What Is Equity Carve-Out (Explained: All You Need To Know)

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What Is Equity Carve-Out

An equity carve-out is a financial term referring to instances when a company sells some of the shares it holds in a subsidiary to the general public.

In other words, with an equity carve-out, a company gives up its controlling stake in a subsidiary so the business can be managed independently.

Companies will mainly perform an equity carve-out to divest some of their business operations, allowing them to focus on their core competencies.

For example, a software development company may have a subsidiary engaged in software implementation services.

To divest its software implementation service business, the software development company may sell 20% of its shares in the subsidiary and keep 80%.

This way, the company gives up 20% of the subsidiary’s shares in exchange for cash.

Keep reading as I will further break down the meaning of an equity carve-out and tell you how it works.

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Why Are Equity Carve-Outs Important

Equity carve-outs are important as they are a form of partial divestiture where a company is able to sell either a minority or a controlling stake in a subsidiary.

This way, the parent company is able to capitalize on the business segment that is not part of its core business operations.

Quite often, the parent company will sell shares of a subsidiary to the general public through an initial public offering (IPO).

Most of the time, in an equity carve-out, the parent company will sell a minority stake in its subsidiary to the general public.

This way, the carve-out will turn the subsidiary into a standalone business having its own board of directors and issuing its own financial statements.

However, the parent entity will continue supporting the subsidiary to ensure it will succeed.

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How Does An Equity Carve-Out Work

An equity carve-out, as the name suggests, is when a company carves out (or sells) some of its shares in a subsidiary.

For example, Company ABC operates a computer hardware business and holds 100% of the shares in a subsidiary in software development.

Since computer hardware is its core business, Company ABC decides to sell 20% of its shares in Company ABC, thereby partially divesting this business segment.

Company ABC will list its subsidiary in the stock market as a separate entity and sell the 20% shares to the general public via an initial public offering.

From the moment the carve-out is effective, the subsidiary will operate independently, have its own board of directors, and make the most appropriate decisions in the software development business.

Many companies will consider performing an equity carve-out before moving forward with a full spin-off in order for the latter transaction to be tax-free.

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Equity Carve-Out Advantages

Let’s look at some of the main benefits of an equity carve-out strategy.

The main benefit of an equity carve-out is for a parent company to focus its time and attention on its core business.

Since the equity carve-out allows the parent company’s subsidiary to operate independently as a separate business, both the parent and subsidiary can focus on their core business operations.

The two companies acting as separate entities may be more profitable than if the subsidiary remained under the parent company’s full control.

Another benefit of an equity carve-out is that the parent company will actually receive cash when selling shares in the subsidiary.

Since the cash comes from the sale of equity securities, the parent company will not have any obligation to pay the money back in the future.

Also, if the subsidiary business performs well as an independent business, the value of the parent company’s shares will increase.

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Equity Carve-Out vs Spin-Off

What is the difference between equity carve-out and spin-off?

The main objective of an equity carve-out and spin-off is to divest a business segment.

However, the difference has to do with the logistics of how the divestiture is done.

In an equity carve-out, a company sells some of its shares in a subsidiary to the general public for cash.

The investors in the subsidiary are not related to the parent company.

On the other hand, a spin-off is when a company divests a business unit by giving away the shares of that business unit to its own shareholders.

In a spin-off, the parent company does not receive any cash by giving away the shares of its business unit to its shareholders.

Also, the shareholders of the new business entity are exactly the same shareholders as the parent company (instead of the general public in an equity carve-out).

Very often, a company may start with an equity carve-out and sell less than 20% of its shares to the general public so it can receive some cash.

Then, it will spin off the remaining 80% by giving away shares to its shareholders. 

Since the parent company relinquishes more than 80% control in the subsidiary, the spin-off will remain a tax-free transaction.

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Equity Carve-Out Example

Let’s look at an example of equity carve-out to better understand the concept.

One notable equity carve-out is when American Express carved out a business unit called Lehman Brothers.

In 1994, American Express announced that it was going to carve out its investment banking unit so it can be operated as a new independent entity.

The company Lehman Brothers were to focus on corporate services, financial planning, signature charge cards, and travel.

American Express retained shares in Lehman Brothers allowing it to receive profits whenever the company declared dividends.

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Takeaways 

So there you have it folks!

What does an equity carve-out mean?

In a nutshell, an equity carve-out refers to the process when a company separates a subsidiary from its operations, turning it into a standalone company.

Essentially, the equity carve-out allows a parent company to partially divest a business unit that may no longer be part of its strategic focus.

The sale of the shares in the subsidiary is generally made through an initial public offering where a minority equity stake is sold in the market.

The divested subsidiary will then have its own board of directors, issue its own financial statements, and make its own strategic decisions.

However, since the parent entity retains a majority interest in the subsidiary, it will continue offering the new business entity strategic support and resources to help it to succeed.

The idea of equity carve-out is not to sell a business unit but partially sell an equity stake in it.

Now that you know what an equity carve-out is and how it works, good luck with your research!

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