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Considering an IPO? Here’s why an Up-C might be advantageous
Observations from the front lines
The fundraising benefits of an initial public offering (IPO) typically require trade-offs for pass-through entities, which have to forfeit the economic and tax benefits of operating as a partnership or related entity. An umbrella partnership C corporation (Up-C) structure allows a pass-through entity the best of both worlds, achieving preferential tax treatment for both the pre-IPO investors and the new publicly traded corporation, while also gaining access to the capital markets.
An Up-C structure can be used across all industries and sectors, but it’s particularly common for private equity portfolio companies. Over the past five years, more than 50 companies have gone public using an Up-C or an Up-SPAC structure.
Common advantages of an Up-C structure
- An Up-C has access to public markets as a publicly traded corporation while retaining the tax benefits of a pass-through structure.
- Pre-IPO investors can receive significant incremental proceeds on exit by implementing a tax receivable agreement (TRA).
- The structure creates additional liquidity for pre-IPO investors by granting them the right to exchange their interests in the operating entity for common stock in the publicly traded company.
- Pre-IPO investors retain control of the consolidated operations of the company through a controlling percentage of voting shares in the publicly traded company (which typically has sole operational control of the pass-through operating entity).
- Pre-IPO investors retain continued access to tax distributions from the pass-through operating entity and avoid double-taxation.
How it works
Take a look at the graphic below, which illustrates how the operating pass-through entity first “unitizes” its interests so that each unit has the same economic rights. Then, in conjunction with the IPO, what we’ll call “PubCo” typically issues two classes of common stock.
- Class A common stock is issued to public investors and carries most of the economic rights (typically mirroring the operating pass-through entity) and a small percentage of voting rights in PubCo. The economics typically mirror the economics associated with each unit in the operating pass-through entity.
- Class B common stock is issued to the pre-IPO investors and carries voting rights in PubCo only.
Pre-IPO investors may then either retain their interests in the operating pass-through entity or liquidate their investment. To liquidate, the pre-IPO investors may either redeem a portion of their interests for cash raised in the IPO or exchange those interests for Class A stock.
Pre-IPO investors and PubCo typically enter into two agreements:
- The pre-IPO investors may exchange remaining operating entity units for PubCo stock or cash (typically at PubCo’s option).
- A TRA may provide that a percentage of any tax benefit derived by PubCo resulting from the Up-C structure be shared with the pre-IPO investors as additional consideration for the interests they sell in the business.
Planning to avoid potential complexities
Like a traditional IPO, an Up-C structure carries a variety of unique accounting and tax complexities. These considerations typically require support and advice from individuals who specialize in these fields and may also require ongoing recordkeeping and maintenance.
Accounting and financial reporting complexities
- PubCo must decide whether to consolidate the operating entity.
- PubCo must evaluate whether the transfer of control of the operating entity to PubCo triggers purchase accounting requiring a step-up in basis of assets and liabilities.
- Pubco must determine if there are other entities (often referred to as “blocker entities”) to reflect in the financial statements.
- In conjunction with the capitalization of PubCo, the company is typically required to recognize noncontrolling interests (NCIs) comprised of the pre-IPO investors' residual interests in the pass-through operating entity. The measurement and classification of NCI can be complicated depending upon the terms and conditions of the exchange agreement or any redemption features.
- The company must assess the probability of TRA payments, whether (and when) the TRA liability should be recognized, and how the TRA liability should be measured.
- PubCo must evaluate the impacts of any restructuring of stock-based compensation awards and the issuance of new or replacement awards in connection with the IPO.
- As a direct result of its capital structure, the computation and presentation of earnings per share requires detailed analysis of participation and redemption rights.
- Up-C IPOs often require S-X Article 11 pro forma financial statements. This is generally due to the material impacts of the change in organizational structure, use of proceeds to repay pre-IPO investors’ interests in the operating entity, and the formation of the TRA.
Additional resources regarding post-IPO complexities are available at “Life after an Up-C IPO: Navigating the financial reporting complexities.”
Tax complexities
The taxable exchange typically results in the company recognizing a deferred tax asset associated with the benefit of tax basis step-up adjustments — created as a result of pre-IPO investors exchanging units in the operating pass-through entity for shares of PubCo. A valuation allowance may be necessary to the extent the tax basis step-up is allocated to corporate stock, to non-amortizable goodwill, or to other assets not recovered in the ordinary course of business.
Depending on the treatment of the TRA payments, the company may need to record a deferred tax asset to the extent that it’s anticipated to give rise to future tax deductions.
At the time of each exchange, the company must calculate the tax basis adjustments and maintain detailed records tracking the tax benefits arising from each exchange by pre-IPO investors. The timing of the exchanges affect both the payments made under the tax receivable agreement and how the operating pass-through entity allocates income and loss.
Any additional compensation cost recognized upon the accelerated vesting of awards or payment of additional bonuses may be subject to excise tax as a non-qualified deferred compensation plan.
The continued existence of the operating pass-through entity requires the continued maintenance of partner capital accounts, tax allocations, and other accounting functions common in partnership structures that are not required in a corporate context.
“Observations from the front lines” provides PwC’s insight on current economic issues, in addition to our perspective regarding the financial reporting complexities and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.
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