Sellers Avoid a Tax Bite With Sponsored Spin-Offs: The deal format also reduces risk and provides a committed financial partner to guide the newly public company

A relatively new deal structure, the sponsored spin-off, appears poised to become an increasingly popular divestiture strategy. The structure allows a seller to divest businesses tax-free, potentially saving billions of dollars, while also enhancing the profile of the spun-off business and benefiting its investors. In a recent deal, Alberto-Culver spun off its Sally Beauty business. Under the deal terms, Alberto-Culver sold a 47.5% stake in the unit to Clayton, Dubilier & Rice for $575 million, and Alberto-Culver shareholders own the remaining 52.5%. The deal marked only the third sponsored spin-off ever to be undertaken in the U.S., but more are likely to follow as the benefits become better understood. Sponsored Spin-Off Benefits In a sponsored spin-off, a parent company sells a minority stake in a unit to a private equity buyer and distributes the remaining interest to its stockholders. Under the Internal Revenue Code, the sale by a company of newly issued stock is not taxable, and a spin-off is not taxable if complicated tax requirements can be met. A straight sale of a business, however, is subject to hefty taxes. Companies often have sought to solve the tax issue by divesting the unit through a leveraged spin-off, a deal structure in which the parent leverages the subsidiary, removes some or all of those funds, then distributes the stock of the company to its shareholders. The problem with leveraged spin-offs is that while they provide cash, they also leave the subsidiary burdened with debt. If the business is too highly leveraged, it may not remain a viable company. A sponsored spin-off avoids both the tax burden of a cash sale and the debt burden of a leveraged spin-off. The first U.S. sponsored spin-off was Lucent Technologies’ sale of its Enterprise Networks Group, renamed Avaya, in 2000. However, the very small stake (about 5%) acquired by the sponsor resulted in the spin-off generating little cash for the parent and did not raise the sort of tax issues that a larger stake would have under the Internal Revenue Code. The conventional tax wisdom had always been that 20% was the maximum amount of stock that could be acquired by a sponsor in connection with a spin-off. A few years later, Pitney Bowes, advised by White & Case, gained IRS approval for a proposed sponsored spin-off of its Capital Services business to an affiliate of Cerberus Capital Management. The deal involved an investment by Cerberus for common and preferred stock of the Pitney Bowes unit representing up to 19.% of the voting interest and up to 48% of the economic interest in the spun-off entity. Pitney Bowes ultimately did not complete the deal as a sponsored spin-off but rather as a taxable stock sale of the business, explaining that the SEC would have required submission of additional financial statements that would have prolonged the time frame of the spin-off. However, because the IRS issued a ruling that approved the structure of the proposed Pitney Bowes sponsored spin-off, it’s likely to remain a model for future sponsored spin-offs. The structure approved by the IRS involved a carefully crafted, two-stage investment by the sponsor. Tax Advantages Companies spin off units to raise funds for a variety of reasons, so minimizing the tax bite of the transaction is central to the deal’s success. Under Section 355 of the Internal Revenue Code, for a spin-off to qualify as a tax-free transaction, the parent must distribute “control” – at least 80% of the voting stock – of the unit. Section 355(e) of the Code stipulates that if one or more persons acting pursuant to a “plan” acquires, directly or indirectly, 50% or more of the stock of the controlled subsidiary or the distributing corporation, the spin-off will be taxable at the corporate level. Generally, any stock acquisition of the subsidiary or the parent within two years of the spin-off is presumed to be part of a plan for purposes of Section 355(e). Because of these tax constraints, the sponsor may want to limit its ownership to a minority stake in the spun-off company for at least two years. A minority stake may constitute up to 19.9% of the spun-off company’s voting rights and up to 50% of an economic interest in the spun-off company. Appeal to Stockholders When the parent distributes the shares to its stockholders in the spin-off, the spun-off unit becomes a public company. Investment by a committed financial partner may be viewed as a vote of confidence in the business, and can ensure that the company has the expertise and guidance it needs to make the transition to a stand-alone firm. Appeal for PE Firms The deal structure is also attractive for the PE firm sponsoring the spin-off. Normally, PE buyers seek to buy a majority stake in the companies in which they invest In a sponsored spin-off, the sponsor acquires only a minority stake, allowing it to invest in a public company with less initial investment risk. A sponsored spin-off offers multiple exit options for the PE firm. If the stock appreciates, the sponsor can sell shares of a liquid investment in the public market. If the spun-off company’s stock trades at a weak level, and the PE firm believes that the company is strong, it can, after at least two years, offer to buy the remaining shares at a low cost per share. That would allow it to gain control of the company, making it a more traditional PE investment. There are many complex issues to consider when structuring a sponsored spin-off, so it’s important for a company that’s mulling over such a transaction to work closely with advisers who have a working knowledge of the applicable rules. Mark Mandel is a Partner at White & Case in New York, where he focuses on domestic and cross-border M&A, private equity, and securities deals. (c) 2007 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com