Is breaking up so hard to do? Pros and cons of demergers

Dissolving a business merger is sometimes a canny way of turning around your company’s fortunes but separating from a partner can be challenging and costly. In this Q&A, we look at the nitty-gritty of demergers.

So, what’s a demerger?

A demerger is a type of corporate restructuring, where a company separates part of its business into a different entity.

A company can decide to demerge for several reasons. The most common motivation is to create additional value for shareholders by splitting out certain activities that may perform better if separated from the main business. The second reason for a demerger is divorce, where parties who have previously worked together in a joint venture or as part of an acquisition decide to go their separate ways.

>See also: Employee Ownership Trust – another way for business owners to successfully exit

Might a demerger be good for my business?

Where JV partners wish to separate, the decision is usually clear cut. If the original merger or acquisition has failed to deliver the anticipated benefits, then there usually little option but to “dis-merge”. Aside from the PR challenges that this type of demerger may bring, and any that result from a strained relationship between the original partners, dissolving the partnership should be straightforward, if costly.

If, on the other hand, you’re looking to drive out value from your business by demerging, these are the kinds of scenarios where this might be a good option:

Market divergence

You are operating in distinct markets or different sectors. You feel that by dividing up your business each one can focus on its core activities, with separate management, balance sheets and revenue goals

Increase star performers’ focus

Key members of your management team have discrete specialisms. You reckon that you can drive out more value if each member concentrates solely on their core competency.

Specialise to grow

Part of your business is growing rapidly in its niche area, and you feel this could be best exploited in a new entity. Or, you’ve a new business idea or IPR and want to keep this separate from your main business.

Red tape

You’re operating part of your business in a highly regulated area and feel that this is holding back the rest of the business.

You’ve got too big

You think that by dividing up the business you could increase shareholder value and market capitalisation. For example, you may feel that dis-economies of scale or growing your business too quickly is proving a drag on profitability

Pre-emptive action

You want to divide your business up pre-sale or wish to fend off hostile offers for your company by hiving off more desirable parts of the business into a subsidiary.

>See also: How to conduct a management buy-out

How might a demerger drive out value?

If you’re dissolving a JV or dis-merging, then the obvious benefit is to undo a partnership that’s gone awry. Each partner cuts their losses and walks away to continue their separate businesses. Aside from any drag on productivity or PR implications resulting from the dis-merger, the parties will hopefully recoup their losses and move on as they were before the JV or unsuccessful acquisition.

In the case of a new demerger, by creating separate entities you can end up owning two businesses that have more capital value individually than they did combined in a single entity.

Whether that be because your star performers are free to go their own way without interference from the centre, or because diseconomies of scale are causing a drag on the P&L, individual companies that are free to focus on what they do best are often worth more over the longer term.

What do I need to think about before I demerge?

If you’re considering a demerger, there are a number of issues you should look at:

IPR and goodwill

Does your company own valuable assets like trademarks or patents? If so, what will happen when you divide up the company? How will you handle any transfers or licenses to the new entity? Will you be charging a fee to the new company for their use?

As for goodwill, what will happen to this when the company splits, and how will this feature in the balance sheet?

Suppliers and customers

Have you consulted with your existing suppliers and read the terms of your major contracts? Will your suppliers be prepared to trade with the new entity and do you need to seek their consent to a split?  May terms such as pricing change?

How about your customers? Do you anticipate any challenges when your spun-off entity starts trading on its own account?

Banking and loans

Will your bank need to consent to a demerger? Might the rate of interest they charge you change as a result of the split?

Premises

Where will your new business trade? Will you need to revisit any property leases or create new arrangements so that the spun-off entities have appropriate premises.

Balance sheet issues

Do you have distributable reserves in the business? This factor may be important when it comes to how you structure your demerger. Drawing up pro-forma balance sheets for each new entity and the retained business is a good way to examine how each will function in the future, particularly in terms of ensuring adequate cashflow.

Employees

What will happen to employees when the company splits? Will they transfer automatically to the new company and will you need to consult with them beforehand? Do you have an employee share scheme in place, and how might this be affected by the demerger?

Demergers: the pros

As we’ve seen, one of the main reasons for demerging is that you can unlock additional value for the shareholders of the demerged firm. Shareholders are normally issued shares in the new companies created following a demerger, and should the deal achieve the anticipated benefit, profits should grow overall with share prices increasing as a result.

One of the reasons for such an increase in profits is that management is free to take charge of their own P&L without interference from the “centre”. A demerger can also force clearer accountability for delivering results, as the executives of each enterprise are more clearly responsible for their company’s bottom line. It can also allow executives to specialise more acutely in their own area of expertise or particular brand — PayPal’s split from eBay, for example.

A final advantage of demergers is that each new unit can self-finance, rather than seeking financial support from the centre.

Demergers: the cons

While demergers can lead to increased profitability, there are some downsides.

Firstly, demergers can be costly as they have to be structured carefully to avoid liability to tax. You’ll need to factor in the cost of expert legal and accounting advice.

Secondly, there may be economies of scale inherent in the group that are reduced by splitting out into new entities. The cost of loans and production can increase, and suppliers may be less willing to trade on favourable terms with a new company. Inevitably, there may be a drag on productivity linked to the transaction and any loss of synergy that results.

Types of demerger

In legal terms there are different types of demerger. What type of demerger you choose depends on your company’s financial situation, tax issues, the background to the deal, and the reasons you want to split off part of your business. You may need distributable reserves available to complete the deal as you envisage.

You need to consider which route to take very carefully so that the tax consequences are minimised. There are special rules that allow you to avoid unwanted charges to income and corporation tax, as well as VAT and stamp duty.

Statutory demerger

This where a new company is created and its shares are transferred to the original company’s owners, either by way of a dividend (a “direct demerger”) or by creating a new subsidiary and moving this to a new holding company, with the shares being transferred to the original shareholders (a “three-corned demerger”).

Reduction of capital demerger

You can also demerge by reducing the share capital of the parent company and transferring a trading business to new shareholders or new holding companies.

Liquidation demerger

In a liquidation demerger, you liquidate your business and transfer assets to new companies. Shares in the new companies are given to original shareholders in return for liquidation rights.

Demergers and taxation

Demergers need to be carefully structured to avoid unintended tax consequences such as a chargeable capital gain for the original company, gains or income tax charges for the shareholders and stamp duty. There may be tax reliefs available, but you should take specialist legal advice in order to make sure that participants can take advantage of these. You can apply to HMRC for special clearance in advance of the transaction to ensure that reliefs will apply.

There should be no VAT charges, and each new company will have to seek its own VAT registration

Calum Covell is marketing manager at Harper James Solicitors

Further reading

Partial exits: a balancing act