Definition Of Demerger
Demerger example can be quoted in different ways depending upon the type of the demerger. However, we need to discuss some basic definitions to get a better understanding.
A demerger meaning is termed as the transfer of business undertakings to another company. Therefore, the company that receives the undertakings is called the resulting company. While the source company that transfers it is known as the demerged company.
Types of demerger
Spinoff
When a line or division of a business of the conglomerate company divides into being a separate entity then this type of demerger example is known as a spinoff.
Demerger example: Let’s say company W has two lines of business mainly insurance and consultancy. However, if the company decides to separate its consultancy service business into a separate entity then it is termed a spinoff. Moreover, this must be noticed that both have separate legal entities, a new company would come into existence and the parent company does not dissolve.
Demerger example: WIPRO IT division in the 1980s
Split-up
In case of a split-up, a conglomerate company splits up into two separate companies each holding maybe one different line of business.
Demerger example: For split-up as a demerger example, company W separates into two new companies X and V with insurance and consultancy as a business. Moreover, this should be noticed that after company W would not exist.
Equity carve-out
This demerger example includes selling off a particular line of business to any external company/party. As result, the parent company might sell its portion of its equity to a strategic investor or third party. Therefore, this type of demerger is known as equity carve-out.
Note:
Apart from the above explanations, there are a few points that must be kept in mind.
- Firstly, splits and spinoffs do not include a sale to a third party. Moreover, they do not constitute infusion of cash while equity carve-out does.
- Secondly, company W remains owned by the same entity, whereas in carved-out, the company becomes a part of the third party.
This explains that it is no longer a part of the parent company as an independent unit.
Advantages of Demerger
Accountability of Management
After separating or splitting off, each company has its management system which further makes them independent from not using other earnings. The management of every company becomes the responsibility of their financial results and position. One cannot control the decision or the operations of the other. It gives the right for their investments or to raise funds on their account from the market.
Aim on the Core Competency
Conglomerate companies often lose to their competitors since they focus on diverse business operations which need different competencies. Where the competitors focus on one line of business, the conglomerate takes into account different areas. However, the modern era talks about specialization and companies have to follow them to focus on core competencies. As result, the demerger example is the one used as the major tool during the process.
Increment of Market Capitalization
Demergers example can be extensively used to make the stock market value. Investors have visibility over the actions and cash flow which has been split-up which in turn improves their investing decisions. Therefore, spinning into separate entities creates an increment in the market capitalization as a whole.
Disadvantages of Demerger
A Decrease in Economies of Scale
One of the disadvantages of demerger example is that the company loses its economies of scale. That was enjoyed due to the large size company and does not prevail during the process of split-up.
Demerger example: If two friends used to live together and then decide to split-up then their expenses would increase comparatively.
Employees problem
The internal factors also get affected by the demerger example i.e employees. When the split-up takes place then the employees also have to split. That explains few in the parent company and the rest in the newly formed company. However, if the shift is according to their consent then it works. But if they are ordered then the employees might feel demotivated or wish to leave the job.
The procedure for above can, however, lead to negotiation between the two which leads to different strategies explained in radpac model.
Clashing of Interests
A conflict among the recognition or reputation of top-level management may occur since a split-up increase the number of top-level managers. The decisions or views might contradict which can lead to delay in work or detrimental to the performance of the organisation.
Why Companies need a Demerger?
- A unit is Loss-making
- Focus on core business
- Value for shareholders
- A single-wing is Self Sufficient
- To list the subsequent company
- Company is debt-laden
- Tax implications
- Stamp duty
A unit is Loss-making
- When a single loss-making unit erodes the valuation especially of the public listed company than it creates a direct impact on the shares of the company.
Demerger example: CESC Ltd had four demerged units namely generation, power, retail, distribution and other ventures. Since the retail unit incurred losses. They did not want the overall valuation to get affected. As a result, the demerger helped the company to get better valuated.
- Even a single loss-making unit reflects in annual reports which in turn affects the investment of the company.
- As a result, companies choose a demerger example and separate that one unit. This method not only valuates the company but also helps to give specialized attention to the unit of loss-making.
- A company can, however, sell the loss-making unit, find a partner or infuse the capital by finding private equity funds.
Focus on core business
- A company has a different line of business that demand various investments, human resources etc. However, few represent the core business of the company and they derive most of their income into that respective business.
- As a result, to find out the true potential the companies consider a demerger example. The firm demerges the potential units or the core business to give a special focus.
- Furthermore, the demerged business takes the benefit of specialization and leadership which streamlines the business.
Demerged example: RCOM who demerges to focus on core assets and formed reliance property
Value for shareholders
- Shareholders benefit from the demerged companies by holding shares separately as well as together as a whole since they receive shares on their holdings in the parent company.
- From the records, this has been noted that the listed demerged companies created a valuable return for their shareholders/investors.
Demerger example: Crompton Geaves which separated Crompton greaves consumer electrical ( a consumer product business) and resulted in a 57% return to its investors.
A single-wing is self-sufficient
- If a particular undertaking depicts growth in a very short period, then the company may opt to demerge that business to focus on strategy and add expertise to gain potential.
Demerger example: Mario Ltd skincare business got demerged due to the group interests from Mario’s core business which is FMCG. The company wanted to raise investments and shareholder pattern.
To list the subsequent company
- According to the regulations in the Securities Contract(Regulation) Rules, it is stated that if the demerged company wish to get listed without following the process of IPO ( Initial Public Offering) then this can be done by straightly applying in the SEBI( Securities Exchange Board of India).
- The demerger, however, becomes a way of getting the undertaking listed without being indulged in a long process.
Company is debt-laden
- A demerger example can also be set when the company wants a resolution from the process of Insolvency or Bankruptcy Code.
Demerger example: Jindal Stainless Ltd demerged its three business namely power, domestic steel and international steel to leverage its idle capacity. The demerger distributed its debt worth 8580 crores and opened the doors to independently raise funds.
Tax implications
- According to the tax implications, if a demerger fulfils the conditions under the IT Act, then the translation of demerger is tax neutral.
- Firstly, by section 47 in the IT act, any capital asset transfer of a demerged company to an Indian company is not termed as a transfer. Therefore the transaction does not count under capital gains.
- Secondly, by section 2(22), distribution to shareholders of a demerged undertaking pursuant by the resulting company is not termed as a dividend.
- Thirdly, by section 72A, unabsorbed depreciation and loss can be transferred by the demerged company to a resulting company in case the undertakings are directly related.
Stamp duty
- Taking a demerger example of Karnataka, since different states have different stamp duty imposition.
- The Karnataka stamp duty states the demerger stamp duty to be 3 per cent referring to the transferor company on the market value of the property being transferred to the resulting company.