The Impact of a Spinoff on the Parent Firm: A Model of Double Adverse Selection with Correlated Types

Abstract

A principal and her worker's type is correlated via the principal's screening ability (a high ability principal is more likely to hire a high ability worker). The firm's stage payoff depends upon the worker's reputation. This paper provides a new explanation for how a spinoff (firm formed when a worker leaves to set up her own firm) can be beneficial for the parent firm. The key idea is that in any market with sufficiently high worker attrition, a firm's future payoff depends crucially on the belief about the principal's ability to recruit good workers repeatedly, i.e. on the principal's reputation. I show that the signals coming from spinoff formation and performance can enhance the reputation of the principal. This follows from my result that spinoffs are more likely to be formed by high ability workers because they have a higher expected payoff from spinoff formation than low ability workers. I further show that there exists an equilibrium which explains a previously unexplained empirical finding - spinoff formation can hurt the parent firm in the short run, but be beneficial over a longer run. My results have policy implications for non-compete covenants.