Supercharged IPO is a new and controversial financial transaction that has dramatically increased in popularity over the past few years as companies try to extract as much value as possible from the IPO process.

A new white paper from Gladriel Shobe, Associate Professor, Brigham Young University Law School looks at the benefits of these transactions and considered whether the SEC should continue to allow such a process.

The supercharged IPO

The traditional IPO structure is comparatively inefficient from a tax perspective. That said, it can be "supercharged" to increases the basis of the assets of the newly public company thus increasing a number of depreciation deductions the new company can take against its future income. Using this method, the company can convert what is often its most valuable asset, its goodwill, from a non-depreciable asset to a depreciable one and the depreciation costs over the life of the asset will reduce the company's future taxable income.

In a traditional IPO, to realize this supercharging, a change in structure is needed as, under the Internal Revenue Code, self-developed goodwill is not depreciable to the company that created the goodwill. If a different entity purchases the historic business, the tax code allows the purchaser to depreciate that same goodwill over a fifteen-year period. The Supercharged IPO goes one step further than the traditional method of supercharging a conventional IPO to add even more benefits. As the white paper explains:

"First, the owners structure the IPO as a sale so that the public company gets a step-up in the basis of its underlying assets, including self-developed goodwill. And second, the company and the pre-IPO owners usually enter into a contract called a “tax receivable agreement,” an agreement whereby the new public company makes payments to the pre-IPO owners for tax assets, including the tax assets created by the taxable sale."

Using this method creates tax assets the business would not otherwise have improving overall IPO returns.

The Up-C

The Up-C is the most common of the three different types of Supercharged IPO structures. To create an Up-C, the company follows the following steps:

1. The new C corporation has two classes of stock, Class A stock with voting and economic rights typical of common stock,
   and Class B stock with voting rights, but no economic rights.
2. The pre-IPO owners recapitalize the partnership, by 1) admitting the new C corporation as the sole managing member of the partnership and 2) by admitting the new C corporation as the sole managing member of the partnership, 3) the recapitalization aligns the value of each partnership unit with the value of each share of Class A stock.
3. After the recapitalization, the C corporation issues the Class A stock to public investors who subscribe in the IPO in exchange for cash while at the same time issuing Class B stock to the pre-IPO owners by their ownership.
4. The pre-IPO owners retain their economic rights through a direct interest in the underlying partnership units, which allows them to maintain certain tax benefits.
5. Immediately after issuing the Class A and Class B shares, The C corporation uses the cash it receives in the IPO to purchase interests in the historic partnership from either the pre-IPO owners or from the historic partnership itself.
6. Public shareholders hold Class A shares of the C corporation, as one share of Class A stock typically represents an interest in one unit of the underlying partnership. The same is true for B shareowners who have been able to acess the public markets while keeping their voting interest.

The Up-C gives the pre IPO owners the right to exchange their (voting) Class B shares together with a corresponding number of (economic) partnership units on a one-for-one basis providing pre-IPO owners liquidity similar to the liquidity they would have in a traditional IPO.

Meanwhile, "The partnership makes an election under Section 754 of the Code, which provides the public company with a stepped-up basis in the assets of the underlying partnership when it acquires partnership interests from the pre-IPO owners. The Section 754 election also turns the historic partnership’s non-depreciable, self-developed goodwill into depreciable goodwill, meaning that the corporation is able to significantly reduce its future tax liability as it deducts for the goodwill."

The benefits of a Supercharged IPO Up-C

Using the Up-C process is relatively costly and complex compared to a traditional IPO, but there are many benefits, which far outweigh the costs and time spent preparing for the structure.

The first major benefit is through corporate tax avoidance. In a traditional IPO, the pre-IPO owners’ interest in the company becomes subject to two levels of federal tax. Income earned by the corporation at a maximum rate of 35% and on earnings distributed at a maximum of 23.8% for a maximum combined rate of 50.5%. Within the Up-C structure, the historic partnership makes distributions directly to the pre-IPO owners, which are taxed at the individual rate maximum rate of 39.6%.

The Up-C also benefits from tax arbitrage as the paper explains:

"This sale of partnership interests to the public corporation results in a step-up in the basis of the partnership’s assets, which the corporation is then able to use to its advantage by depreciating the stepped-up assets at a 35% corporate rate, generally over a fifteen-year period. The net result is that the historic partners pay tax at a preferential capital gains rate of 23.8% while the public company gets an offsetting deduction at a 35% corporate rate. The resulting tax arbitrage generates a net tax benefit on the transaction at the expense of the federal government."

Shobe, Gladriel, Supercharged IPOs and the Up-C (March 24, 2016). University of Colorado Law Review, Forthcoming; BYU Law Research Paper No. 17-03.