Introduction
Before I dwelve more into today's topic, I must admit this could possibly be the most dull theme I cover now and perhaps ever in the future. One thousand five hundred words on legal, taxation, and corporate structuring is not for the faint-hearted, so buckle up and hold on to your seat. But if below citation does happen to make sense to you, then I salute you and recommend you to skip the rest of the article:
Tax Lawyer: “I was trying to structure this acquisition as a reverse triangular merger but there is too much boot in the transaction and a double dummy is too complicated for this crowd, so I am thinking that so long as the target does not flunk the ‘substantially-all-the-assets test,’ we could flip over and do a forward triangular merger instead, which works because of the boot relaxation rules and, just to be careful, we can implement the transaction safely by stacking a reverse triangular merger followed immediately by a Type A, so that the transaction will be aggregated into a forward if it works and disaggregated into a reverse if it doesn’t. That is certainly the right way to implement a forward triangular merger in my opinion. What do you think?”
Bewildered Client: “Huh?”
IronSource is an Israel-based software company that specialises in mobile app monetisation. In early 2021 it announced its intention to go public in a SPAC deal with Thoma Bravo. By all means, IronSource has enjoyed quite stellar traction with $332M revenue in 2020 growing 83% YoY on a positive EBITDA and 149% net dollar retention. Naturally, I picked up the prospectus wanting to learn more.
Most of the time these listing documents are a 30 minute read and you’re done, but there was something peculiar on the post-transaction structure in the very first pages of the >300 page thick book full of poetic financial and legal prose.
See that Showtime Cayman II? It is related to the listing transaction, and tax advisors and lawyers probably know the story immediately, but practitioners like myself will find themselves scratching their heads and quickly falling into a rabbit hole trying to understand what is going on.
Short answer is tax reasons (yes yes, didn't see that one coming did you?) but the long story is still worth the read as the way these cross-border acquisitions are structured can be quite involved. Cue a brief lesson into tax-free merger structuring by the masters of the universe.
Setting the stage
To understand what is happening, let us start with the way how IronSource describes the transaction. It will sound complex, but we will digest it one step at a time.
The terms and conditions of the merger of the Merger Sub with and into TBA (the “First Merger”), with TBA surviving the First Merger as a wholly owned subsidiary of ironSource (such company, as the surviving entity of the First Merger, the “Surviving Entity”), and the merger of the Surviving Entity with and into Merger Sub II (the “Second Merger,” and together with the First Merger, the “Mergers”), with Merger Sub II surviving the Second Merger as a wholly-owned subsidiary of ironSource (such company, as the surviving entity of the Second Merger, the “Surviving Company”) (collectively, the “Business Combination”) are contained in the Merger Agreement, which is attached as Annex A to this proxy statement/prospectus. We encourage you to read the Merger Agreement carefully, as it is the legal document that governs the Business Combination
Makes perfect sense, right? Well, to make it easier to digest I’ve drafted the transaction entities for both IronSource and Thoma Bravo Advantage (“TBA”) before anything has happened. IronSource has created two subsidiaries, Merger Subs I and II (called Showtime Cayman I and II, respectively) solely for the purpose of consummating the transaction.
First thing you'll see is that while Thoma Bravo is US-based acquirer, and IronSource is Israeli-based, the actual transaction happens in Cayman Islands. There are many benefits of having the acquisition entity in Cayman Islands, where the subsidiaries and the SPACs are domiciled. Not only is Cayman Island an established and well understood merger regime enabling a harmonic deal, but it will also allow IronSource to go public as a so called "foreign private issuer" and be subject to more lenient SEC regulation .
Ok, so going back to the transaction (eyes to the graph above), what happens is
- Merger Sub I (“Showtime Cayman I”) acquires Thoma Bravo Advantage ("TBA") in a so-called “reverse triangular merger”. IronSource now owns TBA and Merger Sub I will cease to exist
- TBA (or the ex-Showtime Cayman I) that is now owned by IronSource, merges with another IronSource subsidiary Showtime Cayman II in a so-called “forward triangular merger”
- Combining these transactions together, and executing them simultaneously, the whole transaction becomes one big forward triangular merger
Forward and reverse triangular mergers are funky tax-free transaction structures that involve acquiring another company using a subsidiary. The names seem frightening at first, but are actually quite important in order to understand what is being orchestrated.
Forward triangular merger is the more logical one where an acquirer acquires a target, which then becomes a wholly owned subsidiary of the acquirer. They are great in transactions where payment is a combination of stock and cash, but do come with a high risk of (double) taxation and can be a challenging as the target gets destroyed.
Reverse triangular merger tends to be more often seen in corporate M&A as it offers many benefits and tends to be clean to execute. The downside is that they are strict around how much cash can be used in the payment (or “consideration”), and depending how the SPAC transaction is structured there might be a large non-stock component in the form of Private Investment to Public Equity ("PIPE") or the cash payment from the SPAC's treasury.
The first merger
The transaction begins with a reverse triangular merger . As mentioned it is one of the most popular merger structures due to its simplicity (subsidiary has essentially only one shareholder, its parent) and has an advantage of isolating acquired company's liabilities into a separate entity. In the first phase, the SPAC, Thoma Bravo Advantage, merges with a subsidiary of IronSource, Showtime Cayman I.
When you put two things together, only one of them can exist (or survive) going forward and it's often more beneficial that the target remains intact. In reverse triangular merger it is the acquired entity i.e. TBA that “survives” while the acquirer Showtime Cayman I gets destroyed. In forward triangular merger it’d be the other way around and while this may sound like a subtle difference it actually matters a lot.
Whoever gets destroyed also finds their legal contracts and obligations destroyed as well, which may need to be renegotiated to the newly formed entity. Needless to say all this legal paperwork can get really messy and may need all sorts of third party consents who have the ability to kill the transaction. With reverse triangular merger where the target survives, the legal entity can operate just as before but under a new shareholder ownership removing all the stress and hustle. Simple.
The technical rule that primarily dictates whether it'll be taxable or not is one that requires the acquisition to contribute into the continuity of the merged company - the so called Continuity of Business Enterprise Requirement or "COBE". As Investopedia puts it, the doctrine holds that in order to qualify as a tax-deferred reorganization, the acquiring entity must either continue the target company's historic business or should use a substantial portion of the target's business assets when conducting business.
There is some risk that the acquired SPAC would not fill the business continuity requirement because, for example, (a) it doesn’t have an operating history (SPACs by definition have 24 month operating history at best) or (b) the majority of assets in the acquired entity, the SPAC, are considered non-operating assets such as cash.
By the way, notice how annoyingly confusing it is when I am constantly implying it's the SPAC that gets acquired? Intuitively it's easier to think it's the SPAC that needs to acquire a target company, but as described earlier it's actually the reverse in a reverse triangular merger - the subsidiary acquires the SPAC. Anyhow, I digress.
The continuity requirement sounds trivial, but the risk is real. Although on page 275 of the prospectus the counsels of Thoma Bravo, Kirkland & Ellis, do believe the transaction is likely to be considered a tax-free merger they also caveat it as follows:
Kirkland & Ellis LLP that the Business Combination is more likely than not to qualify as a “reorganization… However, due to the absence of guidance bearing directly on how the above rules apply in the case of an acquisition of a corporation with only investment-type assets, such as TBA, the qualification of the Business Combination as a reorganization is not free from doubt
Here's they juicy bit though: If for some reason the reverse triangular merger blows up because it flunks the above qualifications (i.e. say the regulator agrees to Kirkland & Ellis' doubt and can't accept SPAC contributing to the business continuity requirement), then it's the TBA shareholders who get stuck with the unexpected tax bill.
Not a desirable outcome, but better than in a forward triangular merger where not only do TBA shareholders face the tax bill, but so would IronSource as a company. That would result in a double taxation both on the shareholder and on the corporate level which would obviously be a super bad deal.
So we know reverse triangular merger is simple, allows to retain the original legal entity among all related contracts and has tax benefits in case the transaction flukes but what are we missing? Where do we even need the second merger if it looks like we have already completed the transaction? Well, we haven't touched the payment part yet
You’d think TBA is paying with cash, but actually it’s a stock-for-stock exchange where TBA gets IronSource shares and IronSource gets TBA shares that are promptly converted into IronSource shares. By doing so, IronSource receives the entity that holds all the cash of the SPAC, but TBA is not really "paying" with that cash. Think of it sort of like buying a Porsche by exchanging in an 1983 Datsun that has a glove compartment full of cash. The value of that Datsun is not really in the chassis, in the engine nor in the tires but in the dineros in the cubby.
If it was left at that, we could all go home, but there is also a PIPE from Thoma Bravo, Tiger Global and their rich friends who commit to buy shares directly from existing shareholders. In fact, hidden inside the 300-page guide to tax haven is also an easily missed part where TBA commits to buy more secondaries should there be "excess cash over the company's 'capital needs' after the cash is released from the SPAC’s trust account". There is nothing wrong with these statements or buying secondaries per se (great that they provide liquidity to existing shareholders and employees), but because these secondaries are part of the overall merger payment, things just got 10x more messy for the tax advisors and lawyers.
The second... why do we need this step again?
See, despite the long list of benefits in regards to reverse triangular merger, the major downside is that it limits the amount of non-equity (i.e. cash 💸💸) that can be given as a payment (by the way, the lawyers call it “boot” and the origin of the word is quite interesting ).
And this is where we introduce forward triangular mergers as they do not have this restriction to the same extent which is what this second step is all about. As a reminder, forward triangular transactions are mergers where the acquirer survives instead of the target like before. It's the more "logical" acquisition structure. You acquire something and survive the acquisition. Anyways, key benefit is that you can use vastly more non-stock payment as you want
Of course, as mentioned above if it wasn’t for the PIPEs and secondaries we likely wouldn’t need this scene. And to be clear, it's not that PIPEs per se that make it difficult, but in many cases the PIPE is actually injected into the SPAC itself before the transaction, and then used to buy the shares of the target company in a stock-for-stock transaction. But not here. No, here rich folks pay pure greenbacks to investors and buy shares as part of the overall consideration meaning there is a massive cash component in the consideration.
And then somewhere in the board room a highly paid, and possibly a bit overworked, lawyer suggests that TBA should structure the transaction as forward triangular merger but without it being considered as a forward triangular merger.. People applaud, it's a big brain move but how would you go ahead and do it?
This is where you need the step 2, because if you follow-up the first reverse triangular merger with a second forward triangular merger into a subsidiary, the entire transaction is now treated as a forward triangular merger as long as it’s part of a “single-integrated plan” (or how IronSource calls it, “First and Second Plan of Merger”). Best of all, you can use as much cash (or 👢) as you want. Suddenly paying a few million to white-shoe lawyer firm starts to make sense.
And that’s not all, because if for whatever reason the first merger does not qualify as tax-free e.g. it doesn’t satisfy the previously mentioned COBE requirement, then it’s immediately taxed at that point but no more after it. In other words, while TBA shareholders may be left with the tax bill (ouch, but the prospectus does urge TBA shareholders to consult their tax advisors) there won’t be a double taxation on the corporate level anymore AND you just did a reverse triangular merger using a ton of cash which otherwise wouldn't be possible.
Of course, in a likely outcome nobody is left with a tax bill but the point is that all this hustle minimizes the chance of unexpected charges to all parties. And I'm sure it allows the lawyers to tap into the fee flow just a spoonful more.
Further reading
Now, not all SPACs follow this exact structure and as mentioned, the structure depends a lot on how the consideration is paid. Opendoor and Nikola were, in fact, both a simple one step reverse triangular merger. If it’s clearly a stock-for-stock deal where the PIPE is injected before the merger into the SPAC, then one-step might be fine.
But this two-step dance is not uncommon at all also for cross-border M&A where the acquirers’ and targets’ legal jurisdiction might be different. And it’s not just SPACs, Grubhub / Just Eat Takeaway utilised essentially the same structure. Sometimes as a second step instead of horizontally acquiring another subsidiary, the merger is to the parent (“upward merger”) and sometimes there are just other structuring reasons. Diamond Eagle Acquisition Corp, for example, also did a two step dance but mainly to incorporate itself to Nevada for more lax gambling laws for acquiring DraftKings. And then there was the Pershing Square Tontine one which, uh, was financial engineering at its best.
But the bottom line is that you can do a lot of corporate magic by playing around with the legal entities. How much do you need to care as an investor? Not much - usually it’s in the controlling shareholders’ interest to structure it in a way that’s beneficial for all.
I'd emphasize that I am not a lawyer nor a tax consultant, so I had to study this topic a lot and if you find blatant mistakes do email me. I only scratched the surface here, and if you’re keen to learn more I recommend reading this article: “The Forward Triangular Merger: A Not-So-Straight-Forward Transaction ” by Joseph B Darby from Sullivan & Worcester. For practitioners, I’d recommend Macabus’ page on tax-free acquisitions .
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