The organizational structure has started picking up steam in the wake of high-profile floats such as the upsized debuts of beloved New York-based burger joint Shake Shack Inc. and website domain registrar GoDaddy Inc. Others were quick to follow suit, with Continental Grain Co. unit Wayne Farms LLC, the sixth-largest U.S. chicken processor, recently queuing up an IPO using the Up-C structure.
At its most basic level, the Up-C offering structure allows the pre-IPO owners to take the company public while maintaining the flow-through tax benefits of a partnership structure, explained Joshua Bonnie, a Simpson Thacher & Bartlett LLP partner.
"That's the big innovation. Basically, you deal with the tax rule that says public entities have to be traded by the corporation by having the publicly traded entity own only the portion of the business that is traded by public investors instead of subjecting all of the business to corporate taxes," he said.
Here are five things to know about launching an Up-C IPO.
Up-C Isn't Too Far Off From Up-REIT and MLP Structures
The structure of the Up-C IPO draws inspiration from the Up-REIT structure utilized by real estate investment trusts and the master limited partnership structure employed by the energy industry, noted Patrick Shannon, a Latham & Watkins LLP partner.
"The Up-C structure is a variation on a structure commonly used in REIT IPOs, which we refer to as an Up-REIT structure," he said. "Up-C borrows from the Up-REIT and from structures used in the MLP space. Which, if any of these structures is used in a particular transaction, depends on the industry, tax and other attributes of the company being taken public."
The need for developing the alternative offering structure stems from legal changes enacted by the U.S. Congress in the mid-1980s that removed the pass-through tax treatment for publicly traded partnerships, Bonnie said.
"It's impossible to have partnerships that are public. But what an Up-C does is take a business that is already a partnership and lets it mostly stay a partnership when it goes public," he said.
To move forward with an Up-C IPO, a corporate entity is created to sit above the partnership. It's then taken public, and the proceeds from the offering of Class A stock to public investors are used to buy an interest in the partnership, while the pre-IPO owners continue to hold their stake in the company through the partnership, said Remmelt Reigersman, a Morrison & Foerster LLP partner.
"The thinking is, 'Instead of converting the LLC to a corporation and going public, let's set up a new company, a brand-new company, which can be our public company.' That company goes public, raises the money in the IPO, and that company buys the interest in the partnership," he said.
Corporations Aren't Eligible to Use the Up-C Structure
Some companies may unknowingly waive their right to pursue an Up-C structure when they are mature enough to go public. If a company is founded as a corporation or converts to a corporation during its lifetime as a private company, it cannot convert to a partnership prior to its IPO to then float using an Up-C offering structure, Reigersman said.
"The most important point of it is that they start off as a structure that is a partnership for tax, and so it's a flow-through entity — LLC, LLP or GP, etc.," he said.
While converting from a partnership to a corporation for tax purposes strips away a company's chance to tap the public market using the Up-C structure, there are situations when signing away a shot at preserving a more favorable tax status can be the best option for private companies.
That particularly rings true for companies seeking investments from venture capital firms, which tend to only invest in corporate structures and not partnerships, Bonnie noted.
"What I have come to learn is that a lot of venture capital-backed companies are not organized as partnerships; they are organized as corporations. They are corporations for tax purposes, so this structure would have no benefit to them," he said.
Pre-IPO Owners Don't Give Up Control in an Up-C Offering
While preserving the majority of their flow-through tax status, the pre-IPO owners are also able to hold on to their majority ownership of the partnership and therefore the business, Shannon said.
To do so, when the corporate entity goes public, the pre-IPO owners receive Class B shares equal to their ownership stake in the company. The shares generally provide super voting rights to control the publicly traded corporate entity, are not publicly traded and have no economic rights, Shannon explained.
"This gives them the best of both worlds. They retain the beneficial tax treatment enjoyed by partnerships and continue to retain a high level of control of the business until they have sold down below a certain level," he said.
For example, if a private equity firm wants to sell a 30 percent stake in a portfolio company using the Up-C IPO structure, 30 percent of the company would be offered to public investors via Class A stock. At the time of the float, the remaining 70 percent owned by the private equity firm through the partnership would be represented with the distribution of 70 percent of Class B stock. While the Class B stock does not have any economic rights, it does give the private equity firm control over the actions of the corporate entity.
The Class B shares cannot be sold publicly for the private equity backer to get liquidity. Instead, to liquidate all or a piece of its holdings, the private equity firm would exchange its units in the partnership for a corresponding amount of Class A stock which it can then sell, Shannon said.
"The sponsor achieves liquidity by exchanging partnership units for public company Class A shares on a one-to-one basis and sells those shares into the public market, typically in a SEC registered transaction," he said.
Tax Receivable Agreements Add Another Layer of Complexity
Put into action, the Up-C offering structure is a complex one that will require guidance from legal tax experts. The complexity of the structure, however, doesn't end once the IPO closes. The use of tax receivable agreements by most adds another ongoing layer of complexity, noted John LeClaire, a Goodwin Procter LLP partner.
The tax receivable agreement is not required when using the Up-C IPO structure, but the agreement is generally used to split the cash savings from the resulting structure's tax basis between the pre-IPO owners and the public investors.
"They allow the public company to write up the value of the assets it is deemed to acquire when the legacy owners of the partnership interests exchange their shares for public company stock and to take depreciation against taxable income, which lowers the amount of taxes they pay," LeClaire said. "The public company pays over most of the savings, generally 85 percent, to the pre-IPO owners and keeps the rest. The public company sometimes also compensates the pre-IPO owners for other tax benefits they contribute."
While the tax savings can be substantial, that incentive alone would not be enough to convince a company to launch an IPO earlier in its lifetime or choose to pursue an IPO over another type of transaction, LeClaire said.
"It would not drive one to go public," he said. "It's more of a substantial enhancer if going public is otherwise the right choice."
And with the added levels of complexity, both leading up to the IPO and in the years following it, the structure isn't particularly well-suited for smaller companies, which would see less cash savings in the process, Shannon noted.
"If the company wasn't making a lot of money and not paying a lot of taxes, we might just say, 'You know what, it's not worth it.' It does add a little bit of cost and complexity. It's only worth it if the savings are meaningful," he said.
Structure Has Little Impact on Public Investors' Opinion
The structure offers many twists and turns that, in theory, could ward off potential IPO investors. However, as more companies utilize the structure and perform well following their IPO, the more comfortable both companies and their potential investors have become with the structure, he explained.
"There was concern that the investing public would apply some kind of discount to the value of the company because it has this complicated structure with two different companies," Bonnie said.
Under the Up-C offering structure, the public investors only gain indirect ownership of the company, the pre-IPO investors maintain full control over the corporate entity and the pre-IPO investors gobble up the majority of the tax savings realized by the company.
But investors have relaxed as the Up-C structure has gained favor. Another contributing factor is that the tax attributes, over time, will end as the pre-IPO owners liquidate their stake, Bonnie noted.
While at face value the tax receivables agreement could appear to be unfair, as the pre-IPO owner tends to get 80 to 85 percent of the cash saved in taxes, public investors have tended to not weigh that as a pro or con, Shannon said.
"That's real cash that would otherwise be available to the stockholders. I think the reason that hasn't been a big sticking point is that it’s just the nature of the structure," he said. "The company is still going to receive 15 or 20 percent of that benefit."
--Editing by Katherine Rautenberg and Philip Shea.