Gladriel Shobe’s new work describes the evolution of Tax Receivables Agreements (TRAs) in IPOs, and evaluates the policy implications of these increasingly common agreements.
A TRA is contract entered into in connection with an IPO whereby the new public company agrees to pay the pre-IPO owners for the value of tax assets held by the historic company, which can offset the company’s future taxable income. The most common such assets are depreciable asset basis and net operating losses (NOLs). Under a TRA, the public company pays the pre-IPO owners for the value of these tax assets over a period of years following the IPO as the value is realized.
The Article begins by identifying three distinct generations of TRAs. The agreements first arose in the early 1990s alongside the advent of “supercharged IPOs” that allowed pre-IPO owners to increase the value of tax assets in connection with an IPO. TRAs were adopted so that the pre-IPO owners could monetize the benefits from the tax planning that they engineered. A second generation of TRAs emerged in the early 2000s that expanded the practice to cover other tax assets that existed prior to the IPO. Finally, IN the third generation, TRAs that only covered historic assets began to be used in non-supercharged IPOs. Shobe argues that this third generation of TRAs warrants the greatest attention from policymakers and investors, because these agreements can be used in virtually any IPO where the company has depreciable assets.
As the Article describes, TRAs have been alternatively praised and criticized. Proponents argue that TRAs ensure that pre-IPO owners receive fair value for assets that would not be efficiently priced in the IPO. Critics argue, in contrast, that the practice allows pre-IPO owners to extract value from the company in an underhanded manner, as investors do not appreciate the cost of these agreements. Shobe argues that the best way to test these competing assertions is by comparing TRAs to the valuation of tax assets in private deals. Her analysis finds that TRAs generally subject public shareholders to less favorable terms than what parties typically agree too in private deals, suggesting that TRAs may unduly benefit pre-IPO owners at the expense of public shareholders.
The work concludes by describing a unique benefit pre-IPO owners can achieve through structuring an Up-C transaction. Under an Up-C, the public company is structured as a holding company, with interests in an underlying operating partnership. Pre-IPO owners retain a direct interest in the partnership, and hold a right to exchange their partnership interests for public company shares. Shobe argues that, in this context, the pre-IPO owners can duplicate the benefit of tax distributions from the underlying partnership, by first receiving tax distributions directly as partners, and then exchanging their partnership interests for interests in the public holding company. If the public company has retained its own tax distributions, the pre-IPO owners have achieved a double benefit. Shobe argues that the SEC should require disclosure of this potential “double dip” in Up-C IPO transactions.
As described above, the work focuses on two conflicting accounts of the TRA: as a correction for the failure of investors in the public company to account for the value of tax assets, or as an underhanded way for pre-IPO owners to unduly extract value following the IPO. One might imagine, however, a third account of the TRA that is mutually beneficial to both parties. The value of tax assets such as basis and NOLs is contingent on both the future tax characteristics of the company, as well as future tax law. As a result, a TRA may be viewed as a way for the parties to adopt a “wait and see” approach to valuing these assets, avoiding the risks to either party from undervaluing or overvaluing these assets. In this respect, the best analogy to a TRA may be an earnout agreement often used in a merger or acquisition, whereby a portion of the purchase price is contingent on the financial performance of the company in the years following the acquisition.
This work sheds new light on the increasing use of TRAs in IPOs, and will consequently be of great interest to both policymakers and investors. For policymakers, these insights warrant reconsideration of the efficacy and scope of disclosure requirements in IPO transactions. In particular, Shobe argues that, at the very least, the SEC should require disclosure of the one-sided nature of TRAs, which require the public company to pay for the value of historic tax assets, but do not require pre-IPO owners to pay the public company with respect to historic tax liabilities. Of course, entering into a TRA is not a violation of law, provided the terms and risks are adequately disclosed. In this case, prospective investors would be wise to weigh the effect of these agreements carefully, and to adjust the pricing of their investments accordingly. Finally, the insights of this work could be of interest to short-sellers and arbitrageurs, who may stand to profit from the overpricing of post-IPO public companies with TRAs.