Supercharged IPOs and the Up-C Structure in IPOs: How It Works
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In recent years, so-called supercharged IPOs have become increasingly popular. A traditional IPO is a non-taxable event and tax benefits are not obtained from the company’s debut onto public markets. In a supercharged IPO, the company as well as pre-IPO owners are able to derive significant tax benefits from the IPO transaction. The value of the various tax benefits, such as tax deductions and tax credits are shared between the company and the pre-IPO owners through what is called a tax receivable agreement (TRA).
Structuring a Supercharged IPO
Supercharged IPOs can be structured in a few different ways. The most commonly seen category is the umbrella partnership-C corporation structure, known as the Up-C supercharged IPO or just the “Up-C”. It is an alternative method for an operating partnership to conduct an IPO. The other two commonly seen types of supercharged IPO structures are the Section 338(h)(10) supercharged IPO and the publicly-traded partnership (PTP) supercharged IPO. All three common categories of supercharged IPOs operate in partnership form.
The term “supercharged IPO” was coined by leading tax expert Robert Willens. He sees the technique as helping company founders retain more of their hard-earned gains and asserts that there is “nothing nefarious about it”. Critics argue that supercharged IPOs enable insiders to take advantage of IPO pricing uncertainties. This allows them to reap tax arbitrage opportunities and does not benefit public investors.
Umbrella Partnership-C Corporation Structure (“Up-C”)
The Up-C structure in IPOs has become the most common supercharged IPO structure. It offers pre-IPO owners liquidity in a highly tax-efficient manner. The Up-C structure is named after the Up-REIT structure used in real estate investment trusts that became popular in the 1990s. The entities in the Up-C structure are organized into two tiers. The parent company, referred to as “PubCo”, is incorporated as a C corporation. The newly formed parent company is organized as a holding company. The already existing operating partnership, which is PubCo’s subsidiary, is incorporated as either a limited liability company (LLC) or a limited partnership (LP). It is treated as a flow-through entity for tax purposes. As the operating partnership, PubCo’s subsidiary holds all of the assets and operations of the business.
Once PubCo is formed, it will be structured to have two classes of common stock typically offered in supercharged IPOs — the Class A and Class B shares. The Class A shares, to be sold to the public in the IPO and held by public shareholders, contain voting and economic rights. The Class B shares will not be publicly traded and will be held by the pre-IPO owners. The Class B shares come with voting rights, but no economic rights. In addition to the two classes of common stock, the capital structure of the operating partnership will be modified so that a new class of interests is created. This involves a reclassification of the interests held by the pre-IPO owners into a new class of common units that will be exchangeable for Class A PubCo common stock. These newly issued common units are called “OP Units”.
Essential Agreements in an Up-C IPO
Supercharged IPOs structured as Up-Cs involves three essential agreements — a tax receivable agreement (TRA), an exchange agreement, and a registration rights agreement.
Tax Receivable Agreement
A tax receivable agreement is a central component of any type of supercharged IPO. The TRA mandates that PubCo share tax savings with the pre-IPO owners. Although the exact percentages are negotiated in any given deal, the split of benefits between the pre-IPO owners and PubCo is typically 85:15.
Tax benefits are conferred in an Up-C transaction mainly in the form of an increase in tax deductions. When the pre-IPO owners exchange the OP Units for publicly traded Class A shares, the transaction results in a stepped-up tax basis of the assets of the operating partnership. This increase in the tax basis in turn results in increased depreciation and amortization deductions. The outcome of the increases in the tax basis that occur with these exchange transactions is that less taxes are owed in the future. Under the terms of the TRA, PubCo must share 85% of these tax benefits with the exchanging pre-IPO owner.
Exchange Agreement for Supercharged IPOs
The exchange agreement governs the right provided to pre-supercharged IPOs owners to exchange the OP Units for the publicly traded Class A shares. The exchange of OP Units for Class A PubCo common stock is on a one-for-one basis.
Registration Rights Agreement
A registration rights agreement is needed to accompany the exchange process while meeting the compliance requirements of the Securities Act of 1933. Under Rule 144 under the Securities Act of 1933, the OP Units that are exchanged for Class A shares will be classified as restricted securities. Rule 144 contains limitations on the volume and manner of the sale of restricted securities. Restricted securities cannot be sold unless registered pursuant to an exchange registration statement that is filed with the Securities and Exchange Commission (SEC). Thus, a registration rights agreement can be entered into by PubCo, the pre-IPO owners, and the holders of Class A shares that prompts the filing of an exchange registration statement and enables the exchange process to proceed.
Disadvantages of Supercharged IPOs
As compared with traditional IPOs, supercharged IPOs confer significant tax benefits for businesses taxed as partnerships. There are a number of considerations that should be taken into account before a business decides to use a supercharged IPO structure such as an Up-C. Precautions should be taken to avoid creating the perception that the pre-IPO owners are siphoning off cash from naïve new investors. Additionally, the complex series of transactions involved in a supercharged IPOs can lead to unclear disclosure of actual financial results. Thus, extra efforts need to be made by the company to ensure that their financial disclosures provide sufficient clarity.
Examples of the Up-C Structure in Supercharged IPOs
Many companies have filed for IPOs in recent years with the Up-C structure and a TRA between the company and its pre-IPO owners. Some recent examples include online education company Pluralsight, casual restaurant chain Shake Shack, and digital mortgage lending business Rocket Companies.