Up-C Structured IPOs

Background

Companies are increasingly foregoing the traditional IPO process as pre-IPO owners look for other exit opportunities. An increasingly common alternative to a traditional IPO is the Umbrella Partnership Corporation (Up-C) structured IPO (i.e., the Up-C IPO). The Up-C IPO creates tax assets—future tax deductions for the benefit of pre-IPO owners—that reduce future cash taxes paid and that would not be available in a traditional IPO. The creation of tax assets is the primary benefit of the Up-C IPO, and it can benefit, to some degree, both the pre-IPO owners and new shareholders alike. Nonetheless, skeptics contend that the tax benefits created by the Up-C structure generate misaligned incentives between pre-IPO owners and post-IPO shareholders that ultimately harm post-IPO shareholders. This article focuses on the pros and cons of the Up-C IPO by discussing how it affects both the pre- and post-IPO shareholders.

For a company to be eligible to utilize the Up-C structure, the operating entity must generally be federally taxed as a partnership. This requirement eliminates this Up-C IPO structure alternative for many companies as most pre-IPO companies operate in the C corporation format. However, for those companies that are operating as a taxable partnership, the Up-C structured IPO provides a potentially viable alternative to the traditional IPO structure.

What Is an Up-C IPO?

An Up-C IPO is a type of supercharged IPO in which an operating pass-through entity (an entity that is taxable as a partnership like an LLC or LP) avoids converting itself into a corporation as a company would in a traditional IPO process. Historically, the operating entity would have converted from a pass-through entity into a taxable C corporation just prior to going public.  However, in an Up-C structured IPO, the historical pass-through entity is maintained as a new corporation is formed by the investing public. The proceeds from the IPO are generally used to purchase an interest in the historic partnership or other flow-through entity from the pre-IPO owners. This structure allows the operating partnership to remain a pass-through entity for tax purposes with two basic ownership groups: the pre-IPO owners and a publicly traded corporation. Rather than the public corporation owning operating assets directly, it instead owns an interest in an operating pass-through entity. Additionally, as a result of a tax election made by the pass-through entity, the tax basis of the assets inside the pass-through entity are increased. These assets include internally generated goodwill, which creates valuable tax shields during and after the IPO process. These tax shields would not be available had the company gone public using a traditional IPO structure and can be substantial, saving the public corporation millions or even billions in future taxes. The accompanying figure depicts the Up-C structure.

Typically, two types of stocks are issued by the newly formed public corporation: Class A and Class B common stock. The class A common stock is issued to public investors in the IPO. Class B common stock is issued to the pre-IPO owners, and these shares hold voting rights but no economic rights (the pre-IPO owners’ economic interest are held in the form of partnership units). In addition, in the future the pre-IPO owners may, subject to certain lock-up periods, periodically exchange partnership units for class A common stock typically on a one-for-one basis. These stocks can then be sold on the public market or be sold directly for cash during the IPO. Pre-IPO owners continue to remain partners in the pass-through entity retaining a single level of taxation on the operating activity of the entity.

In most Up-C IPOs, the pre-IPO owners also enter into one or more tax receivable agreements (TRAs) with the corporation. These agreements require the corporation to share the potential tax benefits with the pre-IPO owners. The most common split is 85/15 where the pre-IPO owners receive 85% of the tax benefit generated from the Up-C structure and the public corporation retains the remaining 15% which creates values for both owner groups.

After the IPO, the pass-through entity continues to directly operate the business and holds title to the principal assets. The pre-IPO investors exercise control over the public company as they participate in any stockholder votes with their Class B shares, as well as continue to receive economic interests through their direct ownership in the pass-through entity.

How Common Are Up-C IPOs?

Over the past 20 years, Up-C structured IPOs have become increasingly common for companies that have historically operated as partnerships. Private equity-backed and venture capital-backed companies in particular, tend to favor the Up-C structure because these financial investors often use flow-through entities to hold their interests in portfolio companies.¹ In addition—as discussed earlier—in an Up-C structure, these owners can also receive additional benefits from a TRA they could not have otherwise received.

From 2004-2019 approximately 70 IPOs were structured as Up-Cs. Shown in the above graph,² this made up roughly 9% of IPOs in 2019, and Up-C deals account for up to 23% of annual proceeds in recent offerings (Billings, Hsueh, Lewis-Western and Shobe 2022). Companies such as Pluralsight, Change HealthCare, Planet Fitness, and Shake Shack all had Up-C structured IPOs. Up-C’s have become the most popular form of Supercharged IPO’s due to their significant tax advantages and operational flexibility.

What are the Pros and Cons?

There are differing opinions on the advantages and disadvantages of the UP-C IPO for both the pre-IPO owners and the post-IPO shareholders (i.e., post-IPO owners). As more Up-C IPOs occur in the market, more in-depth research has developed and will continue to develop as academics and professionals study the effect of using the Up-C IPO structure.

Pros

The main reason why proponents of the UP-C structure prefer this type of IPO compared to other methods is because of the tax benefits and incentives provided to the pre-IPO owners while accessing public markets. This helps them avoid the double taxation that comes with a traditional IPO. The pre-IPO owners also enjoy the increased cash flow resulting from the TRA. Additionally, the Class B common stock allows the pre-IPO owners to retain control of the company, while the Up-C structure provides pre-IPO investors with public market liquidity with the right to exchange their interests in the pass-through entity for stock or cash. This allows the pre-IPO investors to have both voting and economic rights in the public corporation.

The biggest advantage of the Up-C IPO structure for post-IPO owners is that the pre-IPO owners’ interest is more aligned with the interest of the public company due to the TRA. 15% of the Up-C value created from tax shields is retained by the post-IPO investors as the values are realized. These payments only arise if the flow-through entity is profitable, which provides an incentive for both pre and post IPO shareholders to operate the business at a profit. This incentivizes the pre-IPO owners to maximize income for the public company so their TRA benefits can be monetized.

Proponents of the Up-C structure rely heavily on the argument that the Up-C structure aligns the pre-IPO investors’ interests with the public company’s interests given that the pre-IPO investors reap the benefits of the company’s tax assets only if the company has taxable income in future fiscal years. Some research suggests that the Up-C structure offers a value-enhancing means of raising capital that will benefit shareholders and motivate private companies to access the public markets more frequently (e.g., Polsky and Rosenzweig, 2018; Edwards et al., 2019). Similarly, this research suggests that organizing an aspiring public company as a pass-through entity leads to superior future performance since the Up-C deal structure increases IPO valuations and predicts positive operating performance post-IPO.

Cons

Other researchers have found that while the Up-C deal structure increases IPO valuations, the low return performance of Up-C IPOs indicates that this structure actually harms public shareholders overall (Billings, Hsueh, Lewis-Western and Shobe 2022). Specifically, one study found that Up-C IPOs are associated with future abnormal returns up to 29% lower over three years than traditional IPOs. This suggests that the Up-C deal structure is linked to significantly negative abnormal stock price returns and the IPO underperforms relative to traditional IPOs.

The reason for this underperformance is due to the costs and payouts associated with this structure. For example, Up-C IPOs face a significantly higher rate of post-IPO litigation expenses as IPO investors turn to litigation as a settling-up mechanism. Generally, this litigation is due to the additional benefits and opportunities that the pre-IPO investors receive—usually as a result of the payments received from the TRA—which causes post-IPO owner disgruntlement. The aforementioned study cites that 34.8% of Up-C IPOs face post-IPO litigation lawsuits, which is more than double the 16.6% litigation rate for non-Up-Cs. Many of these lawsuits are due to the fact that new investors overlook or fail to understand the complexities of the TRA and are surprised by the benefits the pre-IPO investors receive. This has led some commentators to state that a TRA “drains money out of the company that could be used for purposes that benefit all the shareholders” (Browning, 2013) and that “[t]he only people that benefit are the founders who negotiate these arrangements” (Foldy, 2021). In general, post-IPO investors struggle with the ability to determine how much value remains with the post-IPO entity and how much value remains with the pre-IPO investors that may be exploited. In addition, Up-C IPOs are administratively more expensive to account for because of the tax accounting required at the pass-through entity level. The following table summarizes the pros and cons for pre-IPO and post-IPO owners:

Conclusion

While Up-C structured IPOs have multiple tax benefits for the pre-IPO investors through TRAs, recent research shows that the complexities and misaligned incentives of the Up-Cs result in lower return performances and more lawsuits. Investors and pre-IPO owners alike should consider both the advantages and the disadvantages of an Up-C structured IPO before deciding the form of entity structuring when taking their company public.

Resources Consulted

• https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2019/05/on-point--upc-structure-7311324018converted.pdf
• https://www.pwc.com/us/en/services/trust-solutions/accounting-advisory/up-c-structure.html
• https://www.ipohub.org/up-cs-and-other-supercharged-ipos/
• https://www.thetaxadviser.com/issues/2015/nov/an-alternate-route-to-ipo-the-up-c-partnership-structure.html
• https://www2.deloitte.com/us/en/pages/consulting/articles/up-c-ipo-infocus.html
• Polsky, G. and A. Rosenzweig. 2018. The Up-C revolution. Tax L. Rev. 71, 415–470.
• Edwards, A., Hutchens, M., and S. Rego. 2019. The pricing and performance of supercharged IPOs. The Accounting Review 94, 245–273.
• Billings, Mary Brooke and Hsueh, Kevin and Lewis-Western, Melissa Fay and Shobe, Gladriel, Innovations in IPO Deal Structure: Do Up-C IPOs Harm Public Shareholders? (April 2, 2022). Management Science (Forthcoming), Available at SSRN: https://ssrn.com/abstract=4073730