Demerger, Reverse Merger

Demerger

Demerger is the business strategy wherein company transfers one or more of its business undertakings to another company. In other words, when a company splits off its existing business activities into several components, with the intent to form a new company that operates on its own or sell or dissolve the unit so separated, is called a demerger.

A demerged company is said to be one whose undertakings are transferred to the other company, and the company to which the undertakings are transferred is called the resulting company.

The demerger can take place in any of the following forms:

Spin-off: It is the divestiture strategy wherein the company’s division or undertaking is separated as an independent company. Once the undertakings are spun-off, both the parent company and the resulting company act as a separate corporate entity.

Generally, the spin-off strategy is adopted when the company wants to dispose of the non-core assets or feels that the potential of the business unit can be well explored when operating under the independent management structure and possibly attracting more outside investments.

Wipro’s information technology division is the best example of spin-off, which got separated from its parent company long back in 1980’s.

Split-up: A business strategy wherein a company splits-up into one or more independent companies, such that the parent company ceases to exist. Once the company is split into separate entities, the shares of the parent company is exchanged for the shares in the new company and are distributed in the same proportion as held in the original company, depending on the situation.

The company may go for a split-up if the government mandates it, in order to curtail the monopoly practices. Also, if the company has several business lines and the management is not able to control all at the same time, may separate it to focus on the core business activity.

Advantages of Demerger

Helpful in Fixing Accountability

Another benefit is that it helps in fixing the accountability of the top management because when company is big and there are many departments then each department and top management blame each other for the failure but when company is demerged than each company’s top management will be separately accountable and responsible for any failure or loss happening in the company. In simple words if there are 4 sections of 100 students having 25 students each and if students of 3 sections do well but students of 1 section perform poorly than it is easy to fix accountability of class teacher of that section rather than finding fault if there is only one class of 100 students.

Management Accountability:

When companies are split off, the management of each company has its own balance sheet. As a result, it is not possible for certain entities in the group to live as parasites off the earnings of other entities. The management of each company becomes accountable for its own financial results. Also, management tends to have more control over their operations. They have the right to make their own investments and even raise funds from the market on their own account.

Smooth Operations:

The first and foremost advantage of demerger is that it results in smooth operations because when company is big than it is not possible to take area of all areas but when company is split into 2 or 3 companies then each company will have separate top management which ensures that all areas of operations of the company run smoothly. Hence for example, if in a school there are 100 students in one class than it is very difficult to manage all students but if those 100 students are divided into 4 classes of 25 students each than it is very easy to manage all the students same is the case with the company doing demerging.

Unlocking of Value:

It results in the unlocking of the value of the company as a whole because when demerger happens separate companies achieve efficiency due to the specialization of operations which results in greater overall profits for the group of companies as a whole.

Disadvantages:

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.

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.

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.

Reverse Merger:

A merger wherein a publicly listed company is taken over by a privately held company and provides an opportunity, to the private company to go public, without going through the complex and lengthy process of getting listed on the stock exchange. In this type of amalgamation, the unlisted company acquires majority shares in the listed company. The decision of merger is taken with great planning and analysis considering all the positives and negatives.

The sole aim is to accelerate growth and build a good image in the market. It also enhances company’s profitability through economies of scale, synergy, operating economies, entry to new product lines, etc. Further, it removes financial constraints and also minimizes financial cost. However, there are certain restrictions, like high employee turnover, culture conflicts, etc. which might hit the efficiency and effectiveness.

Advantages:

• The private company becomes a public company at a lesser cost and gets listed on the exchange without IPO.
• This type of merger does not create a negative impact on the competition in the market. The chances of reverse mergers being put on hold due to negative impact are very less.
• It helps in saving of taxes of private companies.

Disadvantages:

Equity Dilution:

There is definitely a cost for acquiring a shell. The private company is putting up its assets, reputation, and business to acquire the shell, but the shell’s owners want a continuing equity interest in the restructured company. This means that the private company owner’s equity and voting power are diluted as a result of the merger. The amount of dilution will depend on the value of what the two parties are bringing to the table and their negotiating skills. As discussed previously, a shell with significant loss carry forwards adds value to the transaction, and this will come at a cost to the private company.

Shell’s History:

The shell company is a “shell” for a reason. Most shells are companies that have wound down or sold off their operating business, while some were formed for the sole purpose of being available for reverse merger opportunities. The latter does not have a long or dangerous history and should have significantly fewer pitfalls.

Frequently a company is a shell because it’s a failed company. As a result, remaining shareholders may have grievances with the company and its management. They may be reluctant to get into a reverse merger because they see it as a significant dilution of their equity in the company. Of course, a prudent investor would normally prefer a small piece of a valuable company to a large piece of a worthless company. Yet even when shareholders are convinced to sell most of their shares, or perhaps even invest additional funds, they may want to quickly recoup their investment and get out of the restructured company. To avoid this situation, the reverse merger agreement should contain some timing restrictions on the sale of stock. Another problem with a shell that has a history is the possibility of unknown liabilities. Efforts should be made to contact previous suppliers to make sure there are no outstanding claims against the company. Investigations also need to be made regarding any pending lawsuits, and the shell’s legal counsel needs to provide all relevant information.

Under SEBI Purview:

In a reverse merger, the purchasing company avoids the full IPO process. But not surprisingly, the SEBI is very skeptical of such mergers and may judge individual cases to be illegal, so it’s essential that the purchasing and subsequently the combined company strictly adhere to SEBI rules to avoid sanctions or even prosecution.