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The 1990s were a time of unprecedented growth. Emerging companies, many newly formed and most in the technology sector, enjoyed astronomical valuations. Strategic acquirers enjoyed similarly high stock prices and used their stock to acquire smaller companies in acquisition after acquisition. M&A activity was reaching historic levels, with approximately $1.7 trillion in completed transactions in 1999 alone. [FOOTNOTE 1]Accountants advised management how best to structure these acquisitions and, through a method known as “pooling,” permitted companies to combine their balance sheets without a continuous drag on earnings. Then everything changed. Corporate acquirers have watched their earnings vanish and their stock prices plummet. As the new business cycle wears on, accounting scandals have erupted and companies once heralded as leaders in the new economy have seen their senior management escorted away in handcuffs. Audit committees have replaced accountants as the policemen of financial statements, and independent auditors are becoming more and more independent. [FOOTNOTE 2] Companies have struggled to deal with this “new reality” by attempting to restructure their operations. [FOOTNOTE 3]In addition to slashing overhead, laying off employees and cutting capital expenditures, some companies have attempted to shore up their balance sheets by selling, spinning or carving out business units. Some have been led to this conclusion by their management or advisers, and others, like Enron, have found it inevitable. [FOOTNOTE 4] In many instances, the case for divestitures is compelling. Acquired companies and their personnel often languish within the acquiring companies. Life in many of these units is characterized by lack of strategic direction from the parent, little fit with the parent’s overall strategy, equity stakes that are hopelessly underwater, serial layoffs, and a general desire to start over. In some cases, the strategic rationales underlying their acquisitions have been utterly abandoned, and, in other cases, management teams that were acquisition-oriented have been wholly replaced. A number of these acquired businesses have created impressive technologies or products and hold favorable long-term prospects. This combination of factors presents a significant opportunity to unlock value. MARKET RESPONSE Reflecting current conditions, many recent transactions have involved spin-offs or carve-outs of divisions or subsidiaries of larger companies, often with private equity sponsorship. The classic form of a spin-off is a transaction in which a corporate parent gives away all of its ownership in a business unit to its existing stockholders in the form of a tax-free dividend. A recent example of this type of transaction is Reliant Energy Inc.’s spin-off of its wholesale and retail energy services unit. A variation on this theme is known as a “carve-out,” which is a partial spin-off. A carve-out is a special kind of spin-off in which a parent company, instead of giving shares in a subsidiary directly to its existing stockholders, sells a partial interest to the public in an IPO. The parent benefits from the carve-out by raising cash. Sometimes, the carve-out is followed by a spin-off of the parent’s remaining interest in the subsidiary. [FOOTNOTE 5] Leveraged acquisitions and going-private transactions have become harder to complete in the current market, however, due, in part, to a persistent gap between the price expectations of buyers and sellers and arguably the worst debt market since the 1998 Russian debt crisis. [FOOTNOTE 6]Notwithstanding these gaps in valuation, many corporate parents are eager to clean up their balance sheets to eliminate a division’s persistent drag on earnings, to raise cash or to unload unwanted debt. As the pace of more traditional transactions has slowed in this environment, alternative investment and divestiture strategies have moved to the forefront to meet this demand. Recent transactions involving the separation of a business unit from its corporate parent have taken a variety of forms. The simplest is a straightforward sale of the business which the parent seeks to divest. In such a transaction the new investor typically acquires the business or a controlling interest in the business, employees receive new equity awards, and the parent/seller receives a taxable payment for its equity stake. Buy-out transactions in the current market environment have increasingly involved creative forms of seller financing and/or retention of an equity interest by the parent/seller. A retained equity interest gives the parent/seller an ongoing interest in the divested unit and is sometimes coupled with an ongoing business arrangement, such as a licensing, distribution or technology development agreement. [FOOTNOTE 7]A properly structured retained equity interest can assure recapitalization accounting for the transaction, which will enable the target to avoid amortization of intangibles for accounting purposes. A retained interest can also ease the transition for the separated business as it learns to become independent. The structural possibilities for separating a division or subsidiary from its parent can take many forms. Four different approaches, each geared to different types of strategic, tax and valuation considerations, are illustrative. � Investment/Spin Transactions.In some cases, private equity investors will invest in a corporate subsidiary in conjunction with a spin-off of the subsidiary to the parent’s stockholders. [FOOTNOTE 8]The investor helps establish a value for the newly freestanding entity and provides institutional support and visibility for the new company with prospective underwriters, banks and other key constituencies. Spin-off transactions of this type are tax-free to the parent and its stockholders provided, among other things, the investor does not acquire 50 percent or more of the new company and no other acquisitions of stock occur that would result, together with the investor’s purchase, in 50 percent or more of the new company’s stock changing hands (see below). Transactions of this type usually involve a simultaneous spin-off and investment, but also can be structured as an investment in the subsidiary with a spin-off or other liquidity transaction occurring at a later date. A public equity offering sometimes accompanies or follows the spin-off. � PIPE/Spin Transactions.Parent companies sometimes develop disaggregation strategies involving spin-offs of multiple operating units and seek the participation of a private equity partner to support these strategies. In these situations, the investor acquires securities of the parent in a so-called PIPE (private investment in public equity) investment, rather than investing directly in the smaller unit or subsidiary. These deals usually consist of buying a small stake in a public company through the acquisition of either common (or increasing, convertible) stock or convertible debt. The private equity investor then participates with the parent’s public stockholders in each tax-free spin-off. As these spin-offs occur, the investor’s preferred stock preference may be reallocated among the various distributed companies in accordance with their relative values or other agreed upon criteria. Like the subsidiary spin-off strategy described above, a PIPE-related investment approach sometimes is coupled with secondary equity offerings by the new companies shortly after they are launched. � “Frozen Preferred”/Distribution Transactions.Each of the investment strategies described above usually involves a tax-free spin-off under � 355 of the Internal Revenue Code. A third approach for separating a subsidiary business unit from its parent company involves a taxable spin-off. In this type of transaction, the subsidiary first issues the parent preferred stock having a liquidation preference equal to some or all of the current value of the subsidiary’s business, in exchange for a contribution of the business. The preferred security received by the parent is typically a redeemable preferred stock with no conversion feature, which does not become taxable until an exit. The parent then distributes to its stockholders common stock representing any additional enterprise value at the time of the spin-off plus the right to receive all future appreciation in the value of the business. In contrast to other forms of spin-offs, a frozen preferred transaction is taxable but the parties expect that taxes will be minimized because most of the subsidiary’s value will arise after the spin-off. The risks with this type of transaction include a challenge by the IRS to the value of the common stock, if, for example the preferred stock has too low of a coupon. Also, a later issuance in the proximity of the spin-off can bring unwanted scrutiny to the value initially placed upon the common stock. These types of spin-offs were used widely in recent years by companies seeking to establish separate market capitalizations for their Internet operations, but have since been adapted to other uses. � MBOs Using Leveraged ESOPs.Facing challenging times in the debt and credit markets, some companies have looked internally to fund divestitures. According to the most recent data published by Valuemetrics, there is approximately $400 billion in over-funded defined benefit plans and approximately $585 billion in company contributions invested in 401(k) plan assets, and although these figures are no doubt lower given the market’s prolonged downturn, the amount of capital available in these plans is still likely to be substantial. [FOOTNOTE 9] In a properly structured transaction, these funds can be reinvested in other qualified plans (e.g. an employee stock ownership plan, or an ESOP) to assist an entrepreneurial management team in carrying out a management buyout of the business to be divested (commonly referred to as an MBO). Some of the benefits of an MBO/Leveraged ESOP transaction include a tax-free sale, the ability to borrow money through the ESOP and to repay loans using pre-tax dollars, greater management interest in the transaction, and the absence of corporate level taxes (if structured as an S-corporation). However, like many attractive opportunities, there are a number of disadvantages to using this type of structure, including the regulatory oversight associated with running an ESOP, trustee involvement in management, and, of course, high leverage. CHALLENGES Creating a freestanding business unit from within a larger corporate enterprise presents a number of challenges. Carve-out and spin-off transactions present operational hurdles that must be anticipated and managed for the transaction to succeed. Most importantly, the sponsor of the transaction must seek to align the interests of all stakeholders, including those of the selling parent, management and the investors. Specific operational and strategic issues that should be addressed include the following: � Is the business divisible from a physical, management and systems standpoint? � Can historical financials be recast to draw meaningful conclusions? � Does the parent do business with the division as a customer or supplier of materials? � Are there any real services provided by the parent for which a corporate allocation is charged? � Is the management team entrepreneurial? Is it broad and deep enough, or does it need to be supplemented? � If the parent company’s management has risen through the ranks of the division, should those members of management be offered equity to encourage them to stay with the business being separated? Will the parent company allow that to happen? � If a minority investment is contemplated, are adequate protective rights available? � Are there any contractual limitations that would stand in the way of the transaction, such as lender, customer or supplier approval rights? � If the parent will not provide warranties and indemnification relating to prior operations, will the investor be comfortable relying on management warranties? How can the interests of the sponsor and management be aligned? � Can the sponsor identify specific ways in which it can add or create value after the deal has been closed? � Is there any institutional interest in the business or is it likely that it will languish as an orphan? � Can the sponsor identify two potential exit strategies? Sponsors of carve-out or spin-off transactions must be mindful that the culture and operations of the target business as a stand-alone company will differ from its culture and operations as a unit of a larger enterprise. In this regard, it is important that a seasoned and entrepreneurial management team be in place from the start. A company that has been part of a larger enterprise often retains its key technical personnel, but may lack executive leadership and entrepreneurial management. In some cases investors join with the unit’s original founders or managers as their management partners, to supplement or replace incumbent management of the subsidiary or division. The tax issues associated with spin-off transactions are also complex. A spin-off transaction will not give rise to tax for the distributing corporation or the subsidiary to be distributed if, among other things: � the business to be spun off has a five-year history as an active trade or business (this requirement is often difficult to meet with Internet and e-business related units created in the late 1990s); � the business to be spun off has not been acquired in a taxable transaction in the past five years (companies recently acquired in stock-for-stock exchanges, therefore, may be spun-off but companies acquired in acquisitions involving cash payments may not); � the parent must distribute all of the subsidiary’s stock that it owns, and such stock must represent at least 80 percent of the subsidiary’s voting stock (therefore, if for example, a parent wanted to spin off a subsidiary on a tax-free basis, an investor could not acquire more than a 20 percent voting interest in spun-off entity in advance of the spin); � there must be less than a 50 percent change of ownership at the distributing company and at the spun-off subsidiary, including any “planned” issuances of stock (as defined under very detailed Internal Revenue Code rules) (this rule can be problematic in cases where an investor wants to acquire more of a spun company after the spin or where there is a plan for the spun-off entity to make a number of acquisitions using its stock); and � the spin-off must have a substantial business purpose. The IRS often looks hardest at the substantial business purpose test, and for this reason it is important to be cognizant of the issues that arise. Since failing this test could result in the transaction becoming taxable, it is common to seek an IRS ruling on close calls, but this process can take anywhere from six to nine months to complete. On one end of the spectrum of what will not qualify as a substantial business purpose is a parent’s desire to simply sell a unit on a tax-free basis. Purposes that are more subjective, however, are what are referred to as “fit and focus” purposes. These include arguments that the spin-off will create new synergies, will allow for separate and more efficient management, or is required due to differing cultures at different operating units. Since these reasons are quite subjective, the IRS will often resist issuing a favorable ruling, although obtaining a ruling is often possible when the case is well-substantiated. One purpose that clearly falls into the IRS’s acceptable view of substantial business purpose is the need to complete the spin-off in order to facilitate an equity offering at either the parent or business level. If an investment banker is willing to state that the offering will be more marketable if the spin-off is completed, it should be possible to obtain a favorable ruling. While complicated, these tax rules must be understood to successfully structure a spin-off transaction. For example, if a company wishes to spin off a subsidiary on a tax-free basis, an investor cannot acquire a 21 percent voting interest in the subsidiary in advance of the spin-off, because the parent will be unable to distribute 80 percent of the subsidiary’s voting stock. Similarly, an investor cannot acquire 49 percent of a subsidiary following a tax-free spin-off in conjunction with a plan to have the newly independent company issue 1 percent or more of its stock in an acquisition or public offering, because this would violate the 50 percent change of ownership requirement under � 355. To avoid these limitations, investors who are invited to participate in a spin-off transaction often limit the amount of stock they acquire or use taxable structures such as the “frozen preferred” approach described above. CONCLUSION Spin-off and other divestiture transactions present opportunities for operating companies, private equity investors and entrepreneurial management. For corporate parents, these transactions provide an opportunity to divest non-core operations, raise cash (depending on the structure), and provide stockholders with a separate asset having a separate market valuation, often on a tax-free basis. From the perspective of management, these transactions create an opportunity to gain direct equity ownership of their business at a favorable price and reestablish an entrepreneurial environment. And for private equity investors, corporate divestitures and spin-offs provide an important source of deal flow. When these objectives coincide, a new company can be launched and the captives freed. Andrew J. Weidhaas is a partner and Stephen A. Boyko is a senior associate in the New York office of Goodwin Procter ( www.goodwinprocter.com). This article contains information originally published in the March 2002 issue of theVenture Capital Journal and has been used with permission. ::::FOOTNOTES:::: FN1Source: Thompson Financial Securities Data. FN2The Sarbanes-Oxley Act of 2002 established new responsibilities for audit committees, an oversight board for accountants, and a number of audit-related reforms. See http://www.goodwinprocter.com/ publications/ pc_sarbanes_oxleyact_8_02.pdffor more information. FN3According to webmergers.com, a total of 862 Internet companies shut down their operations from January 2000 to June 2002. While the number of dot-com shut-downs has declined dramatically, the number of asset acquisitions from Internet companies has increased recently. So far this year, acquirers have announced 205 asset acquisitions, an increase of 25 percent over the first nine months of 2001. FN4Enron recently sold its “Crooked E” sign for $44,000 in a two-day auction of company assets. See www.rediff.com/money/ 2002/sep/26enron.htmfor more information. (Last visited Oct. 20, 2002). It has also placed 12 major assets, or approximately 90 percent of its remaining assets, up for sale in an effort to raise money for its creditors. Final bids are expected in November, pending bankruptcy court approval. See www.rediff.com/money/ 2002/aug/28enron.htmfor more information. (Last visited Oct. 20, 2002). FN5If the initial carve-out represented 20 percent or less of the business, then both the carve-out and the second-stage spin-off would qualify as tax-free transactions. An example of this type of divestiture is the widely publicized spin-off by 3Com of its hand-held computer division, Palm Computing. FN6 See money.cnn.com/2002/ 10/10/markets/ bondtrouble/index.htmfor a recent article on the topic (Last visited Oct. 20, 2002). FN7For example, on Oct. 16, 2002, U.S. Steel announced its intent to spin off its coke, ore and transportation businesses to a new company formed by Apollo Management, a New York City private equity firm. Under the proposed terms, U.S. Steel would retain a 20 percent stake in the new company, which would supply the steelmaker with raw materials. FN8A recent example of this type of spin-off is Sony’s $20 million investment in PalmSource, the unit that develops the Palm OS. A spin-off of the remainder of this business is widely expected. FN9Information set forth in this paragraph has been provided, in part, by Valuemetrics, Inc. Valuemetrics is a boutique investment bank focused on advising private market companies. If you are interested in submitting an article to law.com, please click herefor our submission guidelines.

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