Demergers were an American invention of the 1920’s and became common since the 1950’s. The corporate demerger is one of the several ways through which a firm may divest a division and improve its focus. A demerger is a pro-rata distribution of the shares of a firm‘s subsidiary to the shareholders of the firm. There is neither a dilution of equity nor a transfer of ownership from the current shareholders. After the distribution, the operations, and management of the subsidiary or one of the division are separated from those of the parent. Demerger constitutes a unique mode of divesting assets but not the economic interest in the divested assets since they do not involve any cash transaction. Thus, they cannot be motivated by a desire to generate cash to pay off debt, as is often the case with other modes of divestitures.

There are two approaches to business: one, spread your risks by not keeping all your eggs in the same basket or, two, concentrate the risk by putting all your eggs in one basket, and then guard that basket like your life depended on it. The advantages and disadvantages of the two approaches are: in the first approach, risks and rewards are lower. You tend to underperform the best competitors but stay off the bottom in terms of overall results. In the case of the latter, you either do very well or fall out of the race. Both approaches can be justified.

Breaking up can be simplified if all the stages of it are carefully taken care of. We are discussing some of the critical points on which success of demerger depends.

A demerger is a pro-rata distribution of the shares of a firm‘s subsidiary to the shareholders of the firm

Need & right time for demerger:

In practice, what happens after companies grow to a certain size after diversification is that they build large bureaucracies and lose focus on what is important for the individual business. For example, a small but profitable business with high margins will be overloaded with corporate overheads when large, low-margin businesses will be the reason for those high overheads in the first place. The ideal thing would be to give less money to the big business and invest in the smaller one, but the human preference will be to give the bigger businesses more of it despite lower efficiencies and justifications found for the same (number of dependent jobs, suppliers, etc). This sends overall results plummeting from high to average or below for the company as a whole. In India, typically we have favoured the second approach, of diversification rather than the focus.

Main reason for demerger is, Companies often have to downsize or contract their operations in certain circumstances such as when a division of the company is performing poorly or simply because it no longer fits into the company‘s plans or give effect to rationalization or specialization in the manufacturing process.

The decision to demerge and point at which to be demerged is very critical. For breaking up company should not show downsizing trends or ‘not so good going’ divisions. Most of the time it is beneficial for companies involved in a number of business activities to demerge when they are at the peak of growth of the company or at the starting of maturity stage of the company. The main objective behind demerging is to offer the best potential to the business, utilisation of faster and more efficiently the strengths of their customers, more crystallized strategy development etc. For Example –

Recently Hewlett-Packard which is popularly known as HP got demerged into two new publicly traded companies

  • One comprising HP’s market-leading enterprise technology infrastructure, software and services businesses, which will do business as Hewlett-Packard Enterprise, and
  • One that will comprise HP’s market-leading personal systems and printing businesses, which will do business as HP Inc. and retain the current logo.

Experts said :

HP lost much of its sheen as the industry shifted to a new era of cloud and mobility. Sluggish in evolving with the market, it fell behind fleet-footed rivals like Lenovo, Amazon, IBM and Apple.”

“Even the decision makers within HP were quite separate for the printer/laptops as against the data centre equipment and services,”

“The de-merger could have happened five years ago. Today, Lenovo has captured a large share of the global market. HP could have prevented this if it had split earlier”

The time to demerge is the deciding factor for the success of demerger. In the above case, from the experts’ comments, we can conclude that HP would have benefitted over its competitors like Lenovo if it had demerged earlier. The move was long pending and gave limited benefits to HP.

We can also say that companies do not have to demerge only because of a low profit making division or high-cost division. Sometimes it is justifiable for profit making companies to demerge for enhancing growth or increasing the success of the company or invite partners or attract right kind of talent at the industry related compensation.

Shareholders’ Wealth:

Demerger is mostly a win-win deal for stock investors, as it generally leads to a big jump in valuations for the separated entities. Normally shareholders gain on demerger as they get ownership in resulting company as well as demerged company.

Let us study the case of Zee Entertainment Enterprise Limited, demerged on 22nd November 2006.Under the scheme of demerger shareholders of Zee Entertainment, Enterprise Limited received –

  • 45 equity shares of Zee News Limited (First Resulting Company)for every 100 shares held by them in the Company.
  • And, 50 equity shares of Wire and Wireless India Limited(SecondResulting Company) was to be issued in lieu of every 100 equity shares held by the members of the Company.
  • Let us assume a shareholder is holding 100 shares in Zee Entertainment Enterprise Limited, then his wealth will be as follows-
Shareholder’s Wealth pre-demerger :
Company Equity Shares Average pre-demerger Share Price Shareholders’ Wealth
Zee Entertainment Enterprise Limited 100 Rs.291.72 Rs.29,172
Shareholder’s Wealth Post Demerger:
Company Equity Shares Average pre-demerger Share Price Shareholders’ Wealth
Zee Entertainment Enterprise Limited 100 Rs.277.09 Rs.27,709
Zee News Limited 50 Rs.89.11 Rs.4,455.50
Wire and Wireless India Limited 45 Rs.40.32 Rs.1,814.4
Total Shareholders’ Wealth after demerger Rs.33,978.90

Source: Research paper of Macrothink Institute

From the tables above we can see that there has been an increase in the shareholders’ wealth of Television Eighteen India Limited after demerger by 16.48%.

When Gulf Oil Corporation Limited (GOCL) demerged its lubricant business to Gulf Oil Lubricants India Limited (GOLIL), shareholders allotted

  • 1 share (Rs.2) in Gulf Oil Lubricants India (GOLIL) for every 2 shares held (Rs.2) in GOCL.
  • Simultaneously, capital reduction and reorganisation in GOCL has been done by allotting 1 new GOCL share (Rs.2) for every two old GOCL shares.
  • Which means that if the shareholder was holding 100 shares of Gulf Oil Corporation of the face value of Rs. 2 each, the shareholder would have got hold 50 shares of Rs 2 each of GOCL and 50 shares of Rs. 2 each of GOLIL post the demerger.
  • Therefore, prima facie we can say that shareholders were at no profit no loss position.
  • But if one look at the market price of shares pre and post demerger, minimum appreciation is 100%.

Therefore in most of the cases shareholders gain and in some cases value creation is substantial as it happened in the case of celebrated demerger in the case of RELIANCE INDUSTRIES LTD. In other cases like Television Eighteen India Limited, Camlin Limited etc. shareholders have gained substantially.

Income Tax Aspect:

Income Tax Act, 1961 also plays a major role in creating shareholders’ wealth. Company demerging should satisfy conditions under Section 2(19AA) of the Income Tax Act, 1961.Under Section 47 of the Act, any shares transferred by Resulting Company to the shareholders are not regarded as transfer & not liable to capital gains. So tax compliance demerger can be executed almost without any cost except under stamp act.

Employees:

Corporate restructuring exercises (including demergers) have deep psychological scars on employees. While the Demerger mandate is always clear, most of the time to grow the business in a completely independent landscape it is the mind shift of employees that needs to be plotted carefully before the restructuring takes place. Employees can be concerned about their roles in view of the talent movement that will take place. The best way to deal with this scenario is through communication. This means the HR has to be taken into confidence early on in the process so that it can chalk out a communication roadmap for the people who stay back, for the people who move on, and for those who must go.

In 2012, Pantaloon Retail India and Future Ventures India decided to demerge their lifestyle fashion businesses into Future Fashion. Given the speed at which the company was restructuring (it further demerged its businesses in fashion, hypermarket, and food) even altering its business model time and again, it was natural for the employees to feel uneasy. Looking at the growing restlessness and uncertainty among employees, the company management took two key decisions pretty early on its course.First, that it had to “talk” to the people and second, that all communication had to flow from one common source that would filter down to the last employee, even those operating from the shop floor. To this end, the company announced a special-purpose telephone number, dialing which any employee could get in touch with Future Group’s founder Kishore Biyani. Additionally, every Friday Biyani addressed and updated the employees on the company’s plans. Videos were shot specifically targeting the shop floor staff, in which Biyani briefed his employees about the latest developments at the company. The whole exercise was orchestrated in a manner that people felt they knew what was going on leaving little room for speculation.

Experts said :

“Not informing employees timely about demergers could be a ploy to get rid of some part of the workforce. This includes employees who will start looking for opportunities outside the organisation at the sign of trouble.This will ease the downsizing drive.”

Customers & Suppliers

The customers of the new organisation might not feel the same sense of personal aggrievement experienced by some employees, but they are likely to be confused by the change. If not provided with adequate information and a guarantee of continued supply, they will quickly switch allegiances. The same goes for suppliers themselves. Speedy information, the maintenance of key processes during the phase of change and the swift renegotiation of contracts, where appropriate, are essential. Equally vital is the provision of a full and clear explanation to the organisation’s investors.

Conclusion

The secret sauce is to tick all the boxes relevant to any restructuring exercise: preparing early, putting together a transition team, focusing on clear communication and knowing that engagement (even with outgoing employees) won’t be over even after you have gone through the legal routine.

Every case of breaking up is different. So we cannot give the perfect equation & solution for making successful demerger. But carefully taking care of above-explained points will help the company to achieve the objectives set up prior demerger.

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