Rumors Are Afoot: Is the Dell/EMC Merger Starting to Unravel?

It has been an interesting time to be living in the IT world. The ripples and ructions caused by the Dell/EMC merger have quashed almost every other conversation. This is the biggest take-private merger transaction for a tech company ever, dwarfed only by the $106 billion Time Warner/AOL deal in 2006.


When the merger was originally announced on October 12, all appeared rosy in the garden. The deal appeared to be in the bag. The usual sixty-day period allowing EMC to court other potential purchasers expired on Friday, December 11. Those who could raise that kind of money are few and far between, the only obvious ones being HP (at the time undergoing its mega split, de-merging its EDS purchase), IBM (also never a real contender, as it has been actively divesting itself of hardware-based assets or, more to the point, coming clean on who has actually been making its desktop and server hardware for several years), Cisco (the former partner of VCE fame, just jilted; it could have been a possibility if John Chambers were still at the helm, but it still would have been a push with the amount of debt that this purchase will generate), and finally, Oracle (this would be the nightmare scenario). Imagine VMware, RSA, and EMC under the control of Oracle. A private equity buy might have been possible, like the one Dell did itself in 2013. However, there does not appear to be anybody interested.

Now, at the time of the announcement, EMC’s board of directors approved the merger agreement and recommended that EMC stockholders approve the deal.

Of What, Exactly, Does the Dell/EMC Deal Consist?

The Dell/EMC deal involves an offer of $33.15 per share, comprising $24.05 in cash and $9.10 for tracking stock in VMware at the time of the announcement. The cash is to be raised through the issuance of debt, a fancy term for a loan, although at the time of the announcement there were no financing conditions tied to the deal. What a jaw-dropping commission for the salespeople at whatever banks closed that deal.

The smaller amount of $9.10 is made up of tracking stock, a rather obscure financial instrument. What exactly is it? According to Wikipedia, tracking stocks are “specialized equity offerings issued by a company that is based on the operations of a wholly owned subsidiary of a diversified firm. Therefore, the tracking stock will be traded at a price related to the operations of the specific division of the company being ‘tracked.’ Tracking stock typically has limited or no voting rights. Often, the reason for doing so is to separate a high-growth division from a larger parent company. The parent company and its shareholders remain in control of the subsidiarys or units operations.” These first became popular during the dot-com bubble of the late 1990s as a method for raising capital but not losing control. They fell into disuse by the mid-noughties.

One of the reasons for tracking stock’s being included in the deal is to offset the amount of debt that Dell would have to take on to finance the deal. However, over the last couple of months, rumors have started to spread that it is beginning to unravel at the seams.  And one the main reasons for the rumors is the inclusion of tracking stock in the transaction. This issue surrounds Dell’s creation of tracking stock in a company it does not yet own, this being VMware, a subsidiary of EMC. People are concerned that the creation of this tracking stock will invite the scrutiny of the IRS, as the IRS could deem it a taxable distribution under various sections of US tax law namely Section 355 of US tax law, specifically subsection 3B, regarding “certain distributions of stock or securities in connection with acquisitions.” It seems that in certain circumstances, when a parent company distributes shares in a subsidiary within two years before or after being acquired itself, any gains in value on those distributed shares can be taxable. Why is this an issue? Well, if the IRS deems this a breach, then Dell will have to take on a lot more debt to cover the deal. It is currently estimated that Dell will have to add an estimated $50B of extra debt as it is after this deal. In fact, this issue could be a deal killer. This was even highlighted in the text of the merger agreement: in one section, it alludes to taking “any action necessary” to ensure that it qualified for Section 351 for the “intended tax treatment.” (section 351 is a definition section)

Other issues that are causing some consternation are the EMC/VMware joint venture involving Virtustream and the fact that Virtustream’s earnings are against VMware. Keeping that responsibility with EMC would be much more palatable to VMware shareholders, even with forecast revenues in the hundreds of millions of dollars.

Do I think it is going to fall apart? No. I cannot believe that EMC and Dell did not have the best corporate tax lawyers in the US when working on this deal, and it took over a year of negotiation to reach agreement. Further, I do not believe that a minor announcement like the Virtustream venture would derail it. That said, what could derail it is if the IRS rules against Dell and EMC with regard to the Section 351 clause. If that happens, then that will be a deal killer. I do not believe that Dell would be able to or even want to take on the additional debt needed to cover that tax liability.

[Update VMware have rejected the Joint VirtuStream venture in a short and to the point SEC submission on the 11th December 2015].

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