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A Primer on Employee Stock Ownership Plans (ESOPs)

By Richard Puntillo on August 4, 2020 in , ,

I’ve been thinking…Just what is an ESOP?

An ESOP, or Employee Stock Ownership Plan, is a unique, tax-favored employee benefit plan that can be used as an acquisition financing technique in a highly structured M&A transaction designed to provide liquidity to an owner of a business.

This primer will focus on the anatomy of a typical ESOP M&A transaction: the acquisition of a business owner’s equity securities by a Trust acting as a fiduciary on behalf employees of that business.  At its core, an ESOP M&A transaction involves (i) a motivated seller, who initiates the transaction and arranges/approves (and pays for) all material aspects of the ESOP M&A transaction, including the fees of the buyer’s legal and financial professionals; and (ii) a sophisticated buyer (the Trustee acting as a fiduciary for the company employees) who negotiates the terms and conditions of the purchase of equity shares from the seller.

ESOP M&A transactions are subject to specific IRS regulations, certain provisions in the Employee Retirement Income Security Act (ERISA) and are regulated by the U.S. Department of Labor.  Conceived by Louis Kelso in the mid-1950s in part to foster employee ownership, ESOP M&A deals have evolved and are deliberately structured to comprehensibly address the potential risks inherent in a deal involving employees purchasing the owner’s equity securities in a business.   Due to the nature of ESOP M&A deals, both the buyer and the seller are required to adhere to and document extraordinary prudency practices, a cut above, in my opinion, the M&A due diligence standards of care and customs and practices required in other M&A transactions.

Principal players on the seller’s side of an ESOP M&A deal include the  following: the selling shareholders; legal advisors to sellers who are familiar with ESOP M&A deals, including applicable IRS and ERISA requirements; financial advisors to sellers who not only are familiar with structuring ESOP M&A deals but often conceived and pitched the transaction to the prospective selling shareholders, including proposing success fees as their compensation; and an ESOP Trust Committee, whose members are appointed by the company’s Board of Directors and who agree to act as fiduciaries on behalf of the ESOP beneficiaries.

Principal players on the buyer’s side include the following: a trust company with the requisite background and experience to serve as the Trustee in an ESOP M&A deal, which in part involves acting as a fiduciary on behalf of the ESOP beneficiaries in leading the ESOP M&A deal, including assuring reasonable buyer’s side due diligence; legal advisors to the Trustee who are familiar with ESOP M&A deals, including applicable IRS and ERISA requirements, and the performance of reasonable legal due diligence; financial advisors to the Trustee who are familiar with ESOP M&A deals and the performance of reasonable buyer’s side business and financial due diligence; and an experienced valuation advisor to the Trustee who will render a required valuation opinion in connection with the fairness of the specific terms and conditions negotiated by the Trustee and seller in the ESOP M&A deal.

In my experience in M&A deals, both the buyer and the seller must meet their individual due diligence responsibilities by adhering to the required due diligence standards of care and custom and practice. Buyer’s side due diligence, for example, is the investigation process performed by the buyer and its advisors to reasonably understand and evaluate, among other things, the accounting, financial, business and legal aspects of the target in order for the buyer to have a reasonable basis to believe in the accuracy and completeness of material information relied on in negotiating and approving the terms and conditions of the acquisition agreement and in closing the deal.  The applicable standard of care in buyer due diligence is the performance of a reasonable investigation of potentially material information to ensure there is a reasonable basis to believe in the accuracy and completeness of information relied on by the buyer.  The materiality standard dictates that information should be acquired if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision, or if the fact would meaningfully alter the total mix of information available.

Custom and practice of the required reasonable investigation is (i) to make inquiries reflecting a reasonable level of skepticism (that is, acting as the devil’s advocate), (ii) to follow up and reasonably resolve potential material red flags (that is, don’t unreasonably ignore potential material red flags), and (iii) to independently verify material information supplied by executives and advisors of the target (or other parties with potential conflicts of interests) on which the buyer intends to rely.

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A Deeper Dive into High-Yield Debt

By Richard Puntillo on July 21, 2020 in

I’ve been thinking…Just what are Restricted Payment Baskets and how do they work?

In my experience, investors in high-yield debt use a set of negotiated covenants to protect their investment without unreasonably restricting the ability of the debtor to successfully operate its business in order to timely meet all of its material obligations.

For a high-yield offering to go forward, the debtor must first have satisfied all of the material elements of the negotiated financial and non-financial covenants, the so-called “incurrence” covenant test.  Key definitions are provided in the trust indenture document, which discloses the material terms and conditions of the high-yield offering to potential investors.  For example, a widely used financial covenant is a limitation on the debtor’s use of leverage, commonly measured by (i) a minimum debt-to-equity ratio, calculated as of the closing date of the offering, and/or (ii) a minimum EBITDA-to-debt service ratio, calculated using the latest 12 months of the debtor’s performance data.

In general, restricted payment covenants place strict limits on the debtor’s use of so-called “trapped cash” for specific restricted payments, including limits on the amounts of dividends paid, early redemption of outstanding debt and certain investments in unrestricted subsidiaries (versus restricted subsidiaries).  The distinction between restricted and unrestricted subsidiaries is important and is discussed below.

The cumulative amount that can be paid out in the form of restricted payments is commonly referred to as a “basket,” a “dividend basket” or the “restricted payment basket” amount.  In my experience, the available basket amount is commonly increased by 50% of consolidated net income earned by the debtor (including net income of specific subsidiaries designated as restricted) in the periods after the high-yield debt has been issued.  In contrast, the available basket amount is typically reduced by 100% of consolidated losses.  If the debtor or restricted subsidiaries raise equity, the amount of equity raised works to increase the available basket amount dollar for dollar.

In my experience, most subsidiaries are deemed restricted, which means that cash and other assets can flow freely between the parent and restricted subs.  The formal designation between restricted and unrestricted is the sole choice of the debtor and the decision is often a function of expected operating performance of specific subsidiaries, with an eye towards the potential negative impact on the available amount in the basket that can be used for restricted payments.  For example, if a debtor has a newer subsidiary that is expected to incur heavy losses in its start-up years, such a sub is often designated as unrestricted because of the outsized and negative impact of consolidated losses on the available basket amount, as discussed above.

There are a number of common features in high-yield offerings.  For example, while no principal reductions are typically scheduled during the life of the debt, interest payments are most commonly due semi-annually.   Most high-yield debt securities are issued with senior creditor status in the debtor’s capital structure.  In addition, there is typically no covenant default if the debtor’s financial performance in the normal course of business fails to maintain the incurrence covenant qualifications set at the inception of the offering.  Moreover, it is customary for a high-yield offering to be issued subject to Rule 144A of the Securities Act of 1933, with the initial investors being large and sophisticated “qualified institutional buyers.” Such an offering requires the issuer to become a reporting company with the U.S. Securities and Exchange Commission and, therefore, make required financial and other disclosures timely available to existing investors and the market.

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A Primer on Loan Covenants

By Richard Puntillo on June 18, 2020 in

I’ve been thinking… Just what are loan covenants?

In my experience, the nature and extent of loan covenants in a commercial loan are fact-specific and are spelled out in detail in a so-called loan agreement, which is a legal document signed by the lender and borrower.  The loan agreement is designed to protect the lender and details the key terms and conditions of the loan arrangement.  For example, senior secured bank credit facilities use loan covenants to, among other things, preserve seniority of the lender’s loan position, protect the collateral securing the loan facility and assure that cash flow generated by the borrower is not inappropriately diverted.

Commercial banks are not the only alternative for entities seeking credit.  For example, investors can purchase debt securities directly from issuers in the so-called debt capital markets, which as discussed below are remarkably robust and diversified, including the markets for syndicated loans and high-yield debt securities.  In my experience, such debt capital market transactions always involve law firms and investment bankers to, among other things, help craft the language of the agreed upon covenants.  (Note: where applicable, this blog uses the umbrella terms creditor, instead of lender or investor, and debtor, instead of borrower or issuer.)

Credit facilities usually contain both financial and non-financial covenants, which are commonly either negative (prohibited debtor actions) or affirmative (debtor obligations).  In addition, senior secured creditors often require a debtor to pay down the secured debt under certain conditions, including for example if the debtor issues subordinated debt or sells assets.  In the final analysis, the agreed upon language of specific covenants is a product of lengthy and sometimes intense negotiations among creditors and debtors and their respective teams of legal and financial advisors.

In general, financial covenants protect creditors by restricting the debtor’s use of leverage.  Leverage – shorthand for the use of debt – is measured in a number of ways, including  (i) the amount of debt compared to equity, (ii) the amount of debt compared to total capitalization (i.e., the sum of equity and debt), and (iii) the amount of debt compared to cash flow, which often measured by Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).  There are a number of variations of EBITDA, including EBITDAR, where the final “R” stands for rent-related expenses, and EBITDAL, where the final “L” stands for lease-related expenses.  A smaller amount of leverage (that is, a smaller debt-to-equity ratio, a smaller debt-to-total capitalization ratio, or a smaller debt-to-EBITDA multiple) would typically be viewed positively by creditors.  Some of the more commonly used financial covenants operate to set quantified limits on total debt to EBITDA and senior debt to EBITDA as well as minimum levels of interest coverage (ability to make scheduled interest payments from cash flow, commonly reflected as a ratio calculated as EBITDA divided by interest payments during a selected period), EBITDA and net worth (excess of assets over liabilities).

A syndicated loan is made to a debtor by a group of creditors, which is called a syndicate.  The syndicated transaction starts with the negotiation of terms and conditions of the proposed loan between the debtor and a lead investment bank, known as the arranging bank. The arranger’s responsibility is to perform due diligence on the debtor, prepare a term sheet, seek out potential syndicate members and ultimately obtain sufficient commitments to fund the agreed upon amount of the loan.  Often a road show is used to, among other things, introduce the debtor, present key elements of the term sheet, answer any questions on the terms and conditions of the negotiated loan agreement and review the fee sharing arrangements (typically allocated amongst the syndicate in proportion to the amount committed).  Since the loan agreement needs to be signed by each creditor after conducting a reasonable and independent due diligence investigation, it not unusual for the original terms and conditions negotiated by the debtor and the arranging bank to be revised

In syndicated loans it is common to use so-called maintenance covenants, which require debtors to certify ongoing compliance with prescribed covenants, including preparing periodic analyses and signed certifications documenting such compliance.  In the case of a material breach of one or more covenants, the arranging bank negotiates with the debtor (on behalf of syndicate members) the set of acceptable cures to the breach, including the possibility of the debtor raising additional equity capital and/or paying additional fees to the creditors. In contrast, such maintenance covenants are not used in high-yield offerings, which instead use specifically negotiated incurrence-based provisions that must be met at the closing of the transaction as well as at the time of certain debtor-initiated actions, such as selling assets, paying dividends or incurring additional debt.

High-yield debt securities (aka junk bonds) are issued pursuant to a trust indenture, which is a negotiated agreement between a debtor and the trustee bank that is appointed to act on behalf of creditors.  The trust indenture includes terms and conditions negotiated (i) by the debtor and its counsel and, (ii) on behalf of potential creditors, by the trustee’s team of advisors, including the offering’s underwriters.  The trust indenture includes the negotiated covenants, the nature of which reflect, among other things, the specific facts of the proposed offering, the results of a reasonable due diligence investigation, current market conditions, and the nature and extent of covenants used in recent comparable high-yield transactions.

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A Primer on Special Purpose Acquisition Companies (SPACs)

By Richard Puntillo on June 4, 2020 in

I’ve been thinking…Just what is a SPAC?

A SPAC, or Special Purpose Acquisition Company, is a new company formed by an experienced team of executives (called a Sponsor), whose sole intent is to raise equity funds through an IPO to finance the acquisition of a yet-to-be-identified operating business.  Most SPACs use the following proven structure: The Sponsor typically raises sufficient funds necessary to orchestrate an acquisition of the intended size through a private placement followed by an appropriately-sized IPO.  The IPO offering document, typically a Form S-1 registration statement, spells out unique terms and conditions of the IPO, including among other things the acquisition approval process of any “qualifying business combination” to be presented to the IPO shareholders.  Since a SPAC is, by its nature, a two-step transaction involving SEC-regulated disclosures, the Sponsor works with experienced financial and legal advisors for both the financing and the acquisition components.

The private placement investors’ funds are at risk, and the Sponsor typically receives up to 20% promotional ownership in the common shares as well as warrants (packaged as “Units” of the SPAC) for a nominal amount, with the warrants subject to standard financing terms and conditions regarding pricing premium and exercise date. The risks include (i) a failed IPO, or (ii) a successful IPO but a failure to timely conclude a defined “qualifying business combination” within the prescribed time limit specified in the S-1 (typically 18 months).

In contrast, IPO investors (in the aptly named “blank check” company) are initially protected because IPO proceeds are placed in a specially designed trust (Trust), the terms of which are disclosed in the S-1 and the proceeds of which are for the exclusive benefit of IPO investors.  Only after the IPO has been completed does the Sponsor, assisted by financial and legal advisors, embark on the process of identifying acquisition candidates as described the S-1.  Rigorous business, financial and legal due diligence of viable targets follows, and, if warranted, negotiation of definitive merger terms and conditions are concluded with one or more qualified targets.

With negotiations set, the Sponsor and advisors prepare and distribute a proxy statement (Proxy) for the required shareholder vote.  SEC regulations require accurate and complete disclosure of material information so that shareholders have a reasonable basis to make an informed decision.  Importantly, to approve the proposed acquisition, no more than 20% of the IPO shares can vote against the deal.  Those IPO shares voting against an approved deal are entitled to a pro rata share of the Trust’s assets, including any investment income earned by the Trust, in lieu of continued ownership of the SPAC. A tender offer process following SEC rules is often used to effect the shareholder vote.  However, if the size of the proposed transaction is larger than the assets in the Trust, additional financing must be arranged and presented to the IPO investors. In the event that a qualifying transaction is not completed within the timeframe designated in the S-1, the Trust’s assets are distributed to the IPO investors on a pro rata basis.

Because of the Sponsor’s 20% promotional interest, the IPO investors suffer substantial dilution upon the closing of the IPO.  The Sponsor’s promotional interest, which is an essential element of the typical SPAC structure, is designed to act as a powerful incentive to Sponsors to ensure  the completed SPAC transaction is a success.  Among the key ingredients of a successful SPAC are the following: a rich IPO valuation, impeccable  M&A due diligence, favorable acquisition terms and conditions and an outstanding business plan and management team to run the acquired company.

The IPO Underwriters typically defer most of their underwriter fees contingent on a completed qualifying merger transaction.  Legal advisors also commonly defer payment of their full fees until a completed merger.  After the merger, the SPAC changes both its name and ticker symbol to align with the acquired company’s business.

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Delaware C-corporations vs. LLCs

By Richard Puntillo on May 7, 2020 in

I’ve been thinking…Why is Delaware so dominant in chartering limited liability corporations and companies?  This blog analyzes key aspects of Delaware C-corporations versus Delaware Limited Liability Companies (LLCs).  With few exceptions (e.g., super voting shares, staggered boards and outsized Board appointment rights of preferred shareholders), the typical corporate governance model of a Delaware C-corporation works as follows: pursuant to the terms and conditions of a set of Articles of Incorporation and By-Laws, the Shareholders, as Owners, vote their shares annually for a slate of Board Members to manage the company; in turn, the newly elected Board appoints the Officers to run the company on a day-to-day basis.

The comparable set of documents for a Delaware LLC is the Certificate of Formation and the Operating Agreement.  Like the Articles of Incorporation, the Certificate of Formation is publicly disclosed when initially filed.  In contrast, the internal governance documents–C-corporation By-Laws and LLC Operating Agreements–are typically undisclosed.  Among others, a key difference between a Delaware C-corporation and a Delaware LLC is the terms of the Operating Agreement: a contract entered into between all of the Members, as Owners.  All Members must sign the initial Operating Agreement as well as each subsequent amendment to the LLC’s legally enforceable Operating Agreement.  Since the nature and extent of individual contract terms are virtually unlimited, the LLC structure offers extremely wide latitude in setting up even the most complicated of governance structures.  For example, the management default structure is that the LLC is comprised of Members and one Manager; however, the Members may opt to manage the LLC themselves or the Members may choose to hire an External Manager.

Although a discussion of taxation is beyond the scope of this blog, there are important federal tax differences between C-corporations and LLCs.  For example, a Delaware C-corporation must file its own corporate tax return and pay income taxes according to the corporate tax rate schedule.  In contrast, the tax default structure of a Delaware LLC is the filing of a so-called information return, which allocates taxable income to Members pursuant to the terms in the Operating Agreement.

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Dell’s Special Committee…just doing its job

By Richard Puntillo on May 26, 2013 in

I’ve been thinking… The end of the “go-shop” period set by Dell’s Special Committee produced two more potential bidders to try to top with “Superior Proposals” the currently accepted offer of $13.65/share from Michael Dell and Silver Lake Partners.

Blackstone’s March 22, 2013 non-binding bid of “in excess of” $14.25 per share was viewed as superior and got the private equity firm access to perform due diligence on Dell’s non-public information.  Ominously, just four weeks later Blackstone pulled its bid on concerns about the deteriorating state of the personal computer business.  But Carl Icahn and Southeastern Asset Management (collectively, “Icahn”) still have an active bid, which they claim is a superior proposal.  However, Dell’s stock, which had been trading above the $13.65 deal price, is now well below, closing at $13.34 on May 24.

So what’s the disconnect?  Is Icahn’s bid superior or not?  At this point, the Special Committee claims it can’t determine if the bid could “reasonably be expected” to result in a superior proposal.  Why?  The Special Committee says it needs specific information requested from Icahn to complete the required due diligence on the proposal.  But Carl Icahn isn’t cooperating.

On May 13, the Special Committee sent Icahn a detailed letter that, among other things, requested clarification and additional materials in 8 specific areas (e.g., a draft of a definitive agreement; financing terms, including drafts of commitment letters; details on working capital and liquidity; sources of additional cash, if needed; tax issues; names of expected senior management, their role in financing the proposed transaction and the strategy and operating plan they would implement; and terms of any shareholder agreement between Icahn and Southeastern).  Icahn has remained radio silent….

On May 20, the Special Committee sent a follow up letter to Icahn and mentioned that Icahn’s representatives continue to seek information from the advisors to the Special Committee, including data room access for a potential lender.  The Special Committee stated that such information and data room access would not be forthcoming until information that is responsive to the May 13 letter is received from Icahn.   So it’s a standoff…now what?

Icahn’s advisors and lenders undoubtedly would need to review more information on Dell to go forward with the proposed deal, so the Special Committee needs to find a way to provide the information.  However, Icahn must recognize that their group came late to the transaction and must work more cooperatively to get buy in from Dell that the group has put forth a Superior Proposal, as defined in the merger agreement Dell has already announced.  Icahn needs to establish reasonable working relations with the Special Committee, and the next step is Icahn to produce enough information sufficient to break the stalemate.  Clearly, if Dell shareholders get the vote Icahn is requesting, they’d need much more information on Icahn’s proposal that is currently available to reasonably evaluate and vote on the Icahn deal.  Both sides need to compromise.

The Special Committee is simply trying to do its job as a fiduciary.  It must perform a reasonable due diligence investigation on Icahn’s  proposal in order to have a reasonable basis to believe that the proposal could reasonably be expected to result in a Superior Proposal.  If the Icahn group really believes it can make money by getting control of Dell, they will find a way forward…Carl Icahn is a master in this kind of chess game.

This drama is far from over…if and when Icahn’s bid does qualify as a Superior Proposal, the group led by Michael Dell and Silver Lake has one chance to better any rival offer.   Stayed tuned…

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EU membership: enlarged from 6 to 27 and soon 28

By Richard Puntillo on May 23, 2013 in

The inception of today’s European Union (“EU”) can be dated from 1957, when the original six countries (Belgium, France, Germany, Italy, Luxembourg and the Netherlands) signed treaties to form a free trade association, which became known as the European Economic Community or EEC.

The Six became the Nine, when Denmark, Ireland and the UK joined in 1973.   France had initially blocked the UK’s entry but then relented.

The Nine became the Ten when Greece joined in 1981…and then the Twelve when Spain and Portugal joined in 1986.  These three countries, along with Ireland, were given special considerations because they were recognized as not having economies as advanced as the other 8 members.

The Twelve became the Fifteen when Austria, Finland and Sweden joined in 1995.  And the Fifteen became the Twenty-Five when Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia joined in 2004.

The Twenty-Five became the Twenty-Seven when Bulgaria and Romania joined in 2007.  Croatia is set to enter the EU as the 28th member on July 1, 2013.  Note that neither Norway nor Switzerland are EU members…a mistake often made.

There are 23 official languages in the EU, but there is no single required EU language.  Thus, key legislation and documents are produced in all 23 languages.  However, English, French, German and Italian are the most prevalent languages in the EU.

In just over a half century, the EU has become an economic powerhouse, with a population of over 500 million and, measured by GDP, the largest economy in the world.

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A look back at the Euro

By Richard Puntillo on May 22, 2013 in

On January 1, 2014, the 17 so-called Eurozone countries, the member states of the European Union (“EU”) that have adopted the euro as their sole currency, will add Latvia as their 18th member.  The introduction of the euro became a reality on January 1, 1999, when 11 of the then 15 EU countries adopted the euro.

For the first three years, the euro was a virtual currency…no euro bills and coins circulated.  On December 31, 1998, 11 countries individually and irreversibly fixed the rate of exchange of their currencies to the euro.  For example, France fixed its franc at 6.55957 francs to one euro, while Germany fixed its mark at 1.95583 marks to one euro.

And so the euro was born…but physical euro bills and coins would not be put into actual circulation until January 1, 2002.  By then, Greece had become the 12th member of the exclusive Eurozone club at 340.75 drachmas to one euro.   Today, there are 27 EU member countries, and 17 are Eurozone members…with Latvia soon to become the 18th and Lithuania the 19th on January 1, 2015.

To be ready to introduce the physical currency, member countries had worked intensely for over two years to print some 15 billion notes and mint some 50 billion coins.  The total value of the bills and coins produced was some  €650 billion.  Introducing the new euro bills and coins to over 300 million EU citizens on January 1, 2002 required years of planning as well as political leadership and compromise…and extraordinary faith in the EU’s key institutions.

This blog post is the first in a series that will discuss key milestones in the EU’s history and current and future challenges facing the EU.

 

 

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News Corp…spinoff with a twist

By Richard Puntillo on March 19, 2013 in

I’ve been thinking…Months before the Time Inc. spinoff was announced, Robert Murdoch’s News Corp was well underway to spinoff its publishing assets, which include such name brands as The Wall Street Journal, The Times of London and book publisher HarperCollins.  A recent SEC filing valued the spinoff’s assets at some $18.0 billion.

Details of the deal reflect a spinoff transaction with a twist.

The spinoff entity will retain the News Corp name, while the remaining entertainment businesses, including 20th Century Fox, Fox Films, Fox Broadcasting and Fox News, will conveniently be named the Fox Group.  The “new” News Corp will also start off with over $2.5 billion in cash, no debt and Robert Thomson as CEO.  Thomson is proven publishing executive, including stints as Managing Editor of The Wall Street Journal and Editor of The Times of London.  The Fox Group will also indemnify the spinoff from any potential losses from the London hacking fiasco currently facing News Corp.

Clearly, the new News Corp will begin its public life extraordinarily ready for battles it will surely wage.  And to succeed in the print media business, the new News Corp will need to leverage every advantage…and then some.  The print media business has been dealing with long term and accelerating trends of declining revenues and readers…a deadly cocktail that is debilitating to all players in the business.

It’s no surprise that both News Corp and Time Warner are opting to spinoff these businesses.  In addition, the Tribune Company, the Chicago-based media group that owns the LA Times and the Chicago Tribune, recently emerged from a contentious and extended Chapter 11 proceeding and now faces the prospect of spinning off its extensive print media assets from its other digital and broadcast businesses.

Competition for dwindling print media revenues and readers is destined to get even tougher.  Ouch!

Keep an eye on the new News Corp, the spinoff with a twist.  It will have the financial firepower of lots of cash, the ability to lever up and the currency of its soon-to-be publicly traded shares to make whatever acquisitions CEO Thomson and his team can devise.  What will be devilishly difficult is crafting strategies that address the realities of sickeningly shrinking markets in an era of unrelentingly rapid technological change.

 

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Time Inc. spinoff

By Richard Puntillo on March 18, 2013 in

I’ve been thinking…Just weeks ago, Time Warner gave up trying to sell a portfolio of its magazines to Meredith Corp and decided instead to spinoff to its existing shareholders the entire Time Inc. operation.  The proposed spinoff follows the successful path of Time Warner’s 2009 spinoff of AOL.

What are spinoffs and how are they done?

Time Warner is a public company that owns TV networks, production operations in TV and film as well as Time Inc., its print media business.  The spinoff of Time Inc. will create two publicly traded companies owned by the very same shareholders…one company will be Time Warner (but without the operations of Time Inc.) and the other will be Time Inc. (although it’s not known if the new spinout will retain the iconic Time name).  Shareholders will get no money just pro rata shares in the new spinoff.  It seems simple, but there are a lot of moving parts behind the scenes.

Key to the future success of any spinoff is the fundamental soundness of the underlying strategy and the specific people, assets and liabilities allocated to the newly minted firm.  The goal is to create and endow a spinoff entity that can grow and prosper on its own without materially wounding the company that spawned it.  Spinoffs can’t be dumping grounds for bad assets or too much debt…and shortchanging spinoffs with too little cash or ill thought out strategies can be fatal from the get go.

It’s a tricky balance for a Board, but a spinoff is one instance where Boards can clearly see whether their resource allocation decisions create value for their shareholders.  Time Warner arguably got this balance right with its spinoff of AOL, because total shareholder value has increased after the AOL spinoff.  On the other hand, the 1999 spinoff of Delphi from General Motors never really got traction, and Delphi filed for bankruptcy in 2005.

Some tricky accounting issues invariably have to be addressed in each spinoff transaction.  Specifically, management must work with their auditors to reasonably derive from the actual historical accounting record a complete set of books for the spinout…an entity that, in fact, never really existed.  For Time Inc., the end result will be a set of “carve out financial statements,” which will include three years of balance sheets, income statements and cash flow statements and the accompanying footnotes, as if Time Inc. had always been a public company.  It’s new math: 1 minus 1 equals 2.

 

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