In the life of a typical business, things are (relatively) straightforward in terms of company structure. You may have a handful of shareholders, some or all of whom are directors, and a single class of shares. As your business starts to grow, you’ll perhaps onboard more investors, maybe look to acquire a new company to expand your operations, and further down the line, you may decide to exit the business by selling it on.
So far, so simple.
There are, however, circumstances where splitting up a company in the middle of its growth trajectory may be a good option, even if at first this seems counterintuitive. In this guide, we examine the kinds of situations where this course of action, known as a ‘demerger’, could be right for your business, give you an overview of the ways you can achieve this, and the consequences of doing so.
- What is a demerger?
- When and why should you consider splitting a company?
- What are the advantages of a demerger?
- What are the disadvantages of a demerger?
- What kinds of issues come up in demergers?
- Spin-offs and spin-outs
- How to demerge a company
- Employee shares and demergers
What is a demerger?
Demergers are where a business operating as a single company splits off part of its business, putting it into a different company or some other type of legal entity.
There are many reasons why you might want to demerge, but the most common is where shareholders feel they can increase the capital value of their holdings as well as overall profits. If a business would perform better as two companies rather than one, then the aggregate value of the two new companies (and hence the value of the shares) will usually be more than the value of the original single company.
A second reason that companies demerge is the ‘divorce’ scenario – maybe the founders or shareholders have fallen out or simply want to part. Or, this is an acquisition or joint venture scenario and the project’s finished or run out of steam, and the participants want to go their separate ways.
When and why should you consider splitting a company?
Here are some examples of where splitting your business into separate units might work for you. Please take expert legal advice if you feel any of these examples are a good fit:
- You want to re-focus your business because it’s become too large or diverse, and dividing it up will mean that each part of the organisation can concentrate on its core competencies, becoming more productive as a result.
- Your business is serving distinct market sectors, and you feel that these would be best exploited under different management.
- You’ve got a niche product or service and would like to spin this off into a separate enterprise.
- You and your management team feel that individuals or teams would perform better if they were running different companies, accountable for their own results, generating their own profits and raising separate funding.
- You feel that dividing up your business into separate units would increase shareholder value and market capitalisation for the group as a whole.
- You’d like to sell part of your business and want to divide it up in preparation for the sale.
- Different parts of your business have different capital requirements, and it would be more efficient to divide them up so you can allocate funds according to each company’s needs.
- Part of your business is highly regulated and you feel that this is holding back the rest of the business.
- You’re fending off a hostile takeover and want to discourage bidders by hiving off desirable parts of the business to shield them from corporate predators.
- Yours is a joint venture (JV) or other type of partnership that’s no longer working as anticipated or the project’s simply finished.
What are the advantages of a demerger?
One of the principal reasons that companies demerge is to unlock additional value for shareholders. After a demerger, the shareholders are usually issued with shares in the new companies created. If the transaction delivers the promised benefits, profits will grow and share prices in both resulting companies will increase as a result.
One of the reasons profits might increase is that different management teams take ownership of their own profit and loss, without interference from the main board. In addition, since individual teams’ accountability for results is clearer, they may be more highly incentivised to deliver on the bottom line. Finally, a split in management teams can allow executives to specialise in their own area of expertise or brand, think Severn Trent Water and Biffa’s waste management activities.
Finally, in a demerger, each new company can raise its own funds, rather than being dependent on budgets allocated centrally.
Where you’re dealing with the dissolution of a JV an acquisition that hasn’t worked out, the obvious upside is that each party cuts their losses and is free to continue their own distinct businesses.
What are the disadvantages of a demerger?
While demergers can lead to increased profitability, there are some downsides.
Firstly, demergers can be costly as they must 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.
What kinds of issues come up in demergers?
If you’re thinking of a demerger, there are certain aspects of your business you’ll need to unpick to separate the various component parts. Here are the principal issues that tend to come up:
If your company owns valuable assets like proprietary software, trade names, trademarks and patents (intellectual property rights or IPR), what will happen when the company splits? Will the new company need to have IPR transferred to it, and how will work, legally? Will there be costs involved, and will the new company pay a fee to the legacy company for the right to use these assets.
In addition, you’ll need to think about intangible assets like goodwill, and how this will appear in the balance sheet of the new company.
How will customers and suppliers view the change?
Although you may only see upsides to the potential deal, your stakeholders like suppliers and customers may feel unsettled by the change. You’ll need to think about whether they’ll be prepared to deal with the new company, and make sure your customers are supported through the change. There can sometimes be legal issues in transferring supply and purchase contracts so be sure to take advice to make sure things go smoothly.
Banking arrangements are a good example of where a demerger can cause issues. Our advice is to involve lenders and investors early on so that these can be handled smoothly. Equally, you’ll probably need to involve your landlord if you’re leasing premises that the demerged company will need to occupy.
When you split up or demerge a company, the existing employees may move to the new entity, or a change in their employment terms may result. Usually, the transaction is affected by the Transfer of Undertakings (Protection of Employment) Regulations or TUPE.
If your demerger falls under the scope of TUPE, then employees have the right to be consulted, and to transfer to the new business under their existing terms and conditions of employment. If certain employees won’t be required in the new business, then the demerger can be a valid reason for making them redundant.
Demergers can also affect employee share option schemes, either because:
- Employee options become exercisable as a result of the corporate transactions.
- The share option agreement terms give employees a right to options in shares of the new business.
- Terms of a share option agreement or contracts of employment are triggered or otherwise impacted by the deal.
Demergers, if not handled carefully, can lead to 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.
A demerger will not normally attract a charge to VAT. However, the new organisation, if its trading activities take it over the VAT threshold, will need a separate registration for VAT from its parent.
Tax specialists, corporate and property lawyers will be essential members of your demerger team!
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If you’d like to know more about Mergers or Acquisitions or would like further information about buying or selling a company contact our team of expert M&A lawyers.
Spin-offs and spin-outs
In a ‘spin-off’ or ‘spin-out’, an organisation separates part of its activities into a separate business, with its own employees and a separate management team. The owners of the ‘parent’ entity now have a share in two separate organisations. If the parent and the new entity are both companies, the original shareholders may receive 100% of the shares of the spin-out, or they may own part of the shares, with the parent company owning the remainder.
The advantage of a spin-out is that the new organisation can develop its own branding and reputation entirely separate from that of its parent. This can be helpful in a scenario where the parent is a non-profit-making organisation such as a local authority or educational institution that wants the freedom to develop commercial, trading activities and offer more flexible terms and conditions of employment to staff.
The parent organisation can continue to support the spin-off by providing working capital, being a customer of the subsidiary, providing facilities such as an incubation space and access to ICT systems, and providing other help such as accounting and legal services.
How to demerge a company
If you are considering a demerger, you have three potential options that are efficient for tax purposes:
- ‘statutory demerger’
- ‘reduction of capital demerger’
- ‘liquidation demerger’
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.
A so-called ‘statutory demerger’ is a term used to describe a situation where a new company is created, and shares are transferred to the shareholders of the parent company.
Either the parent company makes a direct dividend of the new shares to its shareholders, or it transfers the new subsidiary to a company, with that company issuing shares in the newco to the distributing company’s shareholders in return for the distribution, known as a ‘three-cornered’ demerger.
A direct demerger
In terms of tax, the demerger must meet the following conditions:
- The companies involved must be trading entities that are UK or EU state resident for tax purposes.
- The demerger must be carried out in order to benefit trading activities of the group.
- The parent company must have enough distributable profits to effect the transaction.
- The demerger must not be done in order to avoid tax.
- Any assets distributed must reflect the percentage shareholding that is acquired in the newco.
If these conditions are met, and the transaction is carefully structured then:
- The distribution of shares in newco to the shareholders of the parent company will be exempt from income tax.
- The shareholders won’t be liable to capital gains tax as any gains are rolled over into the new shares. The company won’t be liable for CGT in certain circumstances.
- The transaction won’t attract stamp duty.
- No VAT will be chargeable.
- The parent company won’t have a chargeable gain on its disposal of the shares if the substantial shareholding exemption applies (the parent had a substantial shareholding in the newco before the transfer out).
- No de-grouping charge.
A three-cornered demerger
Again, subject to appropriate structuring and provided the conditions are met:
- For shareholders, the distribution is exempt from income tax.
- No CGT for the shareholders or the parent company.
- No stamp duty.
- No VAT.
- No de-grouping charge.
You can apply to HMRC to clear the transaction for tax purposes in advance of the arrangement being put into place to ensure that any statutory demerger is an exempt distribution and that there are no chargeable payments for CGT. HMRC has 30 days to give or deny clearance, or to ask for additional information.
Reduction of capital demerger
You can also divide up a business by reducing the share capital of the parent company. A trading business is transferred to new shareholders or new holding companies owned by those shareholders with a corresponding reduction in capital of the transferring company.
A reduction of capital demerger can be useful if:
- You can’t use a statutory demerger or liquidation demerger.
- There are non-member state parties.
- The entities aren’t trading companies.
- You don’t want to liquidate any of the companies in the mix.
- You are planning to float or sell certain members of the group.
- There are not enough distributable reserves in the distributing company.
In a liquidation demerger, a business is liquidated, and its assets transferred to new companies. Shares in the new entities are issued to the liquidating company’s original shareholders in return for their rights on the winding up.
You would consider using this kind of demerger where you and your fellow shareholders have different ideas how a business should be run in the future and you’d like to divide it up so that each member can go its own way.
The disadvantage of a liquidation demerger is that existing goodwill of the original company is dissipated as a result of the transaction. In addition, it may be cumbersome to unpick the trading arrangements, assets and liabilities of the liquidating company in order to make the necessary arrangement work in practice.
If the transaction is properly structured, then tax reliefs and exemptions are available for a liquidation demerger, and prior clearance can be obtained from HMRC.
Employee shares and demergers
During the process of splitting a company, the shareholders of the parent company usually receive a dividend of shares, or receive a return on capital. The result of this is that parent company shares are worth less because the organisation has become devalued in some way.
The net effect of this is that share options and share awards held in employee share schemes can be impacted as a result of a demerger transaction, and you should consider the impact on your staff if you have plans to restructure in this way.
As employees who only hold share options are not yet shareholders, they won’t be entitled to receive new shares as a result of the demerger. Furthermore, in most cases, HMRC rules for tax-advantaged employee share option schemes mean that the value of options can’t be adjusted to take account of the reduction in the value of the underlying shares.
For non tax-advantaged schemes, the terms of the share option plan may allow for an adjustment in options or specific awards in the case of a demerger.
Employees who do own shares can participate in demerger arrangements just like other shareholders, receiving new shares or a return of capital.