The stock market is packed with various events and phenomena, making it impossible to keep track of everything. Among these, there are some corporate actions that must be followed closely so that one can at least be prepared for them and know how to act when they occur.

One such event is called a "spin-off". This article is dedicated to spin-offs and their impact on the shares of companies and on investors.

What is a spin-off?

When a company creates a spin-off action, this means that it splits off a section as a separate business, or creates a new independent business entity. In other words, the main (parent) company opens a subsidiary to which it hands over a part of its assets and liabilities, thereby creating a separate business while the first one is still active and preserving its legal entity.

This operational strategy must not be mixed up with that of creating a new company at the expense of founders and investors.

An example of a spin-off*

Let's take an imaginary business as an example. SSS Company manufactures construction materials, gradually extending its product line. In due course, the company offers a whole assortment of such products and takes up its niche in the market.

In such favourable circumstances, the management becomes more and more ambitious, craving for further development, and therefore decides to carry out a spin-off. This allows the company to capture another niche market, namely that of construction and installation works.

SSS is a public company with shares in free turnover. At the general meeting, the shareholders decide to create the SSS-1 subsidiary that will operate in the new niche market. They also decide on the number of funds to be allocated for the establishment of the new entity, and all the relevant organisational processes. This is quite a lengthy process that can take from six months to a year.

The new company takes assets and liabilities from the parent company, such as employees, intellectual property, technology, or existing products. Thereafter, it issues shares and sets up its primary cost. Consequently, all shareholders of the initial company receive equivalent shares in the new company.

This happens at the exchange rate, which is the ratio of the new shares to the share price of the parent company. This is subject to the decision made at the meeting of the shareholders.

Example of exchange rate

The share price of SSS is 100 USD per share. The exchange rate is 0.85 (85%). This means that the initial share price of SSS-1 will be 85 USD. The newly-created company will carry out an IPO at this share price, while investors of the parent company will receive multiple shares in the new one.

Quite often, investors must hold a certain number of shares in the parent company to receive shares in the new one. The numbers are rounded: if investors receive 1 share in the subsidiary per 10 shares in the main one, then they will have 3 new shares per 29 shares in the parent company. Hence, one has to take care and make sure they hold enough shares in the parent company before a certain date.

An example with a construction company was brought up for a better understanding of a spin-off, but most often this procedure is carried out in the technology and science sectors, in the branches of software development and research.

The main aims of a spin-off

  1. Making the company more mobile.
  2. Creating a more efficient, competitive company.
  3. Seeking tax incentives and decreasing debts.
  4. Diversifying risks and business. If the new project fails to develop, the initial company will not suffer much.
  5. Taking up a new business niche and developing a new area of business that's different from the main one.
  6. Making final decisions faster. Fewer managers mean faster decision-making.

Advantages of a spin-off

  1. A new company based on an existing one is better positioned than those that are created from scratch.
  2. The new company makes use of all the results that have been achieved by the parent company, including the client base. This makes promoting it easier.
  3. The subsidiary is created for certain market conditions and requirements. There is no need to look out for a niche.
  4. The parent company incurs fewer risks.

How investors behave at a spin-off

After a spin-off, whoever owns shares of the parent company receives shares of the new one, and they can be used in several ways:

  1. Investors can keep them in the portfolio, thereby diversifying it. Both companies might keep on growing, and even if the shares of one of them go down, the portfolio will remain balanced thanks to the shares of the second company. Of course, there is always the possibility that both shares might go down, but this is a different scenario for other decisions to be taken.
  2. After the subsidiary carries out an IPO, investors can offload their shares and use the money as they please. In this case, the portfolio remains without change, while receiving some free money. However, keep in mind that in the future, the shares might grow.
  3. If after studying the new company the investor finds it promising, they can add more of its shares to the portfolio. As long as people are attracted to "hot pies" with exceptional greed, chances are that the share price of the new company will be growing.
  4. Trading and investing always involve risk, therefore it is always worth studying a new company and estimating its profit prospects.

Conclusion

A spin-off is most often an intriguing event for investors, as it gives them the opportunity to receive shares in a new company apart from the shares they already own in the old one.

After a spin-off and an IPO of a new company, there are situations when the share price of the main company might open with a gap and keep on growing over the next trading session. Sometimes after an IPO of the new company the shares of the old one keep on growing for several months.

* - Different brokers may process this event in different ways. How it is processed by RoboMarkets can be found in FAQ.


Material is prepared by

A trader since 2009, Max specialises in stock and currency markets. He is also a regular speaker in educational events about financial markets and investing.