Expanding into New Business Segments

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Wilson Sonsini Goodrich & Rosati

Unlock Growth Opportunities Using Strategic Corporate Structuring

What do an automotive parts manufacturer, a law firm, and a media company have in common in the 21st century? Companies in each of these sectors are breaking longstanding barriers to innovative revenue generation by leveraging technological advancements to expand the menu of products and services they can offer to customers. Whether through the development of autonomous driving technology, document automation solutions, or new content delivery platforms, companies across a broad range of industries are using newly available technologies to transform antiquated business models and expand into adjacent business spaces. In navigating such expansions, companies should implement appropriately tailored corporate structures to set their business up for success.

When Opportunity Knocks

Technological change consistently brings new opportunities for business expansion. The COVID-19 pandemic has provided an additional push to encourage companies to reevaluate their strengths and weaknesses and to shift their emphasis to newly relevant products and services. Nearly every company has had to re-examine its path forward in the disrupted economic landscape and, as a result, explore new avenues for growth and revenue generation. As a result, many companies that are not considered traditional “tech” companies are expanding into technology-enabled fields and embracing new automated platforms, services, and products that will help drive their reimagined business goals.

Challenges Posed by Growth

Expansion into a new field carries inherent risk. Directors and officers are often rightly concerned about potential liabilities associated with expansion and the effects of such liabilities on the primary business. They should proactively address these concerns by implementing appropriate corporate structures, allowing the business to step into new opportunities for profit growth while minimizing risks to the long-term stability of the parent company. In evaluating opportunities for expansive growth, company management also must carefully assess potential risks and consider the strategic options at its disposal for insulating a new business entity from the existing company.

Minimizing Growing Pains

One way to contain the risks inherent in the new venture is to transfer the assets of the new business to a separate entity that is “independent” from all other affiliated entities. Wilson Sonsini frequently advises clients in connection with the creation of new entities for discrete business purposes, and regularly advises companies on the implementation of processes designed to maintain separateness between affiliates. This approach is not limited to the development of new business segments; it can also be used in connection with internal reorganizations to separate existing business divisions from one another and to provide new opportunities to raise debt capital or engage in joint ventures with strategic partners. Wilson Sonsini also represents clients in connection with the separation of established business divisions from other parts of the business. This article discusses some of the steps that a company can take to structure a new revenue source—or insulate an existing one—in a way that minimizes potential liability and allows company management to focus squarely on executing its business growth strategy.

Advantages and Potential Issues

Advantages of Separating a New Division from the Core Business

By separating an adjacent revenue source from the core business, a company can insulate the assets and liabilities associated with that revenue source. A properly implemented separation shields the emerging business from the parent company’s creditors and is an effective tool for protecting the assets of the new business as they become increasingly valuable. Separation also provides the value of optionality. Eventually, the parent could use the emerging business to raise capital for other ventures by spinning it off to shareholders; alternatively, it could seek raise capital via outside investment in the new entity based on its standalone value. If the parent company’s traditional business ceases to be a part of its core strategy, it may elect to sell the traditional business while retaining the new one. Implementing a proper separation at the outset makes it easier to later dispose of assets that are no longer valuable.

Conversely, in the event that the new business incurs any unexpected liabilities, a properly structured separation can protect the parent’s assets from creditors of the new entity. Strategic development of the corporate organizational structure creates more opportunity for a company to experiment with innovative business models that may incur additional risk.

Potential Issues Associated with Transferring Assets to a New Entity

Any company contemplating separation between several entities should be mindful of the administrative responsibility associated with adopting a nuanced corporate structure. Specific examples of the administrative requirements are discussed in the next section.

Additionally, in evaluating the potential transfer of assets to a new entity, a company should review its existing contractual obligations to determine whether any third-party consents will be required to execute the transfer. As detailed below, the company should evaluate the potential liabilities and costs, including potential losses of revenue, associated with obtaining such consents and/or the termination of such agreements. If the company has outstanding debt obligations, it should determine whether it is subject to any covenants restricting the transfer of assets to a new entity, or if any other consents are required under the debt documents.

Finally, the company should be sure to evaluate the tax implications of adjusting its corporate structure. Among other considerations, the company should understand any transfer taxes that may be imposed in connection with the contribution of assets to the new entity. Company management should also analyze the tax impact of any intercompany service agreements that may be necessary as a result of the asset transfer, and determine whether the entities will file consolidated or separate tax returns.

Creating a Separate Business Unit: The Mechanics

How Can a Company Create a Business Division That Is Separate from All Affiliated Entities?

The first step in the separation process is to form a new subsidiary that will contain the new business division. The company should work closely with counsel to develop appropriate corporate structures and governance procedures for the new entity. The parent company will then need to determine which assets will be transferred to the new entity.

The new entity and any applicable affiliates will need to document the transfer of any assets to the new entity, the parties’ rights with respect to any shared property, the allocation of liabilities with respect to any shared property, and each party’s rights to indemnification for liabilities relating to shared or transferred property.

A variety of factors may determine whether a given asset should be assigned to the new entity or retained by the corporate parent. In addition to the most obvious considerations, such as whether the asset will be used primarily by the new entity, the parties should also consider which entity will be responsible for the maintenance of the asset (including, for IP assets, maintenance of applications and registrations), and whether the asset is encumbered by any third-party liens, as such encumbrances may complicate any asset transfer.

Many companies worry about the administrative burden of operating two (or more) entirely separate businesses. Fortunately, the parent and the new subsidiary—as well as any other affiliated entities—can share certain operational and administrative facilities. As detailed below, it will be important to evaluate and properly document all intercorporate relationships, as well as the relationships of creditors and other third parties with each affiliated entity.

In order to limit liability between the affiliated entities and avoid the legal concepts known as “piercing the corporate veil” and “substantive consolidation” (whereby a creditor of one entity may reach the assets of an otherwise shielded entity in the same corporate structure), the entities must maintain separate identities. Below are some of the measures that the entities should take to limit liability:

Considerations for Parent and Subsidiary

  • Ensure that each entity is adequately capitalized.
  • Observe corporate formalities.
  • Avoid the commingling of assets.
  • Avoid sharing or overlapping of corporate officers, directors, employees, bank accounts, office space, or telephone numbers without identifying on whose behalf they are acting or being used.

Considerations for Parent

  • Avoid siphoning money out of the subsidiary or accept money intended for the subsidiary.
  • Avoid using the subsidiary’s property for the parent’s purposes.
  • Carefully structure the parent’s management of the subsidiary’s employees to avoid projecting the appearance or exercise of control over corporate decision-making and day-to-day operations.

Considerations for Subsidiary

  • Avoid making undocumented “loans” or extending credit to the parent on non-market terms.
  • Avoid generally guaranteeing the debts of the parent, although limited narrower transactional guarantees are possible.
  • The subsidiary should not function as a mere façade for the parent.

What Specific Actions Should the New Entity Take to Maintain Separateness?

The parties should take care to observe all corporate formalities that are indicative of separateness. By successfully maintaining separateness, the parties can minimize the risk of any future legal action in which a third party might hold one entity responsible for the liabilities of the other. 

The following practices will enable a new entity to establish legal separation from its parent:

  • Maintain independent business discretion.
  • Maintain separate books, records, and financial statements (consolidated financial statements are acceptable so long as separate entity financial statements are kept internally, and each entity’s assets and liabilities can easily be identified).
  • Maintain separate assets, where possible, and avoid commingling property with the parent.
  • Maintain separate bank accounts.
  • Pay expenses and liabilities out of its own funds and assets.
  • Use separate invoices and checks.
  • Avoid having debts paid or generally guaranteed by the parent entity, when possible.
  • Maintain adequate capitalization for reasonably foreseeable obligations in light of contemplated business operations.
  • Clearly self-identify as a separate entity to third parties, including using the new entity’s name when engaging in third-party transactions.
  • Where using the parent’s existing third-party arrangements, formalize the intercompany transactions using sublicenses, assignments, or transfers. 

Can the New Entity Still Share Resources with Other Affiliates?

Sharing resources across business segments can create important cost synergies. By appropriately documenting and implementing resource-sharing arrangements, affiliated entities can take advantage of these synergies while maintaining legal separateness.

When sharing services or resources, the affiliated entities should deal with one another at arm’s length; in other words, each entity should act solely in its own self-interest in negotiating and executing the terms and conditions of any service-sharing or resource-sharing arrangement. Any transactions between the entities should be for reasonably equivalent value and on commercially reasonable terms, similar to those available for comparable arm’s length transactions with unaffiliated entities. Formal intercompany agreements, such as the ones discussed below, memorialize such resource-sharing arrangements and are critical indicators of separateness for affiliated entities defending against veil-piercing or substantive consolidation attacks.  

Corporate Services. One of the most obvious needs for intercompany resource-sharing between affiliates arises in the context of general corporate management services. Rather than setting up an entirely new set of internal systems, the entities may elect to share centralized services, including i) treasury, payroll, and other financial services, ii) legal, iii) technology, iv) risk management (including insurance-related services), and v) human resources and employee benefits. The parties should clearly document the exact services being provided and the allocation of costs associated with each service. The parent may charge its subsidiary for such services at cost or at a price commensurate with the value of the services provided.

Cash Management and Accounting. As part of the corporate services agreement or under a separate document, the parties can agree to have the parent provide centralized cash management and accounting services. If the entities pursue this approach, they should establish an appropriate mechanism and procedures for keeping the entities’ cash separate and documenting any intercompany balance—for example, via a revolving intercompany promissory note. Even if the new entity receives funds from the parent or if cash is swept back to the parent through a cash management system, the entities should document and maintain separate finances.

Employee Matters. Among the corporate services, the parent entity may handle employee matters for the new entity, including i) administering payroll, ii) allowing continued participation in the parent entity’s benefit plans, and iii) administering 401(k) plans. If employees are to be transferred to the new entity as part of the separation, the transfer should be documented. For any employee whose responsibilities will include work performed for both entities, the parties should clearly designate the role(s) that the shared employee will perform for each entity. The affiliated entities should distribute costs associated with the shared employee and document the allocation of such costs.

Tax Matters. A tax matters agreement may be useful to coordinate tax payment allocation, consolidated tax returns, usage of tax attributes, and general tax planning. In planning the separation, company management should evaluate all tax implications, including transfer taxes that may be levied in connection with the parent’s contribution of assets to the new entity and the tax impacts of any intercompany services agreements on the affiliated entities.

Intercompany Licenses. If the new entity needs to use intellectual property (IP) and software owned by the parent entity, the parties should ensure that the new entity obtains appropriate, formal license(s) from the parent. The parent may also need to provide sublicenses for third-party IP and software that is licensed to the parent. The parties will need to ensure that they obtain all appropriate consents for such sublicenses, as discussed below.

Shared Facilities. If the entities share any facilities, such as office space, manufacturing facilities, or warehouses, they may benefit from agreements that set forth their respective obligations and rights in relation to the shared facilities. Affiliates that share facilities should consider entering into a formal contract that governs the allocation of property rights, maintenance costs, costs resulting from damages, environmental liabilities, and any other relevant rights and obligations between the parties.

What Happens to Existing Third-Party Agreements?

From the very early stages of evaluating a potential separation, the parent company should be mindful of the impact of the transaction on any third-party agreements. The parent may be party to a wide range of agreements with third parties, including IP and software licenses, real property leases, and vendor agreements, among others. As management considers the formation and separation of a new entity, it should evaluate the rights that the new entity will require under existing third-party contracts by analyzing some basic initial queries: Will any contracts be assigned to the new entity? Will sublicenses be needed for third-party IP and software? Will any of the parent’s real property leases will be assigned to the new entity, or will the parties enter into subleases?

Company management will need to work with counsel to conduct a comprehensive review of the company’s contracts in order to determine the third-party consents that are required in connection with the separation transaction. In evaluating the feasibility of a separation, management should be mindful of the liabilities that may arise, including fees to third parties for consents to assignment or consents to sublease/sublicense, or lost revenue resulting from termination of an agreement (in the event that the company fails to obtain the requisite consents). The entities will need to document the allocation of any such liabilities, as well as any liabilities arising out of shared contracts and the legal fees associated with obtaining consents to assignment or other negotiations.

Conclusion

Any growth strategy should be supported by a tactically designed corporate structure. An effective structure will not only facilitate the immediate objectives of a growth plan and serve as a safeguard against liabilities, but will also provide management with the flexibility required to respond nimbly when confronted with new opportunities and challenges. Accordingly, if a company’s management is considering strategies for developing into a new or adjacent business, it should carefully evaluate the options at its disposal, and then work with counsel to implement a value-additive corporate structure that will complement the growth strategy and minimize the company’s exposure to long-term risks.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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