Spin Outs . . .

occur when an established company transfers, or ‘spins out’, a technology or business activity to a company that was established for the purpose of acquiring the technology or business activity. Often the technology transfer consists of the exclusive right to use the company’s core patents and know how in business markets the company does not serve. A company with medical practice scheduling software, for example, might spin out the rights to use its software in transportation industries to a management group with transportation experience and financial backing. The same company might have a business unit unrelated to its medical scheduling software business that it chooses to spin out. Its reasons for doing this might include the lack of internal resources to properly pursue the market, its lack of expertise in the target market, or its desire to focus its resources on other technologies or products.

Spin outs are usually structured like leveraged buyouts. Often an interested management group, frequently from within the parent company, identifies the proposed technology or business unit, obtains company approval to seek funding for a transfer, and, ultimately, creates the new company and negotiates the transfer of the technology or business activity. The company that spins out the technology or business activity typically obtains one or more of the following compensations in return for the assets it contributes to the new company

• stock in the new company,
  

• royalties from products that use the transferred technology,
  

• cash or deferred cash payments, or
  

• rights within the contributing company’s markets to technology improvements developed by the new company.

It is not uncommon for the contributing company to obtain a seat on the new company’s board of directors or preferential contract rights.

Spin outs require extensive planning and, usually, a financial commitment from the new management as well as the raising of private capital from venture capitalists and banks. Managements of spin outs also have the sensitive task of building consensus for the spin out and raising money for their new business while they remain employed by the contributing company. Internal jealousies and politics of the contributing company often create obstacles to completing a deal on acceptable terms.

The typical steps in completing a spin out, many of which overlap, are as follows:

• Identify the opportunity. Internal management members closest to the opportunity often see the opportunity first, put together the management team to lead the deal, and conduct preliminary due diligence and market research to begin quantifying the extent and reality of the opportunity.
  

• Assemble advisors. It is important to obtain competent legal advice early in the process. The spin out management team must be sensitive to its fiduciary and trade secret obligations to the contributing company throughout the process in order to avoid unnecessary exposure to legal liability. Management’s attorneys can help the team determine the optimal timing for alerting the company to management’s spin out plan, the limits on management’s ability to disclose company information, and the best method for obtaining company approval to pursue the spin out. Counsel can also advise on structure and timing issues relating to the formation of the new company that can minimize management’s exposure to tax liabilities from the spin out.
  

• Obtain preliminary indications of interest. Two activities need to proceed here on parallel paths. First, management must determine the contributing company’s interest in transferring the technology or business activity and the general terms on which such a transfer is possible. Second, management must identify potential funding sources to complete the acquisition and support the new company’s future operations. Those funding sources can sometimes include the contributing company itself.
  

• Obtain a letter of intent. Through a process of persuasion and diligence, the management team must obtain a letter of intent or other formal commitment from the contributing company that spells out the general terms under which the company is willing to make the transfer to a management-backed company. This letter of intent provides management with a period of time during which the contributing company agrees not to pursue alternative transactions for the technology or business activity. Although often difficult to obtain, this formal commitment is critical to the process of completing a spin out because it legitimizes the management’s efforts with outside funding sources and makes it possible to have serious discussions of price and terms for financing. As a practical matter, however, preliminary discussions with funding sources, investment bankers, attorneys and accountants often precede the signing of a letter of intent if for no other reason than for management to get a feel for what terms and conditions will likely be acceptable to the funding sources.
  

• Obtain funding commitment. Once a company letter of intent is obtained, management needs to obtain commitments from lenders and venture capital providers. This process often results in additional negotiations with the contributing company. Management must negotiate deals that create incentives for the contributing company, outside investors and management. Sometimes, preliminary indications of intent from outside investors are received before the signing of a letter of intent with the contributing company.
  

• Complete business planning activities. All the issues of operating the business after the spin out should be considered and planned for. Additional managers and employees should be identified and space and facility needs addressed.
  

• Close the transaction. Extensive additional negotiation and document preparation follows as the parties prepare for the actual closing. The transfer of the technology or business activity from the contributing company, the investment by management in the new company and the funding by a bank or venture capitalist typically occur simultaneously. The resulting new company is ready to open its doors for business.

There are no hard and fast guidelines about the amount or nature of the compensation paid to the contributing company for its contribution or for the amount of stock or other rights given to the venture capital investor in a spin out. Because management is typically perceived as being critical to the success of the new company, however, it is generally true that new investors typically believe that management should be motivated through the ownership of a significant position in the stock of the new company. Nonetheless, management ownership interests in a new spin out company can vary widely, as can the form and amount of consideration flowing to the contributing company.

While all situations are different - company size alone can make a 5% interest in one company worth significantly more than an 10% interest in another - one veteran venture capitalist and investment banker recently summarized his experience by stating that in most situations the management group receives between 12% and 20% of the equity of the new company for putting together the deal, investing their own funds, and running the company with up to another 10% being made available in a stock plan to motivate other key employees. Whether management falls on the high or low side of this range depends on their perceived importance to the deal, the size of the deal, and other factors.

Of the 12% to 20%, as much as half or more may go to the head of the management team with the rest going to the remainder of the founding managers. A significant portion of managements’ stock may be in securities that vest over time to insure that the management team stays with the new company. Outside equity investors and sometimes the contributing company usually expect to receive convertible preferred stock. Management usually receives common stock, at least for the portion of their equity investment that is not issued for equivalent cash investment. See: Convertible Preferred Stock, Convertible Securities, Earnouts, Earnups, Joint Ventures, LBO (Leveraged Buyout), Letter Agreements, Letters of Intent, MBO (Management Buyout), Negotiation, Venture Capital Deal Structures.