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Not an Oopsie: The Up-C IPO Structure



Traditionally, a limited liability company or partnership (which for the purpose of brevity, will simply be referred to as “LLC”) wanting to conduct an initial public offering (IPO), would, prior to the IPO, convert to a corporation. This conversion can usually be accomplished in a manner that is tax-free for the LLC owners, though such owners would recognize income on the conversion to the extent the liabilities of the LLC exceed the LLC’s tax basis in its assets. Under this structure, the public corporation would not receive any tax benefit in connection with the IPO.

For certain LLCs, such as those with liabilities that exceed the tax basis in their assets, those with a large amount of assets that would need to be contributed to the corporation upon conversion, and those expecting high taxable income on a regular and recurring basis following the IPO, the conversion from LLC to a corporation prior to an IPO may not be the best choice. Instead, these LLCs may opt to add a corporate holding company (C-Corp), which will generally own the majority of the LLC’s ownership interests and in turn sell its shares of common stock to the public in the C-Corp’s IPO. This structure is often referred to as an “Up-C,” taking the “Up” in its name from the UPREIT structure, which has been commonly used by real estate investment trusts since the 1990s. The Up-C structure eliminates any liabilities in excess of basis for the LLC owners, and, if an election under Section 754 of the Internal Revenue Code (the Code) is made, creates a valuable amortizable tax basis for the C-Corp any time an LLC owner exchanges its LLC interests for cash or C-Corp stock. As will be discussed in more detail below, the historic LLC owners are often able to negotiate a right to receive the vast majority of these tax benefits, potentially creating a considerable increase in overall IPO proceeds to the LLC owners.

Up-C Basic Corporate Structure
Typically, the C-Corp’s Certificate of Incorporation authorizes Class A and Class B common stock. The C-Corp’s Certificate of Incorporation can also authorize preferred stock, but because such preferred stock is not often used for IPO purposes. The Class A shares have voting power and represent a typical public shareholder in the C-Corp akin to that of any other C-Corporation conducting an IPO. The Class B shares only have voting power, and do not entitle the holder to receive any economic interest in the C-Corp.

Prior to the IPO, the LLC will recapitalize, if necessary, to have one class of interest, expressed in units (Units), with each Unit being equivalent to one share of Class A stock in terms of both voting rights and economic rights. Also prior to the IPO, the LLC’s owners will enter into one or more Exchange Agreements with the C-Corp that allow them to exchange their LLC interests for shares of the C-Corp’s Class A common stock, which, following the IPO, can then be sold for cash in the public market, subject to underwriters’ lock-ups and other typical restrictions. These agreements also may contain provisions allowing the C-Corp to redeem LLC interests for cash rather than issuing shares of Class A common stock. Such provisions would have the same effect as having selling shareholders in the IPO.

In some cases, the LLC members also enter into a Registration Rights Agreement with the C-Corp, requiring the C-Corp to register the Class A shares issued pursuant to the exchange agreements described above. These Registration Rights Agreements, however, will likely become far less common after the SEC’s no action letter issued on November 1, 2016, which indicated that if the Up-C’s Exchange Agreement is drafted properly, for Rule 144 (6- or 12-month) holding period purposes, such holding period tacks back to when the LLC interest was obtained, not when the Class A share is issued.

The members of the LLC and the C-Corp also enter into what is commonly referred to as a Tax Receivable Agreement (TRA), which usually grants the exchanging LLC member rights to receive 85-90% of the tax benefits reaped by the C-Corp as a result of the Up-C structure (with the C-Corp keeping the additional 10-15% of benefit). One of the key drivers of the Up-C structure, the TRA allows pre-IPO LLC members to increase their ultimate proceeds arising from the IPO transaction significantly, as long as the company stays profitable enough over the long term to reap such tax benefits. As payments pursuant to TRAs are generally contractual in nature, they are not necessarily tied to continued ownership of LLC interests (or ownership in the C-Corp). Thus far, neither entrance into these TRA agreements, nor making the payments associated with the agreements, has hurt the value of the C-Corp’s shares in the public market.

The Class B shares are designed to ensure that the public shareholders of the C-Corporation and the LLC owners who continue to own Units in the LLC have voting parity in the C-Corp based on their proportionate direct and indirect ownership of the LLC. Prior to the IPO, LLC members are issued shares of the Class B common stock in proportion to the amount of LLC interests held. If a member sells or exchanges any of its LLC interests, the voting power of its Class B shares is also proportionally reduced by the amount of LLC interests sold or exchanged. If a member sells or exchanges all of its LLC interests (or otherwise ceases to own any LLC interests), then that member’s Class B shares are automatically retired. Because the Class B shares have no economic interest in the C-Corp, their retirement effectively has no adverse economic effect on the C-Corp. Similarly, when LLC interests are ultimately exchanged for Class A shares, the diminution of Class B shares’ voting interests does not affect the control of the C-Corp’s overall voting power.

The Up-C Transaction

Traditionally, the C-Corp’s IPO has been carried out by filing a Form S-1 registration statement with the Securities and Exchange Commission. However, we believe that if a C-Corp were looking to raise $50 million or less in its IPO (and was otherwise eligible to utilize the exemption from registration found under Regulation A of the Securities Act of 1933, as amended under the JOBS Act), the C-Corp could conduct its IPO by filing a Form 1-A (and corresponding offering circular), which could significantly reduce the legal, accounting and underwriting fees typically associated with an Up-C IPO. To date, we do not know of any Up-C IPOs using Regulation A, however, there have been several successful IPOs of UPREITS using Regulation A.

Directly after the C-Corp’s IPO (offering Class A shares to the public), the C-Corp contributes to the LLC all of the capital raised in the capital markets by the C-Corp in the IPO, in exchange for membership interests in the LLC. The operational documents of the LLC (e.g., its Operating Agreement) are typically amended to name the C-Corp (or one of its wholly owned affiliates) as the manager (or managing member) of the LLC. The LLC retains all of the operating assets of the business. The C-Corp then acts as both the holding company and manager of the LLC, owning an interest in the LLC alongside the LLC’s pre-IPO members (which group often includes one or more private equity firms).

Advantages of the Up-C Transaction

After the transactions described above are complete, the pre-IPO LLC members continue to benefit from the pass-through taxation of an LLC (until they exchange their interests for Class A shares) and effectively avoid the double taxation that usually comes with ownership in a C-Corp. The LLC will make tax distributions to both its owners and the C-Corp to fund tax liabilities. LLC distributions will then be tax free to the owners of the LLC, except to the extent it exceeds the owners’ tax basis in the LLC (which is increased by the pass-through income allocated to the owners), whereas C-Corp distributions to the public shareholders will be subject to tax. Further, although the exchange of LLC interests for Class A shares is a taxable transaction, the pre-IPO members will at least avoid double taxation on the ultimate disposition of their LLC interests. Pre-IPO members also have liquidity in that they can exchange their LLC interests for shares of the publicly traded C-Corp.

If the LLC makes a timely election under Section 754 of the Code, the C-Corp will receive a step-up in the tax basis of its share of the LLC’s assets as the historic LLC owners exchange their Units in the LLC for cash or Class A stock. This step-up in basis is most often allocable to goodwill and going concern value, which is amortizable by the C-Corp over 15 years. Assuming the C-Corp has sufficient taxable income to utilize these deductions, these deductions can be very valuable. Despite their potential value, the public markets place little if any value on these tax attributes. This market dynamic creates an opportunity for the owners of the LLC to take a large percentage (typically 85%-90%) of the tax benefits realized by the C-Corporation through the TRA without affecting the share price in the IPO. As an added benefit, payments pursuant to a TRA are treated as contingent installment sale proceeds from the sale of the Units by the historic LLC owner, which generates additional stepped up basis for the C-Corp each time a payment under the TRA is made.

Pitfalls of the Up-C Transaction

Any company considering an IPO using an Up-C structure must conduct a cost-benefits analysis with respect to incurring the added cost and complexity of putting such a structure in place, as well as the cost of maintaining the structure. A company must generate enough income to take advantage of the tax benefits, and correspondingly, the size of the tax benefits of generated must also be significant enough to justify the added expense and administrative burden inherent in the Up-C structure’s multi-entity, multi-tiered ownership structure and in administering the TRA. In order to assist with this cost-benefits analysis, a list of companies that recently completed significant Up-C transactions is included below.

For additional information, please contact Marc Adesso, Wes Scott or any member of the Waller Capital Markets and Securities team.

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.





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