Although several have worked out successfully, a significant number of “spin-off investments” I’ve made or have witnessed over the years have disappointed. Through the colored lenses of a VC, here’s what I’ve learned about investing in spin-offs.
For clarification, in this piece I am referring to investing in the entities which result from corporate actions of carving out and selling an existing activity or business unit. Sometimes the terms spin-off and spin-out are used interchangeably in the market. In contrast, I am not referring to investments which entail forming a new business venture around a specific technology developed inside a company/research organization which is subsequently released or “spun-out” into a newly-created independent company. Nor am I referring to the straightforward seed, early-stage, and growth financing investments which form the bulk of my portfolio historically.
The financial appeal
On paper, investing in spin-offs can appear quite attractive for a venture investor. The seller of the business being spun-off is usually motivated for strategic reasons to divest the activity, and hence, valuation is a secondary concern to them. This can create an opportunity to acquire the business unit at a relative financial bargain. Investors generally like to buy low and sell high.
Additionally, the activity to be divested is probably not in its infancy – if it were, the mother corporation could simply cease it with minimal cost and effort. More likely, the activity is revenue-generating, perhaps even profitable. It has a customer base, some degree of demonstrated product/market fit, and a personnel structure in place.
Accordingly, the combination of low price and low risk can make for a compelling investment case. On paper.
The Hurdles
Spin-off investing requires an opportunistic approach as opposed to a more thoughtful, theme- or thesis-based approach to investing. The variables affecting which corporation will decide to divest, in which sector, and at what time are complex and difficult to incorporate into a strategic investment plan.
Sometimes a business unit to be divested is highly dependent on the mother corporation for revenue, technology platform, or other infrastructure. Properly delineating and mitigating these dependencies is key for a successful spin-off. The untangling process can be tricky.
Similarly, revenue dependencies can manifest themselves both explicitly and implicitly. In the explicit case, the parent company represents the dominant customer. In the implicit case, the newly unbundled activity becomes harder to attract new customers as a standalone product or without the legitimacy of the large group behind it.
Furthermore, the business unit or activity being divested is being divested for a reason. Reasons that are intrinsic to the selling corporation (such as a shift in strategy, internal problems, etc.) may be palatable.
However, if the divestment is motivated for reasons directly related to the fortunes of the activity being sold — such as a distressed business, a declining market, a technology or personnel problem, etc. — then the venture investor in the spin-off will need to overcome these problems to generate a desirable return. Sufficiently understanding the true reasons brings me to my next point…
Inevitably, an information asymmetry exists between Seller and Investor. The selling corporation will be intimately more familiar with the activity to be divested than the investor. Even with full cooperation, transparency, and extensive due diligence, some forms of tacit knowledge about the activity can only be learned over time and with experience of operating the business.
The Inconvenient Truths
Investing in spin-offs is somewhat inconsistent with investing in innovation. When it comes to innovation, starting with a clean slate is almost always more effective than refurbishing a legacy activity.
Perhaps the most challenging aspect of turning a corporate spin-off into a successful standalone company is the requirement for a transformation in company culture.
Key employees must transform into entrepreneurs.
They must become resourceful — able and willing to solve problems themselves — whereas before they had a department that would handle that.
They must become autonomous whereas before they had a hierarchy to respect. Act first and apologize when necessary, rather than ask for permission before doing anything.
They must become apolitical, whereas before they had developed reflexes to avoid potential “career-limiting moves.”
They must become painfully more accountable for the company performance.
They must relinquish many of the creature comforts to which they had previously become accustomed in a larger corporation (stable fixed salary, business class, personal secretary, company car, whatever…)
Private equity / buyout funds could view a spin-off opportunity quite differently, because even a stagnating or declining business could support buyout debt financing if near-term cash flows remain relatively predictable. However, venture funds and growth-oriented equity investors do not frequently pursue a strategy of spin-off investing for the above reasons.
