Divestitures: Definition, Types, Importance and benefits

Definition

Divestitures or divestment as it is commonly known is defined as complete or partial disposal of an asset. There are multiple ways divestitures can happen. It really depends upon the preference of the company’s executives. It can be done through sale, closure, or bankruptcy declaration.

There are many reasons why a company would divest. A company mostly divest from an asset when the cost of keeping and running that asset is much higher than the revenue gained from running that asset.

A company may also get rid of an asset because it is trying to streamline its operation and as a result that getting rid of any asset that is not a part of its core competency. The general economic conditions also impact the Divestiture decision.

It helps a company focus on the growth segments which will increase the shareholder value. Divestiture brings with itself a new set of challenges. There should be a plan set in place before the procedure takes place.

The cost-benefit analysis, standard procedure, whether the company should be a new entity or sold to a buyer who has placed an attractive bid for that particular asset.

Types of Divestiture

There are five main types of divestiture that are classified on the basis of how an asset is disposed of. The five main types of divestiture are shown in figure 1.

                                                    Figure 1: Main types of Divestiture

The company that is thinking of divestment must very carefully think of the method that it chooses for divestiture. The divestment must unlock great share holder value. All five types are described in much detail below:

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Spin-off

The spin-off creates a new entity which then becomes a part of the organization. It becomes its own company. A whole new unit is formed which becomes a subsidiary of the main company. The investors are given equity in the newly formed company.

It has two main advantages; one is that the company is able to unlock shareholder value and the second is that the spin-off can act independently. It incentives the new subsidiary to invest and innovate; as it does not have any pressure from the main company.

One example of a spin-off is the newly created Kioxia, formerly a part of Toshiba and now it is a spin-off. Kioxia is now worth more than the parent company, Toshiba.

Split-off

Split-off is the same as a spin-off with only one major difference and that is the shareholders of the parent company have the choice of buying the shares in the newly formed company. Split-offs are very uncommon and most companies use split-offs when divesting from assets.

The split-off is usually done when the company is divesting from an asset that is not a part of its core competency, but it is a really attractive asset. The shareholders of the company want to be allowed to have the option of buying the shares of the newly formed company.

For example, Viacom split off blockbuster in the 2000s.

Carve-out

Carve-out is the most complex type of divestiture. It involves multiple steps. In carve-out, the company which is the seller would list the asset on a stock exchange through an Initial public offering. This creates a new set of shareholders in the new entity which usually is not the same shareholders as in the seller company.

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The new shareholders are welcomed in a carve-out. In this way, carve-outs are different from spin-offs or split-offs. The usual practice is that the main seller company also holds significant equity in the newly created entity. This helps establish legitimacy for the new company while improving the shareholders’ confidence in the recently carve-out company.

Trade sale

A trade sale is the simplest form of Divestiture. It involves the company selling the part of the company to a buyer, which is another company or private equity nowadays. It does not involve any complex process like in Carve-out. It is quick and easy. Although, this kind of divestiture creates tax liability on the sale.

So, some financial costs are added when doing a trade sale. But, its quickness and no complexity allow it to be favored by many companies. This also allows for quick distribution of the profits from the sales to investors and shareholders.

Liquidation

Liquidation is defined as the sale of all the assets of a particular entity. Liquidation involves the haphazard sale of the asset. This usually happens during bankruptcy proceedings. This is also adopted as an exit strategy from a particular industry.

Why do companies do divestiture?

It has been found that the companies which do divestitures have outperformed those companies that do not do divestiture by a whopping 10-15%.

This is because the companies that are involved in divestiture are able to raise capital for new investment, return money back to the shareholders while also allowing it to streamline its operation and focusing on its own core competencies.

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The companies that do divestitures are also much more nimble and able to adjust better to the prevailing market conditions as compared to their peers which do not do divestitures.

Advantages of a Divestiture

The main advantages of divestitures are:

1) Unlocking value for the shareholders.

2) Creating new avenues for growth.

3) Streaming operations.

4) Reducing debt burdens.

5) Getting rid of unprofitable assets.

6) Focusing on the company’s main operations.

Disadvantages of a Divestiture

As there are benefits of divestiture, there are also some disadvantages of divestiture. The main disadvantages of divestiture are as follows:

1) Legal obligations: vendor contracts, partnership agreements, and supporting agreements raise a big and complex issue.

2) The cost structure of the company is negatively impacted.

3) Divestiture is far more complex than an acquisition.

Conclusion

Divestiture is great for companies to streamline their operation, focus on their core competencies, and also unlocking shareholder value. The company can also reduce the cost of its main operations if divestiture is handled well. The companies should focus on what type of divestiture suits them the best.

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