When should you separate businesses?
Sometimes, a company develops a new line of business that isn’t obviously part of the existing business. The question soon arises whether to separate the new business, and how to do it.
Here are some basic ways of separating a business so that it’s more separate from an existing business:
- Putting it in a separate department or under separate teams with primarily shared services.
- Creating a separate division, with more dedicated personnel, with relatively fewer shared services.
- Creating a subsidiary of the original company.
- Creating a sister company under a new holding company.
There are obviously many variations of the first two, but if you consider them a spectrum, you can see that the two ends are very different.
Now, why might you separate a business?
- business reasons
- capital/financial reasons
- legal issues
- governance/management/leadership factors
Let’s cover each of these briefly.
- Business reasons – you may want to separate a new business when it doesn’t mesh well with the existing one, such as no economies of scale, no shared customers, and relatively few shared resources. An example is a manufacturing company that wants to also provide advertising and marketing services. At some point, that second business is too different to function well inside the original company.
- Capital and financial reasons – similarly, if the two businesses have different capital needs and rates of return, investors in the original business may not want to be in the new business, or vice versa. Consider a professional services business, like a consulting firm or software development. High margins, low capital requirements, and regular cash flow make those very different from a real estate development business.
- Risk – this is a classic reason why real estate investments such as commercial buildings or apartment houses are often owned by separate LLCs. But it applies as well to businesses where the risk profile is very different – a web designer has very few risks (short of copyright infringement), but that business compared to the production of packaged snacks for people looks very different. You may want to separate those risks so that each business can be judged on its own merits and also so that risks from one business don’t damage the other.
- Legal issues – some businesses have to be separate, such as because of ownership restrictions (such as licensed professions or S-corporations) or because the two businesses need different investors for some other reason. For closely held companies, a new partial owner for the second business almost always leads to creating a new legal entity to separate the businesses. It’s possible to allocate equity returns to specific businesses, but those lines don’t work if there’s a problem (see #3 – Risk).
- Governance – if the businesses are different enough to consider separating them, it’s not a big leap to them having different capital requirements, different risks and returns, and different skills needed from the team. Sometimes, those differences can’t be well-managed inside a single structure, where a business creating cash may have that cash reinvested in a second business consuming cash instead of reinvesting in itself. Of course that can affect investors, but the sales and management team may feel that their prospects for future bonuses are being siphoned away as well. Sometimes, the second business just needs a different governance team entirely – board members with industry expertise, different strategic partners, management with domain experience.
Ultimately, the board’s job is to evaluate each new business opportunity as it develops with these frameworks in mind – not as a prescription, but as a mental model to watch the business as it develops and find a way for *both* businesses to be successful.
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