A divestiture, also known as a divestment, involves the liquidation of a company’s assets, such as building or intellectual property, or a part of its business, such as a subsidiary. This can occur through several different means, including bankruptcy, exchange, sale, or foreclosure.
Divestitures can be partial or total, meaning some or all of the company could be spun off or otherwise divested, depending on the reason for the company getting rid of its assets. Corporate mergers and acquisitions are a common example of one type of divestiture.
Often a divestiture reflects a decision by management that one part of the business no longer helps it meet its operational goals. Understanding the meaning of divestiture requires considering the factors that led up to it.
What Are Reasons a Company Would Divest Itself?
A divestiture can be an intelligent financial decision for a business in certain situations.
If one aspect of a business (e.g., a product line or a subsidiary) isn’t working, has become unprofitable, or is likely to soon consume more capital than it can create, then instead of letting that be a continued drain on resources, a company can divest.
This not only does away with the troublesome aspect of the company, but also frees up some money the company can put toward more productive endeavors, such as new research and development, marketing, or new product lines.
There are many other potential reasons for a company to divest itself of a particular aspect of its business as well. The growth of a rival may prove overwhelming and insurmountable, in which case divesting might make more sense than continuing to compete.
A company may choose to undergo a divestment of some sort, such as closing some store locations, in order to avoid bankruptcy, to take advantage of new opportunities, or because new market developments might make it difficult for part of the company to survive.
Companies also sometimes must divest some of their business because of a court order aimed at breaking up monopolies. This can happen when court determines that a company has completely cornered the marketplace for its goods or services, preventing fair competition.
What Happens in a Divestiture?
When a divestiture involves the sale of part or all of a company, the process has four parts. The first two parts involve planning for the actual divestment transaction itself. Once management decides which part of the company to divest and who will be buying it, the divestment can begin.
1. Monitoring the Portfolio
When pursuing an active divestiture strategy, the company’s management team will review each business unit and try to evaluate its importance to the company’s overall business strategy. They’ll want to understand the performance of each part of the business, which part needs improvement, and if it might make sense to eliminate one part.
2. Identifying a Buyer
Once the business identifies some or all of the company as a potential divestment target, the team moves on to the next problem that logically follows: Who will buy it?
The goal is to find a buyer that will pay enough for the business to cover the estimated opportunity cost of not selling the business unit in question. If the buyer does not have the liquidity to make the purchase with cash, they might offer an equity deal or borrow money to cover the cost.
3. Executing the Divestiture
The divestiture involves many aspects of the business, including a change of management, company valuation, legal ownership, and deciding which employees will remain with the company and which ones will have to leave.
4. Managing the Financials
Once the sale closes, attention turns to managing the transition. The transaction appears on the company’s profit-and-loss statement. If the amount that the company receives for the asset it sells is higher than the book value, that difference appears as a gain. If it’s less the company will record it as a loss.
The company will typically share the net impact of the divestiture in its earnings report, following the transaction.
What Are The Different Types of Divestitures?
There are several different ways companies can define divest for themselves. A few of these options include:
• An equity carve-out, when a company can choose to sell a portion of its subsidiaries through initial public offerings but still retain full control of them.
• A split-up demerger, when a company splits in two, and the original parent company ceases to be.
• A partial sell-off, where a business sells one of its subsidiaries to another company. The funds from the sale then go toward newer, more productive activities.
• A spin-off demerger, in which a company’s division becomes a separate business entity.
What Causes a Company to Divest?
A divestiture strategy can be part of an overall retrenchment strategy, when a company tries to reinvent itself by slimming down its activities and streamline its capital expenditures. When that happens, the company will divest those parts of the business that are not profitable, consuming too much time or energy, or no longer fit into the company’s big-picture goals.
Factors that could influence a company to adopt a divestiture strategy can be lumped into two broad groups:
External developments include things outside the company, such as changing customer behavior, new competition, government policies and regulations, or the emergence of new disruptive technologies.
Internal developments include situations arising from within the company, such as management problems, strategic errors, production inefficiencies, poor customer service, etc.
Divestiture Strategy Example
Imagine a fictitious company called ABC was the parent of a pharmaceutical company, a cosmetic company, and a clothing company. After some time and analysis, ABC’s management determines that the company’s financials have begun deteriorating and they need to make a change in the business.
Following the four-step process above, they begin by finding the weakest points of business. Eventually, they decide that the pharmaceutical branch of the company is under-performing and would also be the easiest for the company to divest. It makes more sense to stick to clothing and cosmetics.
After identifying a buyer (perhaps a larger pharmaceutical company or a promising startup looking to expand), the divestment transaction occurs. The employees who work in the pharmaceutical branch either lose their jobs, or they get roles working for the new owner of that part of the business. The cash infusion that ABC gets as a result of the sale of its pharmaceutical branch will go toward new marketing efforts and creating new product lines.
Divesting is essentially the opposite of investing. It involves a company selling off parts of its business. A divestiture can have some positive outcomes on the value of a company, and there are several business reasons that a company would choose to divest. Depending on the circumstances, this process could theoretically be either a positive or a negative for shareholders.
Investors could see news of a divestment as a sign that a company is struggling, leading them to sell the stock. While this initial reaction could be one likely outcome, the company could eventually wind up doing even better than before if it manages itself better as a leaner company. In either case, the divestiture is one factor that investors can use in their analysis of that company’s stock.
Understanding how a divestiture impacts a company’s value is a helpful process in determining whether you want that stock in your portfolio. When you’re ready to start building that portfolio, a great way to start is by opening a SoFi Invest® brokerage account. The SoFi platform allows you to buy and sell stocks, ETFs, and trade cryptocurrencies on your own, or via an automated option that chooses securities and rebalances on your behalf.
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