Review of Dell’s Options for Its VMware Holding

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

In front page news boosting the price of both companies’ stock, Dell Technologies Inc. (NYSE:  DELL) (Dell) has reportedly initiated a process to explore alternative transactions to significantly close the gap between its stock price and that of its 81-percent stake in VMware Inc. (NYSE:  VMW) (VMware).  Another objective of a transaction may be to reduce Dell’s $48 billion debt load. ¹ 

We have written quite a few reports on Dell and VMware, including one from February 26, 2019 with a headline we might have used for this report:  “Buzz Regarding Possible Spin-Off of VMware by Dell.” ²  In fact, according to the news reports, it seems there is now somewhat more than outside buzz, inasmuch as the company is engaging outside advisers to more formally look at alternatives.  In that vein, this report lays out what we see as the principal alternatives, noting the main structural and tax considerations.  These are:

1. Dell spins off its VMware stake to its shareholders.
2. Dell sells its VMware stake in a taxable transaction.
3. VMware does a tax-free, cash-rich split-off to Dell.
4. Dell merges with VMware. This could either involve Dell acquiring VMware in exchange for Dell stock or Dell merging downstream into VMware, with Dell stock exchanged for VMware stock.  (In either case, the resulting company can be named Dell, VMware or Dell VMware.)
5. Dell sells its legacy Dell businesses and merges downstream into VMware. Instead of a sale of the legacy Dell businesses, Dell shareholders could receive distribution of legacy Dell businesses (pro rata or non pro rata) in addition to VMware stock.

In evaluating alternatives, we expect Dell will want to have the following objectives in mind:

• Minimize tax leakage.
• Obtain recognition for its ownership in VMware.
• Obtain recognition for the value of its legacy businesses.
• Rationalize its capital structure, either deleveraging the group or shifting debt to the primary source of cash flow.

#1.  Dell Spins Off VMware

It has become common knowledge that Dell must wait until September 2021, the five-year anniversary of its purchase of EMC Corporation.  This results from the requirement under Section 355 of the Internal Revenue Code that each company be engaged in an active trade or business (ATB) that was not purchased during the preceding five years.  We have written about the possibility that a spin-off could occur sooner, based on the argument that in buying EMC (and indirectly, VMware), Dell was expanding its businesses, and therefore, the five-year “clock” does not begin in September 2016, but looks back to Dell’s prior business history. ³ 

We think the expansion argument has merit, although as we noted in our prior report, while the expansion doctrine is well-established, its application is very much dependent on facts and circumstances.  It is likely a challenging judgment call to determine whether there is a close enough connection between Dell’s historical business and those conducted by EMC and VMware.  This could be the subject of a private letter ruling, but that segues to the question of timing.  From the time a decision is made to seek a ruling, it likely takes more than six months to actually obtain one.

We think that if Dell decides to go the spin-off route, it will play it safer and wait until September 2021 rather than try to act sooner.  If we look at a natural timeline, we would not expect the process of considering strategic alternatives to conclude before the fall.  At that point, it is a year shy of the September 2021 date, and one must consider the normal timeframe for getting a spin-off done.  A year is not at all uncommon, although much of the work associated with spin-off transactions involves the internal process of carving out a business, separating management, negotiating transition agreements, and the like.  There should be much less of that here, since VMware is a separate public company.  Nevertheless, there will be agreements to negotiate, and it may be that both Dell and VMware shareholders will vote on the transaction, the latter at least because there would presumably be an unwinding of the two-class voting arrangement.

With respect to the five-year ATB rule, it is permissible to line up all the details, waiting only for the five-year anniversary before pulling the trigger.

Addressing EMC Acquisition Debt

In order to spin VMware stock out to Dell shareholders, we expect Dell would have to address the roughly $48 billion in debt left over from the 2016 acquisition of EMC.  One objective would be to push all or a significant portion of it down to VMware.  There are different techniques that may allow for this, but one primary strategy that we outline below.

A substantial amount of the group’s debt may be issued by EMC or another intermediate level entity (for simplicity, suppose that EMC itself is the issuer).  One approach would be for EMC to acquire the outstanding public VMware stock in exchange for EMC stock (and probably change EMC’s name to VMware), and Dell would spin off its stock in EMC stock to the Dell shareholders.  This would allow for the EMC debt to be “pushed down” to VMware by bringing VMware up to EMC.  From the standpoint of moving debt around, this is fairly benign and relatively simple.  From a commercial standpoint, it would mean the VMware would be acquiring the EMC operations, though some or all of these might be separately spun up to Dell.

#2.  Dell Sells VMware Stock in Taxable Transaction

This would likely involve a prohibitively high tax cost, though corporate tax rates have come down, and a purchaser could benefit from a step-up in tax basis if a Section 338(h)(10) election is made.  In any case, it is generally a good idea to put a fully taxable transaction on the table as the base case, and we would expect Dell and its advisers to do so.  As potentially complex alternatives are considered, they will come back to the base case for comparison.  The only reason we are listing this as the second alternative is because we thought we should first address the much-discussed tax-free spin-off.

#3.  Cash-Rich Split-Off

We discussed this transaction in our November 27, 2018 report.  This is a transaction that can enable Dell to “sell” its VMware stock back to the company on a tax-free basis, using the tax- free distribution rules of Section 355.  VMware would contribute to a SplitCo a mix of investment and business assets equal to the negotiated value of Dell’s VMware stock.  Cash and other investment assets cannot exceed two-thirds of the total.  While there must be a five-year active trade or business, much of the remaining one-third of business assets can be other sorts of non-investment assets.  Most of the assets in SplitCo can be newly purchased, for example, with new debt financed cash.

Because this is a distribution by VMware, it should not depend on there being a five-year wait after the Dell-EMC acquisition, so it could potentially be done before September 2021.  In view of the many steps to be taken to get such a transaction done, however, we would not expect this to be much of an advantage vis-à-vis the September 2021 issue.

#4.  Dell Merges with VMware

We would expect that regardless of the form of the transaction, a full combination of Dell and VMware would require approximately the same kind of board and shareholder approvals for both companies.

If Dell acquires VMware, presumably a special purpose Dell subsidiary would merge with and into VMware, with solely Dell stock consideration issued in exchange for VMware public stock.  Alternatively, in a downstream merger, VMware might set up a special purpose subsidiary that merges with and into Dell (or Dell into the subsidiary), with the Dell stock being exchanged for VMware stock.

In either case, there should be little problem in the transaction qualifying as a tax-free reorganization.

#5.  Dell Merger with VMware and Sale or Spin of Legacy Dell Business

One possible concern about a negotiated combination of Dell and VMware is that the value of the legacy Dell businesses could be lost.  While the tax cost of a taxable sale of Dell’s VMware holdings may be prohibitive, it may be that the tax cost of a taxable sale of Dell’s legacy business may be far more manageable and a sale might be a relatively straightforward way of realizing its value.  Thus, a sale of one or more of Dell’s businesses can occur in conjunction with a merger between Dell and VMware.  Depending on the timing and terms of the merger, the value of the Dell business could inure to both groups of shareholders, or only to the Dell shareholders.  This might be particularly useful for Dell in that it would remove valuation of Dell’s legacy businesses as a subject of negotiation with VMware.

In lieu of a sale, the Dell business could be distributed out to Dell shareholders in connection with a downstream merger of Dell into VMware.  While very different in lots of ways, it does bring to mind the spin-off of the New Fox business by 21st Century Fox in connection with its merger with Disney.  Such a spin-off could be taxable or tax-free, and could be pro rata or be done in non pro rata to Dell shareholders.

^{[1] Cara Lombardo, Dell Explores Spinoff of $50 Billion Stake in VMware, Wall St. J., June 23, 2020 (https://www.wsj.com/articles/dell-explores-options-for-81-vmware-stake-11592942687).}

^{[2] “Buzz Regarding Possible Spin-Off of VMware by Dell” (Feb. 26, 2019).  See also “Does Dell Ownership Impede VMware’s Acquisition Strategy?  Can Dell Separate VMware Before 2021?” (Nov. 27, 2018).}

^{[3] See further discussion of expansion doctrine in our Nov. 27, 2018 report cited in footnote 2 above.}