Discussing Strategic Spin-offs and Rights Offerings to Existing Shareholders

We have been more frequently discussing strategic spin-offs with our micro- and small-cap clients. Sometimes those discussions involve spin-offs via a rights offering. While these clients have generally been engaged in the life sciences industry and many are located outside the United States, in all instances they are considering, like so many other privately held companies, a number of alternatives to eventually become independent, self-sustaining publicly traded companies in the United States.

Among the alternatives these clients are considering include (i) conducting a so-called mini-IPO under Regulation A+ (Title IV of the JOBS Act) and (ii) combining with and taking control of an already publicly traded company in a reverse merger transaction.

Another option involves a strategic spin-off. With these transactions, a privately held company issues its shares to the publicly traded company as part of licensing or distribution transaction, or the privately held company has otherwise been incubated by the publicly traded company and has issued shares to the publicly traded “parent” company as a wholly or partly owned subsidiary. Then, the shares are spun-off to the shareholders of the publicly traded company, creating a wide shareholder base for the privately held company in the United States.

The first step of a strategic spin-off is to structure and reach agreement with the publicly traded company as to the number of shares to be issued to that company. For example, if the publicly traded company has approximately 100 million outstanding shares of common stock, it may approve a distribution of 1.0 million company shares. As a result, when those shares are distributed to the publicly traded company's shareholders, each shareholder would receive one spin-off company share for every 100 publicly traded company shares held by such shareholder. The publicly traded shareholders should own approximately 10% of the outstanding shares of the spin-off company following the distribution, with the original spin-off company shareholders owning the remaining 90% of outstanding shares.

As part of this transaction, a licensing, distribution, joint venture or shareholder agreement with the publicly traded company will be required to account for the consideration of the initial privately held company stock issuance.

Another consideration is whether the spin-off company needs to raise financing in the transaction in order to launch and sustain its business. For new money investors to receive tradeable shares in the company, the publicly traded company can issue to investors a series of preferred stock. The terms of such preferred stock can, for example, provide that, upon the dividend distribution/spin-off to the publicly traded company shareholders, each of the preferred shareholders would receive 100 spin-off company shares for every one share dividend to the publicly traded company’s common stockholders, with the preferred stock eliminated immediately following the dividend distribution. The issuance price for this preferred stock can be priced competitively and can be applied to offset the publicly traded company’s expenses in connection with this transaction.

Alternatively, a strategic spin-off of the privately held company can be accomplished by means of a rights offering, where the publicly traded company distributes to its shareholders (free of charge) subscription rights to buy shares in the spin-off company. In this way, the spin-off provides shareholder-investors the first opportunity to buy into a business with the characteristics they want by exercising their rights and thereby raising funds for the spin-off company to grow as an independent entity. Another benefit of this format is the rights offering’s oversubscription privilege. If a shareholder purchases all of the spin-off shares available to it pursuant to the basic subscription rights distributed on a pro rata basis to all holders, the shareholder may also choose to purchase a portion of any spin-off shares that other holders of subscription rights do not purchase through the exercise of their basic subscription rights.

Once the transaction structure is agreed to by the companies, the next step is to prepare the necessary SEC documentation. The spin-off company will have to file with the SEC a Form S-1 registration statement (for domestic companies) or a Form F-1 registration statement (for foreign private issuers registering offerings in the United States), to cover those shares to be ultimately dividend to the shareholders of the publicly traded company. The registration statement will set forth information about the spin-off company, its organization, business and properties and the background of the spin-off transaction, to be prepared by counsels for both the publicly traded company and the spin-off company. The publicly traded company will be acting as a statutory underwriter and will need to carefully review, through its management and counsel, the disclosure relating to the spin-off company. The spin-off company will need to include its historical and pro forma financial statements in the registration statement and file its material contracts as exhibits to the registration statement. To the extent the spin-off company does not wish to make public certain terms in its material contracts to be filed with the SEC, the company can make a confidential treatment request with the SEC relating to any sensitive business contract terms. Counsel will work with the company to determine if a confidential treatment request should be submitted.

Another part of the overall plan is to develop an investor relations strategy to increase market awareness of the spin-off company, to develop a strong investor base and to educate market makers. An investor relations firm could coordinate presentations during which the spin-off company will be able to meet with potential investors and market makers. There are many appropriate firms that perform this investor relations service for micro- and small-cap companies. An effective investor relations strategy for the spin-off company is vital given the absence of IPO marketing efforts.

The entire process normally can be completed in approximately 120 days. The time it takes to complete the process is heavily dependent on the scope of the SEC review and the resulting comments and turnaround time for amended filings.

The strategic spin-off has several advantages as compared to a reverse merger and a direct IPO. The primary advantage over a reverse merger is that there are no unknown liabilities. The spin-off company becomes a U.S. publicly reporting company without inheriting the liabilities of the reverse merger “shell company,” which may not be entirely apparent. Many shell companies either have prior failed businesses or are not in compliance with the reporting requirements under the federal securities laws. Additionally, though reverse mergers have become common, they are often not respected by mainstream investment banking firms as a legitimate means to effect public offerings and often invite suspicion and heightened scrutiny from securities regulators.

A spin-off may be more effective in creating a positive company image through investor presentations and conference calls than the potential uncertainty of completing an IPO in the challenging capital markets for micro- and small-cap companies or a reverse merger with a publicly traded shell company.

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