Spinning off some company assets a capital idea

By François M. de Visscher

Capital needs of a family and its business can clash, as CEO Dave Watkins learned at the last meeting of the 17 family shareholders of Watkins Construction Company in Dublin, Idaho. All but two wanted even more in dividends than the healthy payouts the successful company had already been making. "Why now," Dave asked himself, "when the company's core businesses are in full expansion and there's a first rate opportunity for tremendous growth with additional investment?"

Throughout the meeting, Dave kept thinking: "How can I meet the shareholders' demand for some additional liquidity without impairing the future growth of the business?" Immediately after the meeting, he began working with the company's financial and legal advisors to resolve the problem and report back to the board. The solution they hit on, after examining numerous alternatives, was to spin off and sell a division of the company.

Dave controls only 10 percent of the voting stock of the business, founded by his grandfather, Paul Sr., in the early twenties as a commercial construction business. Dave, an engineer, be came chairman and CEO in 1979 after his father, Paul Jr., retired. Over nearly 70 years, the business evolved into three divisions: the original commercial construction business, still representing 50 percent of revenues; construction of water treatment plants, contributing 30 percent of revenues even before potential expansion Dave is eager to pursue; and manufacture of construction products, accounting for 20 percent of revenues.

To find the optimal solution for the business and its shareholders, Watkins advisors started by determining the appropriate value for each division of the company and the value for the company as a whole.

Three sets of values were derived. The first valuation, assuming that Watkins was sold to an outside buyer, put the pre-tax equity value at $110 million, or $120 million market value minus $10 million in outstanding debt. The second valuation, assuming the company would go public, put the market value of the equity at a deeply-discounted $70 million, reflecting the mood on Wall Street. The third valuation, assuming each of Watkins' three segments were sold individually, put the pre-tax equity value at $130 million after subtracting debt. This was based on pretax values of $50 million for the construction division, $40 million for the water treatment plant business, and $50 million for the manufacturing division.

Selling stock to the public through an initial public offering was examined-and rejected. Though it would allow shareholders to liquify some (or all) of their holdings, this route also had a host of negatives: Watkins would be forced to issue public disclosure documents; family control, nurtured for decades, would be at risk; and the public market values were at a large discount to private values.

A second option-a family buyout in which the company redeemed all or part of their shares by using money raised through a debt offering-was also rejected. As a construction company, raising debt would severely restrict the company's bonding capability.

A third possibility-bringing in a joint venture partner to buy part of the equity interest of the family- was also problematic. With potential buyers fearful of a recession, they would be unlikely to pay a price that the advisors felt reflected the long-term value of the stake. In addition, Dave was not keen about bringing in "Big Daddy."

Sale of a stake in the company to employees through an employees' stock ownership plan was impractical, because the non-union payroll of Watkins was not large enough.

Finally, a solution was found. If a division of Watkins could be spun off, it could be sold separately for the benefit of the shareholders, without impairing the future growth of the remaining two divisions. There were additional advantages. Because the value of Watkins would be greater in pieces than as a whole, spinning off a division would allow shareholders to liquify at the highest possible value. Moreover, a spin-off and sale reduced taxes compared with a direct sale of the division: If the company sold the division, the company faced corporate taxes on the proceeds and the family members faced individual taxes on the dividends they received from the proceeds. But by spinning off the division as a separate company and distributing its shares directly to Watkins family shareholders (typically a tax- free transaction), the only taxes are those paid by family members when they sell their shares.

The manufacturing segment was the best candidate for the spin-off because it was the least dependent on the other two, and was therefore the most separable.

Dave was very intrigued by this possibility for several reasons. First, it would satisfy family shareholders' desire for additional liquidity. Second, it would allow the main business to remain independent and in family hands. Further, the company would not incur additional debt and financial charges which would limit future growth.

Following board and shareholder approval, the financial advisors marketed the newly spun-off manufacturing company. More than 30 U.S. and foreign companies expressed an interest. A successful auction among top bidders enabled the 17 shareholders to collect over $60 million before taxes while continuing as shareholders of Watkins Construction Co. with its two thriving divisions.

By permission of the publisher from Family Business (May, 1990). Family Business Publishing Company, http://www.familybusinessmagazine.com.