In 1996, Youngsoft Inc., an IT consulting firm, had 14 employees and was making $230,000 in net sales. Over the next three years, the Wixom, Mich.-based firm grew by over 4,000 percent, and by 2001 ranked No. 43 on Inc. 500 list of the nation's fastest growing private companies with more than $9.9 million in net sales.

About the same time, CEO Rupesh Srivastava began noticing insurance providers growing more concerned about complying with the recently enacted Health Insurance Portability and Accountability Act slated to take effect in 2003. Using its in-house expertise in software development, Youngsoft launched a Web-based application to help doctors prepare claims for insurance companies that would comply with the new regulations.

The resulting business spin-off, H2H Solutions, grew by more than 800 percent over the next three years, hitting annual revenue of $6.5 million in 2005 -- more than half of what the parent company made that year. That kind of growth landed H2H on this year's Inc. 500 list at No. 113.

"Both companies are now run separately, but they augment each other in important ways. It's a very good situation," says Youngsoft Vice President Sandeep Upadhyaya.

Whether it's the existing division of a company restructured into a wholly separate business or an entirely new product or service, spin-offs like H2H have a range of attractive benefits for smaller businesses looking to grow, but can also come with as many pitfalls, market watchers say.

"Spin-offs can potentially reveal a hidden business within an existing business," says Bill Mitchell, the founder of Gemfinder, a Costa Mesa, Calif.-based service that tracks business spin-offs and reorganizations.

Unlike a startup, spin-offs have the advantage of by being carried along by the momentum of an already successful business or brand -- a crucial launching pad that offers a head start to the market over other businesses started from scratch, Mitchell says.

While often relying on established contacts, suppliers, and customers, spin-offs can also open up untapped markets inaccessible to a parent company -- or even wholly new markets -- while leveraging its expertise and infrastructure, he adds.

Vance Patterson, the CEO of Blythewood, S.C.-based Patterson Fans -- another former Inc. 500 company -- got the idea for a spin-off from watching his employees flipping hamburgers on a grill made of spare parts from the company's industrial fans. Within a year and a half the Town & Country grill was patented and Patterson was running a second business, Down South Inc.

Yet just as spin-offs can be carried aloft by a successful parent company, they can also become dead weight if they fail. Spin-offs that aren't profitable can take a heavy financial toll on an otherwise well-run company, while giving potential investors pause for thought about the soundness of company management, Mitchell says.

"No matter how you spin-off the new business, it's typically going to start off much smaller than the parent company. That means its credit rating and the cost of capital is going to be higher," Mitchell says.

If it goes public, the new business is also going to have comply with costly regulations governing smaller firms, such as Sarbanes-Oxley, he added. "At the beginning, that money is coming out of the parent company."

So how big should a business be before launching a new company devoted to a second service or product? "The question should be whether the company you're going to spin-off is likely to be dominant in the market segment it serves," Mitchell says.

Taking its cue from popular television show spin-offs such as Frazier (Cheers) and Joey (Friends), the National Federation of Independent Business (NFIB) offered these tips for owners considering spinning off a second business:

  • Choose the right product of service that's a logical component of your existing business.
  • Keep the brands separate by treating the new business as a companion brand to avoid diluting your existing business.
  • Reassess your strategy if the spin-off is distracting you from taking care of the existing business.

Mitchell says one overlooked challenge for spin-offs is simply knowing when to let go. For its part, Youngsoft is planning to take H2H public within the next few years, while the parent company itself remains private. "We now have a strong presence across the country in most major health-care markets," says Upadhyaya, adding that an early hurdle in the process was changing the company's overall mindset from a service provider to a product maker. "It really comes down to good timing."

Angus Loten is a reporter for Inc.com.