Life after an Up-C IPO: PwC

Observations from the front lines

We continue to see companies leverage umbrella partnership C corporation (Up-C) organizational structures when accessing the capital markets. As discussed in a previous “Observations from the front lines” article, structuring an IPO, or special purpose acquisition company (SPAC) merger, as an Up-C requires considering unique and often complex financial reporting and tax implications.

Although the challenges of preparing to be public and going public should be addressed in parallel, once the bell is rung and a company is public, the challenges of being public take on added gravity. And ongoing accounting and financial reporting complexities related to an Up-C organizational structure and legal agreements will continue to impact a company long after the IPO or SPAC merger.

Post-IPO structure

The majority of the financial reporting complexities are driven by a company’s post-IPO organizational and ownership structure. Post-IPO Up-C structures are typically characterized by a public corporation (PubCo) owning economic interest in the form of ownership units and being the sole managing member of a pass-through operating entity.

Owners of PubCo include:

The public: The IPO offers Class A common stock to the public, giving them economic and voting rights in PubCo.
Pre-IPO investors: These owners hold Class B common stock, giving them voting power and no economic rights. These investors obtain economic rights through their ownership of an equal number of exchangeable units in the pass-through operating entity.

In addition, the following terms are common in Up-C agreements and must be considered when determining the appropriate accounting once the Up-C structure is in place:

The pre-IPO investors may exchange remaining operating entity units and Class B shares for PubCo Class A common stock or cash (generally at PubCo’s option). Typically, these exchange features require a careful analysis of the accounting impact, including the balance sheet classification of the NCI.
A tax receivable agreement (TRA) may require a percentage of any tax benefit derived by PubCo resulting from the Up-C structure to be shared with the pre-IPO investors.
A one-for-one relationship may exist between the Class A common stock outstanding and the number of units in the pass-through operating entity held by PubCo.

Accounting and reporting considerations

The Up-C structure and any associated legal agreements raise numerous accounting and reporting considerations. These can be nuanced, and a thorough understanding of a company’s specific facts and circumstances is necessary to reach the right accounting conclusions. Potential considerations include:

Non-controlling interest (NCI)

The structure of this statement should clearly delineate between the pre- and post-IPO periods. This results in significant NCI balance on the balance sheet, as well as an attribution of earnings to the NCI holders on the income statement and statement of equity.

Income statement: The allocation of income to non-controlling interest will change during the period of the IPO as the pre-IPO investors’ ownership changes. PubCo will need to determine the income calculated before the IPO, post-IPO and after any subsequent event (e.g., exercise of underwriters’ option to purchase additional IPO shares and unit exchanges by pre-IPO investors) that changes the pre-IPO investors’ ownership percentage of the pass-through operating entity.
Balance sheet: NCI on the balance sheet created as a result of the Up-C IPO will represent the pre-IPO investors’ ownership in the pass-through operating entity at a point in time. Careful consideration is needed to establish NCI and adjust NCI as ownership percentages change. As stated previously, the exchange feature held by the NCI needs to be carefully evaluated. Terms surrounding the exchange feature often can lead to a conclusion that the NCI should not be classified as permanent equity and rather should be classified as either mezzanine equity or a liability.
Statement of equity: The structure of this statement should clearly delineate between the pre- and post-consolidation periods. Multiple rows for net income, for example, may be required to appropriately reflect the change in the pre-IPO investors’ ownership in the pass-through operating entity.

Earnings per share (EPS)

The calculation and disclosure of EPS can present unique challenges. For example, companies will need to determine the appropriate presentation of EPS in pre-IPO periods where the Up-C structure was not in place.

Additionally, the dilutive nature of the exchange feature held by pre-IPO investors can significantly change the presentation of the EPS footnote depending on the number of outstanding shares held by pre-IPO investors. The dilutive or antidilutive conclusion may be sensitive to certain activities, and management should be fully aware of when an exchange feature results in a dilutive versus an antidilutive conclusion.

Terms written in the legal agreements should be fully understood when calculating EPS. Companies may determine that dilutive securities impact the EPS numerator, as the assumed issuance of new securities could change the ownership percentage of the controlling interest.

Taxes

The calculation of corporate taxes on net income attributable to PubCo requires an initial analysis of all income taxed and untaxed below PubCo within the Up-C organizational structure.

The TRA liability and deferred tax assets resulting from the Up-C IPO must be continually assessed and updated in line with the appropriate accounting framework for changes in ownership and the impact of the company’s operations.

Additionally, the Up-C structure provides its owners with tax advantages and economic flexibility not found in traditional IPOs.

Tax basis step-up: The Up-C structure provides tax advantages to PubCo, which receives additional amortizable tax basis when historical owners exchange their units for PubCo stock, leading to tax savings for PubCo over time when compared to a traditional IPO. Some of these tax savings can be recaptured by the historical owners via the tax receivable agreement.
Tax receivable agreement (TRA): Existing equity owners frequently negotiate a TRA that grants the founders, sponsors, and others a right to share in the actual tax savings resulting from the structure or from other specified tax attributes. Typical TRAs require PubCo to pay annually 85% of actual tax savings back to the exchanging partner responsible for creating the tax benefit.
Navigating “publicly traded partnership” rules: Because the interests in the operating partnership will be exchangeable into PubCo stock, the company must take care to avoid treatment as a “publicly traded partnership,” which could cause the partnership to be taxed as a corporation. Frequently, this is accomplished by limiting the number of partners to 100 or fewer.
Tax reporting considerations: Companies adopting an Up-C structure will complete both corporate and partnership tax returns each year. Companies with a TRA must compute their federal income tax liability on a “with and without” basis, effectively completing two federal returns to determine the annual tax savings attributable to tax attributes covered by the TRA.

Footnote disclosures

Several additional footnotes will now be relevant and may include:

Variable interest entities
Related party transactions
Contingencies
Non-controlling interest.

Additionally, other footnotes may need to be reexamined and tailored to the IPO.

Non-GAAP measures

As it relates to Non-GAAP measures, comparability across a company’s industry and with its peers is critical. An Up-C structure presents some unique challenges in achieving such comparability. Often investors and analysts will disregard the split in income between PubCo and the pre-IPO investors. They will also want to understand the future benefits that will be received as a result of the Up-C structure and associated TRA.

Journal entries

PubCo must record several journal entries to account for the reorganization, new ownership structure, cash proceeds and its use, the TRA, issuance of equity awards, and offering costs. Careful consideration should be given to the entity at which these journal entries are recorded. From an economic perspective, journal entries recorded at the PubCo entity reflect impacts to the public shareholders exclusively, whereas journal entries recorded at the pass-through operating entity or below reflect impacts to both the public shareholders and pre-IPO investors.

Stock compensation

The accounting assessment and appropriate presentation of stock compensation post-IPO requires careful consideration when an Up-C structure is in place. Often in conjunction with the IPO, companies may modify existing stock-based compensation plans, establish a new stock compensation plan, and issue new stock-based compensation awards to employees. PubCo must evaluate the impacts of any restructuring or issuance of awards.

For example, if the operating entity had stock-based compensation awards outstanding prior to the IPO, it is common to amend the terms and conditions of the awards in conjunction with the anticipated IPO for a number of reasons. These include changes in the LLC agreements related to the terms of exchange with PubCo and lack of a liquid market for units in the operating entity. Entities will need to assess the accounting impact of such changes.

Additionally, stock compensation instruments commonly are issued in an Up-C structure and should be evaluated carefully over their contractual terms to ensure the appropriate accounting treatment within the PubCo financial statement. Such an evaluation should include assessing the impacts on a company’s NCI and EPS, given certain terms within the company’s governance documents that often are seen with Up-C structures.

Early planning and coordination are key

The significant advantages of an Up-C structure, including incremental cash flows for pre-IPO investors, have contributed to its increasing popularity. Companies should consider and prepare for the complexities. Early involvement and coordination between cross-functional teams from accounting, tax, and finance is critical in order to align expectations and evaluate the financial reporting implications.

PwC’s Deals and Tax specialists can advise management teams through the details of how an Up-C structure may impact your organization. For more insight on Up-C structures and how to prepare for the ongoing reporting requirements, please contact PwC to request a meeting.

Note: “Observations from the front lines” provides PwC’s insight on current economic issues, 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.