units that no longer align with the strategy. In particular, a conglomerate is always changing its portfolio of companies. It buys a few, and it sells a few.
Types of Divestitures
There are some variations on the divestiture concept. One is the spinoff, which is when you create a new corporate entity by separating a business unit from its parent. The result is a free-standing business that has not been bought by another firm. Instead, the shares might be distributed to the parent company’s shareholders, in which case the parent gets no cash from the deal – only the shareholders benefit. Or, the parent company can then turn around and sell the shares in the new entity to investors – in which case the parent directly benefits from the deal. There could also be a buyout, where the managers of the business unit buy the shares of the spun-off entity – sometimes with financing from the parent.
Problems with Divestitures
There can be lots of problems with divestitures. One is certainly the accounting system. Larger businesses have comprehensive, centralized systems that contain the accounting records for the entire business, so you need to figure out a way to split off the accounting transactions for the business unit into a separate accounting system. This can be really hard when the business unit being divested didn’t really exist as a separate entity within the parent company beforehand. For example, it might be parts of three different business units. In which case, how do you identify which transactions go with the divested business unit? The same problem comes up for finances, where cash flows might have been centralized at the corporate level, for hedging and cash management purposes. Now some of it has to be pulled out and moved over to the divested unit, which might require new bank accounts. This is a real problem when new legal entities are being set up for the divested business, because the bank accounts have to be tied to the new legal entity – which in some countries can take months.
Another problem is patents. The divested business might own patents that the parent company is using, or the other way around. If so, there needs to be an arrangement to keep using the patents, maybe in exchange for a royalty.
Yet another issue is staffing. The divested business might have to increase its staffing to take care of the administrative areas that used to be handled by the parent company. If so, you might have to transfer some employees from the parent company, or hire new ones and train them up. And on top of that, if you’re transferring people over from the parent company, their payroll and benefit information has to be transferred over too, along with their seniority information.
An uncomfortable outcome is that a divestiture might cost more than the parent company expects to earn from selling it. You need to consider a lot of costs. For example, just the cost of creating separate financial statements for the carved out entity could be in the tens or hundreds of thousands of dollars. And then there are banking fees to set up new accounts, legal fees for new entities and regulatory filings, consulting fees to set up new systems, and payments to relocate or terminate employees.
And then there’s this thing called dis-synergies, where operating costs increase. For example, the volume discounts that the divested business used to get by being part of the parent company go away, which means that its gross margin goes down, so it’s worth less money.
Another problem is stranded costs. These are costs associated with the divested entity that are left behind at the parent company. For example, the parent might have constructed a data center, for which half the capacity was intended for the business unit that’s now being divested. In this case, the parent can’t very well shift the data center over to the divested business, so it’s basically stuck with more data center capacity than it needs. It helps to make a first pass at what these costs might be before going too far down the road of divesting a business unit.
Shared Services Arrangements
And there may be cases in which you can’t just divest a business unit and walk away. It may take a long time for the new business to set up some functionality that the parent company had been taking care of for it. If so, you might need to set up a shared services arrangement, where the parent company keeps supplying a few services – like human resources or accounting – for a fee. These arrangements have a bad habit of getting extended, so the agreement should include a cutoff date, or at least an increased fee schedule, so the divested business has an incentive to get off the arrangement as soon as possible. Since the parent company is probably not in the business of providing shared services, it’s quite possible that it won’t do a good job, so the divested business might want to include performance criteria in the agreement, where it can withhold payment if service levels fall below a certain minimum threshold.
The Separation Management Office
If you’re in the business of doing a lot of divestitures, then it can make sense to set up a separation management office. This group provides analyses for each proposed divestiture, and standardizes some of the transactions. For example, it can provide an analysis for what it will cost to divest a specific business unit. It can also provide a canned legal agreement for shared service arrangements with divested businesses. Another possibility is to monitor each step in the divestiture process, and step in when something isn’t working right. In short, this is an in-house consulting group that smooths the way for each divestiture.
Accounting for Divestitures
Let’s tackle some accounting issues. The accounting staff of the parent needs to know exactly which assets and liabilities are going with the divested business, so that they can be shifted out of the parent company. This can be really difficult when you’re dealing with individual receivables and payables. The accountants might also need to apportion some of the parent company’s goodwill asset over to the new business. This might be a good time to see if some of that allocated goodwill is impaired, too.
Another problem is compensation. The accountants will need to shift some of the parent’s pension expense and liabilities over, as well as some of the deferred compensation expense.
Yet another problem is hedging. Hedging instruments should be assigned to the divested business if they’re linked to something within the entity, such as commodity trades or foreign exchange transactions. This can be hard, since the parent company might be setting up hedges based on aggregated transactions from all of its subsidiaries.
And finally, if the intent is to sell the divested business, then it’s quite possible that potential buyers will want to see audited financial statements, so the books have to be cleaned up enough to withstand an audit.