Yahoo’s $40 billion spin-off is a raw deal for Alibaba—at least for now

Alibaba’s top executives didn’t know about Yahoo’s plans to spin-off its $40 billion stake until it was made public yesterday, say two people briefed on the situation, leaving the Chinese online giant scrambling to respond—especially since its own quarterly earnings are due out tomorrow.

Yahoo plans to move its 15% stake in Alibaba shares into a separate company that is called, for now, “SpinCo.” The new company will essentially be an investment fund that holds one stock, plus a small, yet-to-be-determined piece of Yahoo’s existing business. The move is designed to net Yahoo investors a tax-free windfall, but it presents Alibaba with a much messier dilemma.

The spin-off, currently scheduled for the fourth quarter of 2015, threatens to saddle the Chinese e-commerce company with an impotent mini-me. SpinCo will have less than one-fifth the market cap of Alibaba, and no actual business to speak of, but will probably command roughly the same per-share stock price, and draw a subset of investors away from Alibaba’s own stock.

Alibaba’s bankers, lawyers and other advisers are currently working frantically on a strategy to explain the company’ response when its fourth quarter earnings are released at 7am ET tomorrow (Thursday, Jan. 29). One feasible option—as explained in depth by Bloomberg View’s Matt Levine—would have Alibaba purchasing SpinCo with its own stock, and essentially getting the company for free, while also avoiding taxes for Yahoo’s existing shareholders. Levine explains:

I don’t know if that’s the plan, but it would be sort of nuts if it isn’t! SpinCo is an utterly pointless beast. It is a one-stock mutual fund. Wouldn’t you rather have the stock? Yes, you would rather have the stock. Alibaba, similarly, would rather get rid of SpinCo — a weird alternative vehicle confusing its investors and fragmenting its liquidity — especially if it can do so at a discount. So everyone will be better off when Alibaba buys SpinCo. So you’d expect that to happen, as soon as it can.

That scenario is a good indication of the way things could go, one Alibaba adviser told Quartz.

There are some caveats, though: SpinCo would need to wait about a year before selling itself to Alibaba in order to placate US tax authorities. And Yahoo’s tax lawyers and M&A advisers know that any hint of a pre-arranged deal for Alibaba to eventually buy SpinCo would kill the tax exemptions that are the whole reason for setting up SpinCo in the first place. The US Securities and Exchange Commission, of course, also has rules on divulging publicly-traded stock information, which explains why Yahoo executives couldn’t discuss the transformative deal with Alibaba beforehand.

Relations between Yahoo and Alibaba executives have also been strained since at least 2011, when Alibaba founder Jack Ma spun off payment system Alipay from his company, but neglected to tell its largest outside shareholder until five weeks later.

In 2012, the two companies and Alibaba investor Softbank discussed another collaborative spin-off that would have also been tax-free, but the talks were torpedoed by insurmountable disagreements. The creation, spin-off, and then ultimate takeover of SpinCo now appears to be the only way that the two companies can finally go their separate ways.

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