Does Dell Ownership Impede VMware’s Acquisition Strategy? Can Dell Separate VMware Before 2021?

By Stuart E. Leblang Michael J. Kliegman and Amy S. Elliott

VMware, Inc. (NYSE: VMW) (VMware) recently announced it had signed a definitive agreement to acquire privately held Heptio sometime in the quarter ending February 2, 2019^.[1] Although the terms were not publicly disclosed, rumors and past valuations of Heptio suggest that the cash price was “significantly more” than $250 million.^[2]

This continues a string of cash acquisitions, most recently including the $500 million acquisition of CloudHealth Technologies, Inc. announced in August;^[3]the acquisition of E8 Security for an undisclosed sum announced last March;^[4]and the December 2017 acquisition of Velocloud Networks, Inc. for a purchase price of $449 million.^[5] Clearly, modest‐sized acquisitions of closely held companies have been important to VMware’s growth strategy.  But if a larger merger transaction were on the table, could VMware actively pursue it in view of the fact that it is an 80.8 percent^[6]subsidiary of Dell Technologies Inc. (Dell)?  Dell’s tracking stock is its Class V common (NYSE: DVMT), which tracked 61.1 percent of Dell’s 80.8 percent interest in VMware (as of October 15).  Dell may soon convert its Class V into newly public Class C.

Without having any particular transaction in mind, assume for discussion purposes that there may be interesting business combination opportunities for VMware of a size that would involve a significant amount of stock consideration (either exclusively or along with cash) and that Michael Dell would—for the right deal—be willing to pursue such a transaction.  Using VMware stock as acquisition currency in a large transaction would likely reduce Dell’s ownership below 80 percent, resulting in removal of VMware from Dell’s consolidated federal tax return (and possibly even below 50 percent, resulting in financial deconsolidation).  And indeed, the board of directors of any public company target would need to take into account Dell’s recent treatment of its minority stockholders in determining whether any deal with Dell was in its stockholders’ “best interests.” These considerations might not be great enough to block an otherwise advantageous business combination:  however, it is fair to say that Dell’s ownership in VMware presents a different decision matrix for large deals than would be the case if VMware were a fully independent public company.

Could VMware use Dell stock as consideration in a large merger?  It is technically possible, though to satisfy the tax‐free reorganization rules, it might require some restructuring of group entities in the Dell‐EMC‐VMware chain.  More to the point, though, would Dell’s Class C or Class V stock be attractive acquisition currency relative to VMware’s own stock?

Separation of Dell’s VMware Stake in a Spin‐Off

A number of tax‐free spin‐offs have been done when one business needs to be separated from the parent group in order to use its stock as acquisition currency.  Whether for this or other good reasons, a distribution by Dell of its VMware stock to shareholders could be a desirable transaction to undertake.  Also, it goes without saying that while the impetus might come from VMware, Dell, which controls VMware, would have to approve any such deal.  The prevailing wisdom is that because Dell acquired EMC Corporation (EMC) in September 2016, a tax‐free spin‐off of Dell’s VMware stake (which was previously held by EMC) could not occur before September 2021.  This results generally from the rule that in a tax‐free spin‐off, both the Parent and Spinco must be engaged in an active trade or business that has been continuously carried on for at least five years and was not acquired during that period in a taxable transaction.^[7] In view of Dell’s September 2016 acquisition of EMC in a partly taxable transaction, this presumptively requires a five‐year wait to qualify VMware under the active trade or business test.

However, under the well‐established “expansion” doctrine, where a corporation that is already engaged in an active trade or business makes one or more taxable purchases of business operations that merely expand the scope of that trade or business, the acquired assets may be spun without waiting for five years.^[8] Where, as in the case of the EMC transaction,^[9]the taxable acquisition takes the form of a stock purchase, there are certain technical issues to address apart from the central active business question.  Specifically, there are provisions in the statute that indicate that a stock purchase may be more problematic than an asset acquisition where a trade or business was purchased within the five‐year period.  Interpreting subsequent amendments to the statute testing active business by reference to affiliated corporate groups, current and proposed regulations effectively treat the two in an equivalent manner.^[10]

Accordingly, if the VMware business could be viewed as a strategic expansion of one or more businesses previously carried on by Dell, then it could be possible to obtain a favorable private letter ruling from the IRS allowing a spin‐off well before the expiration of five years after the EMC acquisition.  There may well be a narrative that can be presented to the IRS indicating that not only EMC but VMware’s businesses represent areas into which Dell could have expanded organically but made a strategic decision to bring in via acquisition:  as such, the 2016 transaction would not be treated as the acquisition of a new trade or business, and a new five‐ year waiting period would not be required.

One non‐tax impediment to a spin‐off of VMware to Dell’s shareholders might be the high level of debt Dell undertook to fund the EMC acquisition.  If a spin‐off were undertaken, it seems likely that at least a portion of this leverage could be pushed down to VMware with proceeds used to pay down Dell’s indebtedness.  Techniques to do this on a tax‐free basis are available, and we have discussed these in prior reports.

If there were a spin‐off, to whom would the VMware shares be distributed?  In many previous transactions undertaken by companies with tracking stock, holders of the tracking shares received all or most of the tracked shares in a non pro rata split‐off, but there are exceptions.^[11] The Dell tracking stock provisions are not mandatory in this regard, but do seem to contemplate that if the company were to make a distribution of VMware shares, DVMT shareholders would be entitled to their share of those shares in redemption of their DVMT shares.^[12]

If a VMware spin‐off were undertaken after the pending recapitalization to convert the Dell Class V (DVMT shares) into Class C, then the presumptive transaction would be a pro rata spin‐off to the common shareholders, though a non pro rata split‐off of some kind still remains a possibility.

The Cash‐Rich Split‐Off Option

As an alternative to a spin‐off of VMware shares to Dell’s shareholders, another approach to substantially reducing Dell’s ownership in VMware might be a cash‐rich split‐off.  This would involve very different tax and other issues than a VMware spin‐off.  For example, in order to redeem Dell’s approximately $50 billion worth of VMware stock at a discounted value of $45 billion^[13], VMware would contribute to newly formed Splitco $30 billion of cash and other investment assets and $15 billion in non‐investment assets including an active trade or business and redeem Dell’s VMware stock in exchange for 100 percent of the Splitco stock.

Such a cash‐rich split‐off may qualify for tax‐free treatment under Section 355.  Dell could use the cash and investment assets to pay down debt and redeem DVMT stock.

There are certainly technical and commercial issues to navigate.  In the latter category, VMware would have to select sufficient non‐investment business assets to divest to Dell.  As for tax, there are rules under Section 355(d) that impose corporate level tax on the distributing corporation (VMware) in a Section 355 distribution to a stockholder that obtained a cost basis in its stock within the previous five years.  This problem might be avoided through some intra‐group restructuring in the Dell‐EMC group:  if not, there could be some corporate tax leakage to VMware with respect to low‐basis business assets included in the Splitco mix.  Dell’s ability to “cash out” of VMware on a wholly tax‐free basis would presumably be worth more than this leakage.

^{[1] VMware Nov. 6 press release, “VMware to Acquire Heptio to Accelerate Enterprise Adoption of Kubernetes On‐Premises and across Multi‐Cloud Environments,” (https://ir.vmware.com/overview/press‐releases/press‐release‐details/2018/VMware‐to‐ Acquire‐Heptio‐to‐Accelerate‐Enterprise‐Adoption‐of‐Kubernetes‐‐On‐Premises‐and‐across‐Multi‐Cloud‐ Environments/default.aspx).}

^{[2] “A source familiar with the deal pegged the price as ‘significantly more’ than the $250 million that Red Hat paid for CoreOS in January, but declined to comment further.  Heptio commanded a valuation of $117 million following its last funding round, according to data provided by PitchBook,” as reported by Tom Krazit in his Nov. 6 GeekWire article, “VMware acquires Seattle’s Heptio to double down on Kubernetes,” (https://www.geekwire.com/2018/vmware‐acquires‐seattles‐heptio‐double‐ kubernetes/).}

^{[3] VMware’s Sept. 11 Form 10‐Q (https://www.sec.gov/Archives/edgar/data/1124610/000112461018000031/vmw‐ 83201810xq.htm).}

^{[4] VMware’s March 28 end‐user computing blog post, “VMware Acquires E8 Security: Leveraging Behavior Analytics to Secure the Digital Workspace,” (https://blogs.vmware.com/euc/2018/03/e8‐security‐behavior‐analytics‐digital‐workspace.html).}

^{[5] VMware’s March 29 Form 10‐K (https://www.sec.gov/Archives/edgar/data/1124610/000112461018000012/vmw‐22201810xk.htm).}

^{[6] As of Oct. 15, Dell owned approximately 331 million shares of VMware common stock, representing approximately 80.8% of all total outstanding VMware common stock.  (https://www.sec.gov/Archives/edgar/data/1571996/000119312518303075/d681091d424b3.html.}

^{[7] IRC § 355(b).}

^{[8] See Treas. Reg. § 1.355‐3(c) Examples 7 and 8 and Estate of Lockwood v. Comm’r, 350 F.2d 712 (8th Cir. 1965).}

^{[9] The acquisition of all of the shares of EMC by Dell, which closed on Sept. 7, 2016, generally resulted in the exchange of each EMC share for $24.05 in cash and 0.11146 shares of Class V such that the receipt of cash was a taxable transaction for U.S. federal income tax purposes (https://www.sec.gov/Archives/edgar/data/1124610/000112461016000063/a8‐k09x01x16.htm:  https://www.sec.gov/Archives/edgar/data/790070/000119312516614138/d59207ddefm14a.htm).}

^{[10] There is some technical inconsistency between certain statutory provisions in IRC § 355(b) and 355(a)(3)(B) and the later‐ added separate affiliated group (SAG) rules in § 355(b)(3).  Proposed regulations on the SAG approach make clear that an acquisition of a corporation conducting a trade or business will be treated as if the underlying assets were acquired (Prop. Treas. Reg. § 1.355‐3).  See also Treas. Reg. § 1.355‐2(g).}

^{[11] A few examples: In 2000, AT&T issued for cash in a public offering a new class of stock that tracked its AT&T Wireless business, and fourteen months later AT&T was split off from AT&T in redemption of the tracking stock.  In 2000, Cablevision issued a tracking stock with respect to its Rainbow Media Group subsidiary, and, in 2011 Cablevision distributed the tracked subsidiary, now known as AMC, in a leveraged spinoff to all Cablevision shareholders.  In 2003, General Motors split off 80.1 percent of Hughes Electronics to holders of GM Class H tracking stock.}

^{[12] According to Dell’s Fourth Amended and Restated Certificate of Incorporation, dated Sept. 6, 2016, and subsequently amended June 27, 2017, (https://www.sec.gov/Archives/edgar/data/1571996/000157199617000020/exhibit31_080417.htm), “For so long as any shares of Class V Common Stock remain outstanding, the Corporation shall not authorize or issue any class or series of common stock (other than (i) Class V Common Stock or (ii) common stock of the Corporation with an Inter‐Group Interest in the Class V Group) intended to reflect an economic interest of the Corporation in assets comprising the Class V Group, including common stock of VMware. . . . At any time that shares of common stock of VMware comprise all of the assets of the Class V Group, the Corporation may, at its option and subject to assets of the Corporation being legally available therefor, redeem all outstanding shares of Class V Common Stock for shares of common stock of VMware (the “Distributed VMware Shares”), as provided herein. . . . The Corporation shall not redeem shares of Class V Common Stock for Distributed VMware Shares pursuant to this Section 5.2(m)(1) without redeeming all outstanding shares of Class V Common Stock for Distributed VMware Shares in accordance with this Section 5.2(m)(1).”}

^{[13] The tax benefits of this transaction inure primarily to Dell:  hence, the presumed discount.}