Navigating mergers and acquisitions (M&A), as well as initial public offerings (IPOs), can be tricky.

One tool that’s becoming more common in these deals is the TRA (Tax Receivable Agreement). But how exactly does it impact your deals? 

Understanding this financial agreement can be important for both buyers and sellers. In this article, we’ll explain what a TRA is, how it affects deals, and what to consider when working with one.

What Is A TRA (Tax Receivable Agreement)?

A Tax Receivable Agreement is a contract between a company (often called IPOCo during an IPO) and its original owners, such as early shareholders or partners. It allows these owners to keep benefiting from certain tax savings, like deductions or credits, even after the company goes public or is sold. 

What is a Tax Receivable Agreement used for? 

The main purpose of a TRA is to let the original owners continue to gain from the company’s tax assets, like depreciation, amortization, or net operating losses (NOLs). 

In an Up-C structure, when pre-IPO owners exchange their partnership units for shares, the company gets a “step-up” in the tax basis of its assets. This step-up means the company can reduce its taxable income over time by using the new tax-deductible value of its assets.

A TRA agreement typically requires the company to pay back around 85% of the tax savings to the original owners. This way, those owners can still benefit financially even after selling their ownership in the business. For new investors or buyers, it’s important to understand how a TRA will impact the company’s future cash flow.

How A TRA (Tax Receivable Agreement) Impacts Deals

A TRA can affect deals in several ways. Here’s how it might change things for buyers, sellers, and the overall transaction:

1. Financial structure and cash flow

TRAs require a company to pay its original owners as it realizes tax savings. This means that some cash that could be used for reinvesting in the business has to be directed towards TRA finance payments. This impacts cash flow and could influence the company’s valuation. Buyers need to think about these future payments when considering a purchase.

2. Valuation alignment

TRAs can help solve disagreements between buyers and sellers over the value of certain tax assets. Instead of paying for these tax benefits upfront, buyers only pay as they are realized. For example, in transactions using a 338(h)(10) election, a tax receivables agreement can allow sellers to benefit from future tax deductions without increasing the buyer’s initial costs.

3. Impact on IPO structures

In IPOs, especially with Up-C structures, TRAs can align the interests of pre-IPO owners and new shareholders. Since pre-IPO owners get paid only when the company realizes tax savings, they have an incentive to help the company grow. This alignment can boost the company’s performance after going public.

4. Long-term financial planning

Knowing how to handle TRA finance is crucial for companies. TRA (Tax Receivable Agreement) payments are calculated by comparing the company’s actual tax bill with what it would have been without the tax benefits covered by the TRA. This approach makes sure payments reflect real savings but can also mean the obligations last for many years, depending on how profitable the company is.

Key Considerations For Buyers And Sellers In A TRA

If you’re entering into a tax receivables agreement, there are some key points to keep in mind:

• Contingent liabilities: For buyers, a TRA is a future liability that will affect the company’s cash flow. Forecasting how much the tax benefits will be worth and how long the payments will last is crucial. This requires understanding how much taxable income the company is likely to generate in the future.
• Negotiating terms: Sellers can use a TRA agreement to increase their earnings from a sale. By setting up a TRA, they can receive payments based on future tax savings, potentially getting a better deal. Buyers, however, should ensure that the terms of the TRA fit within the company’s financial plans.
• Risk of changes in tax law: TRAs come with the risk that tax laws might change, which could reduce the value of the tax benefits. For instance, if corporate tax rates are lowered, the value of deductions could decrease, leading to smaller TRA payments. Buyers should consider this when structuring a deal and setting up the terms of the TRA.

Tax Receivables Agreements And Finance

Understanding how TRA finance impacts cash flow is important for both original owners and new shareholders. Here’s what to keep in mind:

Cash flow impact

TRAs are often structured so that TRA payments take priority over other uses of cash, like investing in new projects or paying off debt. This can limit a company’s ability to grow or reduce its debt. However, if a TRA is structured well, the company might still keep enough of the tax savings to make the payments worthwhile.

Secondary market for TRAs

There is a growing market where original owners can sell their TRA rights to third parties for immediate cash. This gives TRA holders more flexibility, but it means potential buyers of these rights need to do their homework and understand how much future cash flow the TRA could provide.

TRA termination provisions

Sometimes, companies want to end their TRA obligations early. They can do this through a buyout or negotiated deal. An early termination payment is usually based on the present value of future TRA payments, adjusted using a discount rate. This option can simplify the company’s financial structure but requires careful analysis of the costs versus the long-term savings.

Conclusion

A TRA (Tax Receivable Agreement) can be a useful tool for structuring M&A deals and IPOs, benefiting buyers and sellers. By sharing future tax savings, TRAs can make deals more appealing for sellers while allowing buyers to manage valuation risks. However, they can add complexity, so careful planning is necessary.

If you are thinking about using a TRA in your next deal, it’s wise to seek advice from experts who understand what a TRA is and the details of TRA finance. With the right strategy, a tax receivables agreement can boost the value of your transaction and ensure that all parties benefit.