A Theory of Equity Carve-Outs and Negative Stub Values under Heterogeneous Beliefs

We develop a theory of new project financing and equity carve-outs under heterogeneous beliefs among investors in the equity market. We consider a setting where an employee of a firm generates an idea for a new project that can be financed either by issuing equity against the future cash flows of the entire firm, i.e., both assets in place and the new project (quot;integrationquot;), or by undertaking an equity carve-out of the new project (quot;non-integrationquot;). The patent underlying the new project is owned by the firm. However, the employee generating the idea needs to be motivated to exert optimal effort for the project to be successful. The most important ingredient driving the firm's choice between integration and non-integration is heterogeneity in beliefs among outside investors (each of whom has limited wealth to invest in the equity market) and between firm insiders and outsiders. If outsider beliefs are such that the marginal outsider financing the new project is more optimistic about the prospects of the project than firm insiders, and this incremental optimism of the marginal outsider over firm insiders is greater regarding the new project than about the firm's assets in place, then the firm will implement the project under non-integration rather than integration. Two other ingredients driving the choice between integration and non-integration are the cost of motivating the employee to exert optimal effort for project implementation, and the synergy between the new project and the firm's assets in place, which is eliminated under non-integration. We derive a number of testable predictions regarding a firm's equilibrium choice between integration and non-integration. We also provide a rationale for the quot;negative stub valuesquot; documented in the equity carve-outs of certain firms (e.g., the carve-out of Palm from 3Com) and develop predictions for the magnitude of these stub values