FUNKO, INC. You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements based upon current plans, expectations and beliefs involving risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various important factors, including those set forth under "Risk Factors" included in this Annual Report on Form 10-K. Our results of operations for the year endedDecember 31, 2018 , including a discussion of the year endedDecember 31, 2019 compared to the year endedDecember 31, 2018 , have been reported previously under "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year endedDecember 31, 2019 . Overview We are a leading pop culture consumer products company. Our business is built on the principle that almost everyone is a fan of something and the evolution of pop culture is leading to increasing opportunities for fan loyalty. We create whimsical, fun and unique products that enable fans to express their affinity for their favorite "something"-whether it is a movie, TV show, video game, musician or sports team. We infuse our distinct designs and aesthetic sensibility into one of the industry's largest portfolios of licensed content over a wide variety of product categories, including figures, plush, accessories, apparel and homewares. Key Performance Indicators We consider the following metrics to be key performance indicators to evaluate our business, develop financial forecasts, and make strategic decisions. Year Ended December 31, 2020 2019 (in thousands) Net sales$ 652,537 $ 795,122 Net income$ 9,763 $ 27,820 EBITDA (1)$ 66,868 $ 88,764 Adjusted EBITDA (1)$ 80,216 $ 123,037 (1)Earnings before interest, taxes, depreciation and amortization ("EBITDA") and Adjusted EBITDA are financial measures not calculated in accordance withU.S. GAAP. For a reconciliation of EBITDA and Adjusted EBITDA to net income, the most closely comparableU.S. GAAP financial measure, see "Non-GAAP Financial Measures" in this item. Factors Affecting our Business Growth in the Market for Pop Culture Consumer Products Our operating results and prospects will be impacted by developments in the market for pop culture consumer products. Our business has benefitted from pop culture trends including (1) technological innovation that has facilitated content consumption and engagement, (2) creation of more quality content, (3) greater cultural prevalence and acceptance of pop culture fandom and (4) increased engagement by fans with pop culture content beyond mere consumption driven by social media and demonstrated by fan-centric experiences, such as Comic-Con events around the world. These trends have contributed to significant growth in the demand for pop culture products like ours in recent years; however, consumer demand for pop culture products and pop culture trends can and does shift rapidly and without warning. To the extent we are unable to offer products that appeal to consumers, our operating results will be adversely affected. This is particularly true given the concentration of our sales of products under certain of our brands, particularly our Pop! brand, which represented approximately 76% and 79% of our sales for the years endedDecember 31, 2020 and 2019, respectively, and which is sold across multiple product categories. 58 -------------------------------------------------------------------------------- Table of Contents Relationships with Content Providers We generate a majority of our net sales from products based on intellectual property we license from others. We have strong relationships with many established content providers and seek to establish licensing relationships with newer content providers. Our content provider relationships are highly diversified, allowing us to license a wide array of properties and thereby reduce our exposure to any individual property or license. We believe there is a trend of content providers consolidating their relationships to do more business with fewer licensees. We believe our ability to help maximize the value and extend the relevance of our content providers' properties has allowed us to benefit from this trend. Although we have a successful track record of renewing and extending the scope of licenses, our license agreements typically have short terms (between two and three years), are not automatically renewable, and, in some cases, give the licensor the right to terminate the license agreement at will. In addition, the efforts of our senior management team have been integral to our relationships with our licensors. Inability to license newer pop culture properties, the termination or lack of renewal of one or more of our license agreements, or the renewal of a license agreement on less favorable terms, could adversely affect our business. Retail Industry Dynamics; Relationships with Retail Customers Historically, substantially all of our sales have been derived from our retail customers and distributors, upon which we rely to reach the consumers who are the ultimate purchasers of our products. Our top ten customers represented approximately 48% and 44% of our sales for the years endedDecember 31, 2020 and 2019, respectively. During the year endedDecember 31, 2020 , we saw shifts in our client mix as a direct result of the COVID-19 pandemic and the related retail shutdowns and limited store occupancy upon reopening. We depend on retailers to provide adequate and attractive space for our products and point of purchase displays in their stores. We continue to have dedicated shelf space for our products in a variety of aisles in mass-market retailer and specialty stores, with our growing diversified product offering. In recent years, traditional retailers have been affected by a shift in consumer preferences towards other channels, particularly e-commerce. We have seen an increase in sales for our product on retailers' e-commerce platforms, particularly in 2020 as a result of the COVID-19 retail shutdowns. Our customers do not make long-term commitments to us regarding purchase volumes and can therefore easily reduce their purchases of our products. Any reduction in purchases of our products by our retail customers and distributors, or the loss of any key retailer or distributor for any reason could adversely affect our business. In addition, our future growth depends upon our ability to successfully execute our business strategy. See Item 1A, "Risk Factors." Content Mix The timing and mix of products we sell in any given quarter or year will depend on various factors, including the timing and popularity of new releases by third-party content providers and our ability to license properties based on these releases. We have diversified our product offerings across property categories. We have visibility into the new release schedule of many our content providers and our expansive license portfolio allows us to dynamically manage new product creation. This insight allows us to adjust the mix of products based on classic evergreen properties and new releases, depending on the media release cycle. For example, in 2020 there was a lack of new content releases due to the impact of COVID-19 on new content production and the movie theater industry. Due to this impact, the percent of our sales attributable to classic evergreen properties was higher compared to historical trends. In addition, over time, we have continued to increase our number of active properties. An active property is a property from which we generate sales of products during a given period. For the years endedDecember 31, 2020 and 2019, we had sales of our products across 854 and 804 properties, respectively. 59 -------------------------------------------------------------------------------- Table of Contents Our results of operations may also fluctuate significantly from quarter to quarter or year to year depending on the timing and popularity of new product releases and related content releases. Sales of a certain product or group of products tied to a particular property can dramatically increase our net sales in any given quarter or year. While we expect to see growth in the number of properties and products over time, we expect that the number of active properties and the sales per active property will fluctuate from quarter to quarter or year over year based on what is relevant in pop culture at that time and the types of properties we are producing against. In addition, despite our efforts to diversify the properties on which we base our products, if the performance of one or more of these properties fails to meet expectations or are delayed in their release, our operating results could be adversely affected. Taxation and Expenses After consummation of our IPO onNovember 6, 2017 , we became subject toU.S. federal, state and local income taxes with respect to our allocable share of any taxable income ofFAH, LLC , and we are taxed at the prevailing corporate tax rates. In addition to tax expenses, we incur expenses related to our operations, as well as payments under the Tax Receivable Agreement. We have caused and intend to continue to causeFAH, LLC to make distributions in an amount sufficient to allow us to pay our tax obligations and operating expenses, including distributions to fund any ordinary course payments due under the Tax Receivable Agreement. Components of our Results of OperationsNet Sales We sell a broad array of licensed pop culture consumer products across a variety of categories, including figures, plush, accessories, apparel, games and homewares, primarily to retail customers and distributors. We also sell our products directly to consumers through our e-commerce operations, our retail stores and, to a lesser extent, at specialty licensing and comic book conventions and exhibitions. Revenue from the sale of our products is recognized when control of the goods is transferred to the customer, which is upon shipment or upon receipt of finished goods by the customer, depending on the contract terms. The majority of revenue is recognized upon shipment of products to the customer. We routinely enter into arrangements with our customers to provide sales incentives, support customer promotions, and provide allowances for returns and defective merchandise. The estimated costs of these programs reduce gross sales in the period the related sale is recognized. Sales terms typically do not allow for a right of return except in relation to a manufacturing defect. Shipping costs billed to our customers are included in net sales, while shipping and handling costs, which include inbound freight costs and the cost to ship products to our customers, are included in cost of sales. Cost of Sales Cost of sales consists primarily of product costs, royalty expenses paid to our licensors and the cost to ship our products, including both inbound freight and outbound products to our customers. Our cost of sales excludes depreciation and amortization. Our products are produced by third-party manufacturers primarily inVietnam ,China andMexico . The use of third-party manufacturers enables us to avoid incurring fixed product costs, while maximizing flexibility, capacity and capability. As part of a continuing effort to reduce manufacturing costs and ensure speed to market, we have historically kept our production concentrated with a small number of manufacturers and factories even as we have grown and diversified. In recent years, we have worked to improve the efficiency of our supply chain to improve our gross margins. Our product costs and gross margins will be impacted from period to period based on the product mix in any given period. Our Loungefly branded products tend to have a higher product cost and higher duties as a percentage of sales and therefore lower gross margins than our Pop! branded products. Our royalty costs and gross margins will also be impacted from period to period based on our mix of licensed products sold, as well as a variety of other factors including reserves for minimum guarantees and ongoing and future royalty audits. 60 -------------------------------------------------------------------------------- Table of Contents Our shipping costs, both inbound and outbound, will fluctuate from period to period based on customer mix due to varying shipping terms and other factors. Selling, General and Administrative Expenses Selling, general and administrative expenses are primarily driven by wages, commissions and benefits, warehouse, fulfillment (internal and external), rent and facilities costs, infrastructure and technology costs, advertising and marketing expenses, including the costs to participate at specialty licensing and comic book conventions and exhibitions, as well as costs to develop promotional video and other online content created for advertising purposes. Credit card fees, insurance, legal expenses, other professional expenses and other miscellaneous operating costs are also included in selling, general and administrative expenses. Selling costs generally correlate to revenue timing and therefore experience similar moderate seasonal trends. We expect general and administrative costs to increase as our business evolves. We have invested considerably in general and administrative costs to support the growth and anticipated growth of our business and anticipate continuing to do so in the future. Since our IPO, we have experienced a significant increase in accounting, legal and professional fees associated with being a public company as further described above under "-Factors Affecting Our Business-Taxation and Expenses." Depreciation and Amortization Depreciation expense is recognized on a straight-line basis over the estimated useful lives of our property and equipment. Amortization relates to definite-lived intangible assets that are expensed on a straight-line basis over the estimated useful lives. Our intangible assets, which are being amortized over a range of two to 20 years, are mainly comprised of trade names, customer relationships and intellectual property we recognized as part of the ACON Acquisition and, to a lesser extent, the 2017 acquisition of Underground Toys, the 2017 acquisition of Loungefly and the 2019 acquisition of Forrest-Pruzan. Interest Expense, Net Interest expense, net includes the cost of our short-term borrowings and long-term debt, including the amortization of debt issuance costs and original issue discounts, net of any interest income earned. 61 -------------------------------------------------------------------------------- Table of Contents Results of Operations Year EndedDecember 31, 2020 Compared to Year EndedDecember 31, 2019 The following table sets forth information comparing the components of net income for the years endedDecember 31, 2020 and 2019: Year Ended December 31, Period over Period Change 2020 2019 Dollar Percentage (in thousands, except percentages) Net sales$ 652,537 $ 795,122 $ (142,585) (17.9) % Cost of sales (exclusive of depreciation and amortization shown separately below) 403,392 512,580 (109,188) (21.3) % Selling, general, and administrative expenses 181,234 193,803 (12,569) (6.5) % Depreciation and amortization 44,368 42,126 2,242 5.3 % Total operating expenses 628,994 748,509 (119,515) (16.0) % Income from operations 23,543 46,613 (23,070) (49.5) % Interest expense, net 10,712 14,342 (3,630) (25.3) % Other expense (income), net 1,043 (25) 1,068 nm Income before income taxes 11,788 32,296 (20,508) (63.5) % Income tax expense 2,025 4,476 (2,451) (54.8) % Net income 9,763 27,820 (18,057) (64.9) % Less: net income attributable to non-controlling interests 5,802 16,095 (10,293) (64.0) % Net income attributable to Funko, Inc.$ 3,961 $ 11,725 $ (7,764) (66.2) % Net Sales Net sales were$652.5 million for the year endedDecember 31, 2020 , a decrease of 17.9% compared to$795.1 million for the year endedDecember 31, 2019 . The decrease in net sales was due primarily to the impacts from the COVID-19 pandemic, including reduced shipments to our specialty retailer and distributor customers as limited in-store occupancy and social distancing guidelines or non-essential business closures were in effect for a majority of the year endedDecember 31, 2020 . These decreases were partially offset by growth in our net sales to e-commerce sites and our own direct-to-consumer channels. In the year endedDecember 31, 2020 , the number of active properties increased 6.2% to 854 from 804 in the year endedDecember 31, 2019 , and average net sales per active property decreased 22.7% to$0.8 million in the year endedDecember 31, 2020 from$1.0 million in the year endedDecember 31, 2019 . While we expect to see growth in the number of active properties over time, we expect that the average sales per active property will fluctuate from year to year or quarter to quarter based on what is relevant in pop culture at that time and the types of properties we are producing against. On a geographical basis, net sales inthe United States decreased 6.7% to$488.8 million in the year endedDecember 31, 2020 as compared to$523.9 million in the year endedDecember 31, 2019 , net sales inEurope decreased 43.5% to$112.0 million in the year endedDecember 31, 2020 from$198.2 million in the year endedDecember 31, 2019 and net sales in other International decreased 29.2% to$51.7 million in the year endedDecember 31, 2020 from$73.0 million in the year endedDecember 31, 2019 . On a product category basis, net sales of Pop! branded products decreased 20.4% to$497.3 million in the year endedDecember 31, 2020 as compared to$624.6 million in the year endedDecember 31, 2019 . Net sales of Loungefly branded products increased 17.0% to$84.8 million in the year endedDecember 31, 2020 as compared to$72.5 million in the year endedDecember 31, 2019 . Net sales of other products decreased 28.2% to$70.4 million in the year endedDecember 31, 2020 as compared to$98.0 million the year endedDecember 31, 2019 . 62 -------------------------------------------------------------------------------- Table of Contents Cost of Sales and Gross Margin (exclusive of depreciation and amortization) Cost of sales (exclusive of depreciation and amortization) was$403.4 million for the year endedDecember 31, 2020 , a decrease of 21.3%, compared to$512.6 million for the year endedDecember 31, 2019 . Cost of sales (exclusive of depreciation and amortization) decreased primarily as a result of the decrease in net sales, which drove a$56.9 million decrease in product costs, a$21.8 million decrease in royalty expenses and a$2.2 million decrease in shipping and freight costs. Gross margin (exclusive of depreciation and amortization), calculated as net sales less cost of sales as a percentage of sales, was 38.2% for the year endedDecember 31, 2020 , compared to 35.5% for the year endedDecember 31, 2019 . Gross margin (exclusive of depreciation and amortization) increased 270 basis points for the year endedDecember 31, 2020 compared to the year endedDecember 31, 2019 , due primarily to a one-time$16.8 million charge for the year endedDecember 31, 2019 related to the write-down of inventory as a result of the Company's decision to dispose of slower moving inventory to increase operational capacity. Selling, General, and Administrative Expenses Selling, general, and administrative expenses were$181.2 million for the year endedDecember 31, 2020 , a decrease of 6.5%, compared to$193.8 million for the year endedDecember 31, 2019 . The decrease was driven primarily by a$3.8 million decrease in warehouse and office support, a$3.6 million decrease in advertising and marketing, a$3.5 million decrease in professional fees, a$2.9 million decrease in equity-based compensation, and a$1.8 million decrease in personnel expenses and commissions. These decreases primarily reflect the impact of the COVID-19 pandemic and the efforts to reduce costs and preserve liquidity. Selling, general, and administrative expenses were 27.8% of sales for the year endedDecember 31, 2020 , compared to 24.4% of sales for the year endedDecember 31, 2019 , primarily due to the decrease in net sales. Depreciation and Amortization Depreciation and amortization expense was$44.4 million for the year endedDecember 31, 2020 , compared to$42.1 million for the year endedDecember 31, 2019 , primarily driven by an increase in depreciation on our office and warehouse facilities including the full year recognition of ourHollywood retail store. Interest Expense, Net Interest expense, net was$10.7 million for the year endedDecember 31, 2020 , a decrease of 25.3%, compared to$14.3 million for the year endedDecember 31, 2019 . The decrease in interest expense, net was due to lower interest rates and lower average balances of debt outstanding during the year endedDecember 31, 2020 . Income Tax Expense Income tax expense was$2.0 million for the year endedDecember 31, 2020 , a decrease of 54.8%, compared to$4.5 million for the year endedDecember 31, 2019 . The decrease was primarily due to a decrease in income before income taxes of$20.5 million for the year endedDecember 31, 2020 as compared to the year endedDecember 31, 2019 . Net Income Net income was$9.8 million for the year endedDecember 31, 2020 , compared to$27.8 million for the year endedDecember 31, 2019 . The decrease in net income was primarily the result of the decrease in net sales offset by decreases in cost of goods sold, selling, general and administrative and interest expense, net for the year endedDecember 31, 2020 as compared to the year endedDecember 31, 2019 , as discussed above. 63 -------------------------------------------------------------------------------- Table of Contents Non-GAAP Financial Measures EBITDA, Adjusted EBITDA, Adjusted Net Income and Adjusted Earnings per Diluted Share (collectively the "Non-GAAP Financial Measures") are supplemental measures of our performance that are not required by, or presented in accordance with,U.S. GAAP. The Non-GAAP Financial Measures are not measurements of our financial performance underU.S. GAAP and should not be considered as an alternative to net income, earnings per share or any other performance measure derived in accordance withU.S. GAAP. We define EBITDA as net income before interest expense, net, income tax expense, depreciation and amortization. We define Adjusted EBITDA as EBITDA further adjusted for non-cash charges related to equity-based compensation programs, acquisition transaction costs and other expenses, customs investigation and related costs, certain severance, relocation and related costs, foreign currency transaction gains and losses, Tax Receivable Agreement liability adjustments, the one-time inventory write-down and other unusual or one-time items. We define Adjusted Net Income as net income attributable toFunko, Inc. adjusted for the reallocation of income attributable to non-controlling interests from the assumed exchange of all outstanding common units and options inFAH, LLC for newly issued-shares of Class A common stock ofFunko, Inc. and further adjusted for the impact of certain non-cash charges and other items that we do not consider in our evaluation of ongoing operating performance. These items include, among other things, reallocation of net income attributable to non-controlling interests, non-cash charges related to equity-based compensation programs, acquisition transaction costs and other expenses, customs investigation and related costs, certain severance, relocation and related costs, foreign currency transaction gains and losses, Tax Receivable Agreement liability adjustments, the one-time inventory write-down and other unusual or one-time items, and the income tax expense effect of these adjustments. We define Adjusted Earnings per Diluted Share as Adjusted Net Income divided by the weighted-average shares of Class A common stock outstanding, assuming (1) the full exchange of all outstanding common units and options inFAH, LLC for newly issued-shares of Class A common stock ofFunko, Inc. and (2) the dilutive effect of stock options and unvested common units, if any. We caution investors that amounts presented in accordance with our definitions of the Non-GAAP Financial Measures may not be comparable to similar measures disclosed by our competitors, because not all companies and analysts calculate the Non-GAAP Financial Measures in the same manner. We present the Non-GAAP Financial Measures because we consider them to be important supplemental measures of our performance and believe they are frequently used by securities analysts, investors, and other interested parties in the evaluation of companies in our industry. Management believes that investors' understanding of our performance is enhanced by including these Non-GAAP Financial Measures as a reasonable basis for comparing our ongoing results of operations. Management uses the Non-GAAP Financial Measures: •as a measurement of operating performance because they assist us in comparing the operating performance of our business on a consistent basis, as they remove the impact of items not directly resulting from our core operations; •for planning purposes, including the preparation of our internal annual operating budget and financial projections; •as a consideration to assess incentive compensation for our employees; •to evaluate the performance and effectiveness of our operational strategies; and •to evaluate our capacity to expand our business. By providing these Non-GAAP Financial Measures, together with reconciliations, we believe we are enhancing investors' understanding of our business and our results of operations, as well as assisting investors in evaluating how well we are executing our strategic initiatives. The Non-GAAP Financial Measures have limitations as analytical tools, and should not be considered in isolation, or as an alternative to, or a substitute for net income or other financial statement data presented in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K as indicators of financial performance. Some of the limitations are: •such measures do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments; •such measures do not reflect changes in, or cash requirements for, our working capital needs; •such measures do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments on our debt; 64 -------------------------------------------------------------------------------- Table of Contents •although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future and such measures do not reflect any cash requirements for such replacements; and •other companies in our industry may calculate such measures differently than we do, limiting their usefulness as comparative measures. Due to these limitations, Non-GAAP Financial Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on ourU.S. GAAP results and using these non-GAAP measures only supplementally. As noted in the table below, the Non-GAAP Financial Measures include adjustments for non-cash charges related to equity-based compensation programs, acquisition transaction costs and other expenses, customs investigation and related costs, certain severance, relocation and related costs, foreign currency transaction gains and losses, Tax Receivable Agreement Liability adjustments and other unusual or one-time items. It is reasonable to expect that these items will occur in future periods. However, we believe these adjustments are appropriate because the amounts recognized can vary significantly from period to period, do not directly relate to the ongoing operations of our business and complicate comparisons of our internal operating results and operating results of other companies over time. Each of the normal recurring adjustments and other adjustments described herein and in the reconciliation table below help management with a measure of our core operating performance over time by removing items that are not related to day-to-day operations. The following tables reconcile the Non-GAAP Financial Measures to the most directly comparableU.S. GAAP financial performance measure, which is net income, for the periods presented: Year Ended December 31, 2020 2019 (in thousands, except per share data) Net income attributable to Funko, Inc. $
3,961
5,802 16,095
Equity-based compensation (2) 10,116 13,044
Acquisition transaction costs and other expenses (3) - 383
Customs investigation and related costs (4) - 3,357
Certain severance, relocation and related costs (5) 2,190 739
Foreign currency transaction loss (gain) (6) 955 (177)
Tax receivable agreement liability adjustments 87 152
One-time inventory write-down (7) - 16,775
Income tax expense (8) (4,259) (12,166)
Adjusted net income $
18,852
30,898
Equity-based compensation awards and common units of
16,227 21,167
Adjusted weighted-average shares of Class A stock outstanding - diluted
51,498 52,065
Adjusted earnings per diluted share $ 0.37 $ 0.96
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Year Ended December 31,
2020 2019
(in thousands)
Net income $ 9,763 $ 27,820
Interest expense, net 10,712 14,342
Income tax expense 2,025 4,476
Depreciation and amortization 44,368 42,126
EBITDA $ 66,868 $ 88,764
Adjustments:
Equity-based compensation (2) 10,116 13,044
Acquisition transaction costs and other expenses (3) - 383
Customs investigation and related costs (4) - 3,357
Certain severance, relocation and related costs (5) 2,190 739
Foreign currency transaction loss (gain) (6) 955 (177)
Tax receivable agreement liability adjustments 87 152
One-time inventory write-down (7) - 16,775
Adjusted EBITDA $ 80,216 $ 123,037
(1)Represents the reallocation of net income attributable to non-controlling
interests from the assumed exchange of common units of FAH, LLC in periods in
which income was attributable to non-controlling interests.
(2)Represents non-cash charges related to equity-based compensation programs,
which vary from period to period depending on timing of awards.
(3)Represents legal, accounting, and other related costs incurred in connection
with the acquisitions and other transactions.
(4)Represents legal, accounting and other related costs incurred in connection
with the Company's investigation of the underpayment of customs duties at
Loungefly. For the year ended December 31, 2019 , includes the accrual of a
contingent liability of $0.5 million related to potential penalties that may be
assessed by U.S. Customs in connection with the underpayment of customs duties
at Loungefly.
(5)Represents certain severance, relocation and related costs. For the year
ended December 31, 2020 , includes charges related to the global workforce
reduction implemented in response to the COVID-19 pandemic and impairment
related charges to the right-of-use leased and fixed assets related to Funko
Animation Studios . For the year ended December 31, 2019 , includes $0.4 million
of severance costs incurred in connection with the departure of our former Chief
Financial Officer and $0.3 million of severance, relocation and related costs
associated with the consolidation of our warehouse facilities in the United
Kingdom .
(6)Represents both unrealized and realized foreign currency losses (gains) on
transactions other than in U.S. dollars.
(7)Represents a one-time $16.8 million charge for the year ended December 31,
2019 to cost of goods sold for additional inventory reserves to dispose of
certain inventory items. This charge is incremental to normal course inventory
reserves and was recorded as a result of the Company's decision to dispose of
slower moving inventory to increase operational capacity.
(8)Represents the income tax expense effect of the above adjustments. This
adjustment uses an effective tax rate of 25% for the years ended December 31,
2020 and 2019.
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Liquidity and Financial Condition
Introduction
Our primary requirements for liquidity and capital are working capital,
inventory management, capital expenditures, debt service and general corporate
needs.
On October 22, 2018 (the "Closing Date"), Funko Acquisition Holdings, L.L.C.,
Funko Holdings LLC, Funko, LLC and Loungefly, LLC (each, an "Original Borrower"
and collectively, the "Original Borrowers"), entered into a Credit Agreement (as
amended, the "Credit Agreement") by and among each Borrower, certain financial
institutions party thereto and PNC Bank, National Association , as administrative
agent and collateral agent, providing for a term loan facility in the amount of
$235.0 million (the "Term Loan Facility") and a revolving credit facility of
$50.0 million (the "Revolving Credit Facility" and together with the Term Loan
Facility, the "Credit Facilities").
On February 11, 2019 , the Company amended the Credit Agreement to increase the
Revolving Credit Facility to $75.0 million , reflecting the incremental capacity
of $25.0 million contemplated under the Credit Facilities prior to such
amendment.
On September 23, 2019 , the Original Borrowers and Funko Games, LLC
(collectively, the "Borrowers") entered into a second amendment to the Credit
Agreement (the "Second Amendment"). The Second Amendment, among other things,
extends the maturity date of the Credit Facilities to September 23, 2024 ,
reduces the interest margin applicable to all loans under the credit agreement
by 0.75% and reduces certain fees incurred under the Credit Agreement. The
Second Amendment also allows the Company to request that the Term Loan Facility
be increased by an additional $25.0 million .
On May 5, 2020 the Company entered into a third amendment to the Credit
Agreement ("Third Amendment") which amended and modified the Credit Agreement,
to, among other things, (i) waive the financial covenants under the Credit
Agreement for the fiscal quarters ending June 30, 2020 and September 30, 2020
(the "Waiver Period"), (ii) add a requirement to maintain a minimum liquidity of
at least $30.0 million until the Leverage Ratio (as defined in the Credit
Agreement) is less than 2.50 to 1.00 for a period of four consecutive fiscal
quarters, (iii) hold the incurrence ratios for certain restricted payments,
investments and dispositions at the levels applicable prior to the effectiveness
of the Third Amendment, (iv) increase the interest and fees payable under the
Credit Agreement from the date of Third Amendment through (but excluding) the
first date on which the Company receives cumulative net cash proceeds of at
least $50.0 million from certain issuances of permitted equity or convertible
subordinated debt and (v) allow that any calculation of Consolidated EBITDA (as
defined in the Credit Agreement) that includes the fiscal quarter ended December
31, 2019 may include non-cash expenses for inventory write-downs incurred by the
Company during such quarter. For the four consecutive fiscal quarter period
ended June 30, 2020 we were able to demonstrate a leverage ratio of less than
2.50 to 1:00 and were therefore no longer subject to the minimum liquidity
requirement for the three months ended September 30 , and December 31, 2020 ,
respectively.
The Credit Facilities are secured by substantially all assets of the Borrowers
and any of their existing or future material domestic subsidiaries, subject to
customary exceptions. We are a holding company with no material assets and we do
not conduct any business operations of our own. We have no independent means of
generating revenue or cash flow, and our ability to pay dividends in the future,
if any, is dependent upon the financial results and cash flows of FAH, LLC and
its subsidiaries and distributions we receive from FAH, LLC . Under the terms of
the Credit Facilities, our operating subsidiaries are currently limited in their
ability to pay cash dividends to the Company, subject to certain customary
exceptions, including:
•the ability to pay, so long as there is no current or ongoing event of default,
amounts required to be paid under the Tax Receivable Agreement, certain expenses
associated with being a public company and reimbursement of expenses required by
the LLC Agreement or the Registration Rights Agreement; and
•the ability to make other distributions of up to $25.0 million during any
period of four fiscal quarters in order to pay dividends to the common unit
holders of FAH, LLC (including the Company) as long as the funds received by the
Company are used to pay dividends to the Company's stockholders, the Leverage
Ratio under the Pro Forma Financial Covenant Requirement (as defined in the
Credit Agreement) is not greater than a ratio that is 0.50:1.00 less than the
Leverage Ratio (as defined in the Credit Agreement) for the applicable fiscal
quarter and there is remaining Availability (as defined in the Credit Agreement)
under the Credit Facilities of at least $25.0 million .
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We expect these limitations to continue in the future under the terms of the
Credit Facilities and that they may continue under the terms of any future
credit agreement or any future debt or preferred equity securities of ours or of
our subsidiaries.
On February 11, 2019 , we acquired Forrest-Pruzan Creative LLC , a board game
development studio in Seattle, WA. See Note 3, Acquisitions for further
information.
On April 20, 2019 , we filed a preliminary shelf registration statement on Form
S-3 (as amended on May 13, 2019 and August 30, 2019 , the "Form S-3") with the
SEC . The Form S-3 was declared effective by the SEC on September 16, 2019 . The
Form S-3 allows us to offer and sell from time-to-time up to $100.0 million of
Class A common stock, preferred stock, debt securities, warrants, purchase
contracts or units comprised of any combination of these securities for our own
account and allows certain selling stockholders to offer and sell 27,884,185
shares of Class A common stock in one or more offerings. On September 19, 2019 ,
certain selling stockholders completed a secondary underwritten public offering
of 4,000,000 shares of Class A common stock under our Form S-3.
The Form S-3 is intended to provide us flexibility to conduct registered sales
of our securities, subject to market conditions and our future capital needs.
The terms of any future offering under the shelf registration statement will be
established at the time of such offering and will be described in a prospectus
supplement filed with the SEC prior to the completion of any such offering.
Liquidity and Capital Resources
The following table shows summary cash flow information for the years ended
December 31, 2020 and 2019 (in thousands):
Year Ended
2020 2019
Net cash provided by operating activities $ 107,239 $ 90,765
Net cash used in investing activities (18,482) (48,633)
Net cash used in financing activities (61,838) (28,340)
Effect of exchange rates on cash and cash equivalents 107 (2,049)
Net increase in cash and cash equivalents $ 27,026 $ 11,743
Operating Activities. Our net cash provided by operating activities consists of
net income adjusted for certain non-cash items, including depreciation and
amortization, equity-based compensation, accretion of discount on long-term
debt, as well as the effect of changes in working capital and other activities.
Net cash provided by operating activities was $107.2 million for the year ended
December 31, 2020 , compared to $90.8 million for the year ended December 31,
2019 . Changes in net cash provided by operating activities result primarily from
cash received from net sales and cash payments for product costs and royalty
expenses paid to our licensors. Other drivers of the changes in net cash
provided by operating activities include shipping and freight costs, selling,
general and administrative expenses (including personnel expenses and
commissions and rent and facilities costs) and interest payments made for our
short-term borrowings and long-term debt. Our accounts receivable typically are
short term and settle in approximately 30 to 90 days.
The increase for the year ended December 31, 2020 compared to the year ended
December 31, 2019 was primarily due to changes in working capital, which
increased net cash provided by operating activities by $28.2 million and were
primarily due to decreases in accounts receivable, net and prepaid expenses and
other assets of $24.0 million and $18.1 million , respectively, and increases in
accrued expenses and other liabilities, accrued royalties, and income taxes
payable of $12.8 million , $10.3 million and $3.4 million , respectively. This was
partially offset by an increase in inventory and accounts payable of $22.5
million and $17.9 million , respectively. The increase in net cash provided by
operating activities was also offset by a decrease in net income, excluding
non-cash adjustments, of $11.7 million , driven primarily by an decrease in net
sales.
Investing Activities. Our net cash used in investing activities primarily
relates to the purchase of property and equipment and acquisitions, net of cash
acquired. For the year ended December 31, 2020 , net cash used in investing
activities was $18.5 million , which was used for the purchase of property and
equipment, primarily related to tooling and molds used for the expansion of
product lines.
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For the year ended December 31, 2019 , net cash used in investing activities was
$48.6 million and was comprised of $42.3 million used for the purchase of
property and equipment, primarily related to tooling and molds used for the
expansion of product lines, and cash consideration, net of cash acquired of $6.4
million for the Forrest-Pruzan Acquisition.
Financing Activities. Our financing activities primarily consist of proceeds
from stock issuances, the issuance of long-term debt, net of debt issuance
costs, the repayment of long-term debt, payments and borrowings under our line
of credit facility, contributions from, and distributions to, members and the
payment of contingent consideration. We do not anticipate any financing activity
related to contributions from members going forward.
For the year ended December 31, 2020 , net cash used in financing activities was
$61.8 million , primarily related to payments under the Tax Receivable Agreement
of $4.6 million , distributions to the Continuing Equity Owners of $3.6 million ,
payments on the Term Loan Facility of $26.4 million , and net payments on the
Revolving Credit Facility of $26.8 million , partially offset by $0.2 million
proceeds from the exercise of equity based options.
For the year ended December 31, 2019 , net cash used in financing activities was
$28.3 million , primarily related to distributions to the Continuing Equity
Owners of $23.9 million and payments on the Term Loan Facility of $11.8 million ,
partially offset by net borrowings on the Revolving Credit Facility of $5.7
million and proceeds from the exercise of equity based options of $2.2 million .
Financial Condition
Notwithstanding our obligations under the Tax Receivable Agreement between
Funko, Inc. , FAH, LLC and each of the Continuing Equity Owners, we believe that
our sources of liquidity and capital will be sufficient to finance our continued
operations, growth strategy, our planned capital expenditures and the additional
expenses we incur as a public company for at least the next 12 months.
However, we cannot assure you that our cash provided by operating activities,
cash and cash equivalents or cash available under our Revolving Credit Facility
will be sufficient to meet our future needs. If we are unable to generate
sufficient cash flows from operations in the future, and if availability under
our Revolving Credit Facility is not sufficient, we may have to obtain
additional financing. If we obtain additional capital by issuing equity, the
interests of our existing stockholders will be diluted. If we incur additional
indebtedness, that indebtedness may contain significant financial and other
covenants that may significantly restrict our operations. We cannot assure you
that we could obtain refinancing or additional financing on favorable terms or
at all.
As noted above, on October 22, 2018 , we entered into the Credit Facilities
which, as amended, are secured by substantially all assets of the Borrowers and
any of their existing or future material domestic subsidiaries, subject to
customary exceptions.
The Borrowers and any of their existing or future material domestic
subsidiaries, subject to customary exceptions, guarantee repayment of the Credit
Facilities. The Term Loan Facility matures on September 23, 2024 (the "Maturity
Date"). The Term Loan Facility amortizes in quarterly installments in aggregate
amounts equal to 5.00% of the original principal amount of the Term Loan
Facility in the first and second years of the Term Loan Facility, 10.00% of the
original principal amount of the Term Loan Facility in the third and fourth
years of the Term Loan Facility and 12.50% of the original principal amount of
the Term Loan Facility in the fifth and sixth year of the Term Loan Facility,
with any outstanding balance due and payable on the Maturity Date. The Revolving
Credit Facility terminates on the Maturity Date and loans thereunder may be
borrowed, repaid, and reborrowed up to such date.
As amended, loans under the Credit Facilities, at the Borrowers' option, bear
interest at either the Euro-Rate (as defined in the Credit Agreement) or, in the
case of swing loans, the Swing Rate (as defined in the Credit Agreement), plus
3.00% or the Base Rate (as defined in the Credit Agreement) plus 2.00%, with
0.25% step-downs based on the achievement of certain leverage ratios following
the Closing Date. The Euro-Rate is subject to a 1.00% floor and for loans based
on the Euro-Rate, interest payments are due at the end of each applicable
interest period.
The Borrowers may request that the Term Loan Facility be increased by an
additional $25.0 million .
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The Credit Agreement governing the Credit Facilities contains a number of
covenants that, among other things and subject to certain exceptions, restrict
our ability to:
•incur additional indebtedness;
•incur certain liens;
•consolidate, merge or sell or otherwise dispose of our assets;
•alter the business conducted by us and our subsidiaries;
•make investments, loans, advances, guarantees and acquisitions;
•pay dividends or make other distributions on equity interests, or redeem,
repurchase or retire equity interests;
•enter into transactions with affiliates;
•enter into agreements restricting our subsidiaries' ability to pay dividends;
•issue or sell equity interests or securities convertible into or exchangeable
for equity interests;
•redeem, repurchase or refinance other indebtedness; and
•amend or modify our governing documents.
In addition, the Credit Agreement requires FAH, LLC and its subsidiaries to
comply on a quarterly basis with a maximum Leverage Ratio and a minimum fixed
charge coverage ratio (in each case, measured on a trailing four-quarter basis),
except as described above in connection with the Waiver Period. The maximum
Leverage Ratio and the minimum fixed charge coverage ratio for the fiscal
quarter ending December 31, 2020 are 4.25:1.00 and 1.25:1.00, respectively. As
of December 31, 2020 and December 31, 2019 , we were in compliance with all
covenants in our Credit Facilities. In accordance with the Third Amendment, the
financial covenants under the Credit Agreement were waived during the Waiver
Period. In accordance with the Third Amendment, the financial covenants under
the Credit Agreement were waived during the Waiver Period.
We expect to maintain compliance with our covenants for at least one year from
the issuance of these financial statements based on our current expectations and
forecasts. If economic conditions caused by the COVID-19 global pandemic worsen
and the Company's earnings and operating cash flows do not continue to recover
as currently estimated by management, this could impact our ability to maintain
compliance with our amended financial covenants and require the Company to seek
additional amendments to our Credit Agreement.
The Credit Agreement also contains certain customary representations and
warranties and affirmative covenants, and certain reporting obligations. In
addition, the lenders under the Credit Facilities will be permitted to
accelerate all outstanding borrowings and other obligations, terminate
outstanding commitments and exercise other specified remedies upon the
occurrence of certain events of default (subject to certain grace periods and
exceptions), which include, among other things, payment defaults, breaches of
representations and warranties, covenant defaults, certain cross-defaults and
cross-accelerations to other indebtedness, certain events of bankruptcy and
insolvency, certain judgments and changes of control. The Credit Agreement
defines "change of control" to include, among other things, any person or group
other than ACON and its affiliates becoming the beneficial owner of more than
35% of the voting power of the equity interests of Funko, Inc.
As of December 31, 2020 , we had $52.3 million of cash and cash equivalents and
$120.7 million of working capital, compared with $25.2 million of cash and cash
equivalents and $101.6 million of working capital as of December 31, 2019 .
Working capital is impacted by seasonal trends of our business and the timing of
new product releases, as well as our current portion of long-term debt and draw
downs on our line of credit. For further discussion of changes in our debt, see
below, and Note 10, Debt of the notes to our consolidated financial statements.
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Future Sources and Uses of Liquidity
Sources
As noted above, historically, our primary sources of cash flows have been cash
flows from operating activities and borrowings under our Credit Facilities. We
expect these sources of liquidity to continue to be our primary sources of
liquidity.
Credit Facilities. On October 22, 2018 , the Company entered into the Credit
Facilities. For a discussion of our Credit Facilities, see Note 10, Debt of the
notes to our consolidated financial statements.
Offerings of Registered Securities . In addition, as described above, on April
20, 2019 , we filed a preliminary shelf registration statement on Form S-3 with
the SEC , which was declared effective by the SEC on September 16, 2019 . The Form
S-3 allows us to offer and sell from time to time up to $100.0 million of Class
A common stock, preferred stock, debt securities, warrants, purchase contracts
or units comprised of any combination of these securities for our own account.
The terms of any offering under the shelf registration statement will be
established at the time of such offering and will be described in a prospectus
supplement filed with the SEC prior to the completion of any such offering.
Uses
Additional future liquidity needs may include public company costs, tax
distributions, the redemption right held by the Continuing Equity Owners that
they may exercise from time to time (should we elect to exchange their common
units for a cash payment), payments under the Tax Receivable Agreement and
general cash requirements for operations and capital expenditures. The
Continuing Equity Owners may exercise their redemption right for as long as
their common units remain outstanding. Although the actual timing and amount of
any payments that may be made under the Tax Receivable Agreement will vary, we
expect that the payments we will be required to make to the Continuing Equity
Owners will be significant. Any payments made by us to the Continuing Equity
Owners under the Tax Receivable Agreement will generally reduce the amount of
overall cash flow that might have otherwise have been available to us or to FAH,
LLC and, to the extent that we are unable to make payments under the Tax
Receivable Agreement for any reason, the unpaid amounts generally will be
deferred and will accrue interest until paid by us; provided however, that
nonpayment for a specified period may constitute a material breach under the Tax
Receivable Agreement and therefore may accelerate payments due under the Tax
Receivable Agreement.
Seasonality
While our customers in the retail industry typically operate in highly seasonal
businesses, we have historically experienced only moderate seasonality in our
business. Historically, over 50% of our net sales are made in the third and
fourth quarters, primarily in the period from August through November, as our
customers build up their inventories in anticipation of the holiday season.
Historically, the first quarter of the year has represented the lowest volume of
shipment and sales in our business and in the retail and toy industries
generally and it is also the least profitable quarter due to the various fixed
costs of the business. However, the rapid growth we have experienced in recent
years may have masked the full effects of seasonal factors on our business to
date, and as such, seasonality may have a greater effect on our results of
operations in future periods.
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Contractual Obligations
The following summarizes our future minimum commitments as of December 31, 2020
(in thousands):
2021 2022 2023 2024 2025 Thereafter Total
Long term debt and related
interest (1) $ 22,537 $ 34,683 $ 37,565 $ 132,849 $ - $ - $ 227,634
Operating leases 14,315 14,312 11,952 11,279 10,028 27,614 89,500
Liabilities under tax
receivable agreement (2) 2,020 5,350 3,651 3,724 3,804 43,768 62,317
Minimum royalty
obligations (3) 4,985 231 63 - - - 5,279
Total 43,857 54,576 53,231 147,852 13,832 71,382 384,730
(1)We estimated interest payments through the maturity of our Credit Facilities
by applying the interest rate of 6.04% in effect as of December 31, 2020 under
our New Term Loan Facility. See Note 10, Debt of the notes to our consolidated
financial statements.
(2)Represents amounts owed under our Tax Receivable Agreement. See Note 13,
Liabilities under Tax Receivable Agreement for additional information.
(3)Represents minimum guaranteed royalty payments under licensing arrangements.
Off-Balance Sheet Arrangements
As of December 31, 2020 , we did not have any off-balance sheet arrangements.
Recent Accounting Pronouncements
See discussion of recently adopted and recently issued accounting pronouncements
in Note 2, Significant Accounting Policies of the notes to our consolidated
financial statements.
Critical Accounting Policies and Estimates
Discussion and analysis of our financial condition and results of operations are
based on our consolidated financial statements which have been prepared in
accordance with U.S. GAAP. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets and liabilities and related disclosures of contingent assets and
liabilities, revenue and expenses at the date of the consolidated financial
statements. We base our estimates on historical experience and on various other
assumptions in accordance with U.S. GAAP that we believe to be reasonable under
the circumstances. Actual results may differ from these estimates under
different assumptions or conditions.
Critical accounting policies and estimates are those that we consider the most
important to the portrayal of our financial condition and operating results and
require management's most difficult, subjective or complex judgments, often as a
result of the need to make estimates about the effect of matters that are
inherently uncertain. Our critical accounting policies and estimates include
those related to revenue recognition and sales allowances, royalties, inventory,
goodwill and intangible assets and income taxes. Changes to these policies and
estimates could have a material adverse effect on our results of operations and
financial condition.
The JOBS Act permits us, as an "emerging growth company," to take advantage of
an extended transition period to comply with new or revised accounting standards
applicable to public companies. We have chosen to "opt out" of this provision
and, as a result, we will adopt new or revised accounting standards upon or
prior to required public company adoption dates. This decision to opt out of the
extended transition period under the JOBS Act is irrevocable.
Revenue Recognition and Sales Allowance. Revenue from the sale of our products
is recognized when control of the goods is transferred to the customer, which is
upon shipment or upon receipt of finished goods by the customer, depending on
the contract terms. The majority of revenue is recognized upon shipment of
products to the customer.
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We routinely enter into arrangements with our customers to provide sales
incentives, support customer promotions, and provide allowances for returns and
defective merchandise. These sales adjustments require management to make
estimates. In making these estimates, management considers all available
information including the overall business environment, historical trends and
information from customers, such as agreed upon customer contract terms as well
as historical experience from the customer. The estimated costs of these
programs reduce gross sales in the period the related sale is recognized. We
adjust our estimates at least quarterly or when facts and circumstances used in
the estimate process change; historically adjustments to these estimates have
not been material.
We have elected to account for shipping and handling activities that occur after
control of the related good transfers as fulfillment activities instead of
assessing such activities as performance obligations. Accordingly, shipping and
handling activities that are performed by us, whether before or after a customer
has obtained control of the products, are considered fulfillment costs to
satisfy our performance obligation to transfer the products and are recorded as
incurred within cost of goods sold.
We have made an accounting policy election to exclude from revenue all taxes
assessed by a governmental authority that are both imposed on and concurrent
with a specific revenue-producing transaction and collected by the Company from
a customer (for example, sales, use, value added, and certain excise taxes).
Royalties. We enter into agreements for rights to licensed trademarks,
copyrights and likenesses for use in our products. These licensing agreements
require the payment of royalty fees to the licensor based on a percentage of
revenue. Many licensing agreements also require minimum royalty commitments.
When royalty fees are paid in advance, we record these payments as a prepaid
asset. If we determine that it is probable that the expected revenue will not be
realized, a reserve is recorded against the prepaid asset for the
non-recoverable portion. As of December 31, 2020 , we recorded a prepaid asset of
$6.3 million , net of a reserve of $1.0 million . As of December 31, 2019 , we
recorded a prepaid asset of $13.0 million , net of a reserve of $2.4 million .
We record a royalty liability as revenues are earned based on the terms of the
licensing agreement. In situations where a minimum commitment is not expected to
be met based on expected revenues, we will accrue up to the minimum amount when
it is reasonably certain that revenues generated will not meet the minimum
commitment. Royalty and license expense is recorded within cost of sales on the
consolidated statements of operations. Royalty expenses for the years ended
December 31, 2020 and 2019, were $105.0 million and $126.8 million ,
respectively.
Inventory. Inventory consists primarily of figures, plush and accessories and
other finished goods, and is accounted for using the first-in, first-out, or
FIFO, method. Inventory costs include direct product costs and freight costs. We
maintain reserves for excess and obsolete inventories to reflect the inventory
balance at the lower of cost or net realizable value. This valuation requires us
to make judgments, based on currently available information, about the likely
method of disposition, through sales to customers, or liquidation, and expected
recoverable value of each disposition category. We estimate obsolescence based
on assumptions regarding future demand.
In addition, during the year ended December 31, 2019 , we recorded a one-time
$16.8 million charge related to the write-down of inventory as a result of the
Company's decision to dispose of slower moving inventory to increase operational
capacity. This charge is incremental to normal course reserves.
Goodwill and Intangible Assets. Goodwill represents the excess of the purchase
price over the net amount of identifiable assets acquired and liabilities
assumed in a business combination measured at fair value. We evaluate goodwill
for impairment annually on October 1 of each year and upon the occurrence of
triggering events or substantive changes in circumstances that could indicate a
potential impairment by assessing qualitative factors or performing a
quantitative analysis in determining whether it is more likely than not that the
fair value of the net assets is below their carrying amounts.
Intangible assets acquired in a business combination are recognized separately
from goodwill and are initially recognized at their fair value at the
acquisition date. Intangible assets acquired include intellectual property
(product design), customer relationships, and trade names. These are
definite-lived assets and are amortized on a straight-line basis over their
useful lives. Intangible assets are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of the assets might
not be recoverable. Conditions that would necessitate an impairment assessment
include a significant decline in the observable market value of an asset, a
significant change in the extent or manner in which an asset is used, or any
other significant adverse change that would indicate that the carrying amount of
an asset or group of assets may not be recoverable.
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Income Taxes. We apply the provisions of Accounting Standards Codification
("ASC") Topic No. 740, "Income Taxes" ("ASC 740"). Under ASC 740, deferred tax
assets and liabilities are determined based on differences between the financial
reporting and tax bases of assets and liabilities and are measured using the
enacted tax rates and laws that will be in effect when the differences are
expected to reverse. We record a valuation allowance against our deferred tax
assets when it is more likely than not that all or a portion of a deferred tax
asset will not be realized. In evaluating our ability to recover our deferred
tax assets, we consider all available positive and negative evidence, including
our operating results, ongoing tax planning and forecasts of future taxable
income on a jurisdiction-by-jurisdiction basis. If we determine we will not be
able to fully utilize all or part of these deferred tax assets, we would record
a valuation allowance through earnings in the period the determination was made,
which would have an adverse effect on our results of operations and earnings. In
accordance with ASC 740, we recognize, in our consolidated financial statements,
the impact of our tax positions that are more likely than not to be sustained
upon examination based on the technical merits of the positions. We recognize
interest and penalties for uncertain tax positions in selling, general and
administrative expenses.
We are subject to U.S. federal, state and local income taxes with respect to our
allocable share of any taxable income of FAH, LLC and are taxed at the
prevailing corporate tax rates. FAH, LLC is treated as a partnership for U.S.
federal income tax purposes and, as such, generally is not subject to any
entitylevel U.S. federal income tax. Instead, taxable income is allocated to
holders of its common units, including us. As a result, we incur income taxes on
our allocable share of any net taxable income of FAH, LLC . Pursuant to the
Second Amended and Restated FAH, LLC Agreement, FAH, LLC will generally make pro
rata tax distributions to holders of common units in an amount sufficient to
fund all or part of their tax obligations with respect to the taxable income of
FAH, LLC that is allocated to them.
In connection with the consummation of the IPO, we entered into the Tax
Receivable Agreement with FAH, LLC and each of the Continuing Equity Owners.
Pursuant to the Tax Receivable Agreement, we are required to make cash payments
to the Continuing Equity Owners equal to 85% of the tax benefits, if any, that
we realize, or in some circumstances are deemed to realize, as a result of
(1) any redemptions funded by us or exchanges (or deemed exchanges in certain
circumstances) of common units for Class A common stock or cash, and (2) certain
additional tax benefits attributable to payments under the Tax Receivable
Agreement ("Tax Receivable Agreement Payments"). Amounts payable under the Tax
Receivable Agreement are contingent upon, among other things, (i) generation of
taxable income over the term of the Tax Receivable Agreement and (ii) changes in
tax laws. If we do not generate sufficient taxable income in the aggregate over
the term of the Tax Receivable Agreement to utilize the tax benefits, then we
would not be required to make the related Tax Receivable Agreement Payments.
Therefore, we only recognize a liability for Tax Receivable Agreement Payments
if we determine that it is probable that we will generate sufficient future
taxable income over the term of the Tax Receivable Agreement to utilize the
related tax benefits. Estimating future taxable income is inherently uncertain
and requires judgment. In projecting future taxable income, we consider our
historical results and incorporate certain assumptions, including projected
revenue growth, and operating margins, among others.
Upon redemption or exchange of common units in FAH, LLC , we record a liability
relating to the obligation if we believe that it is probable that we would have
sufficient future taxable income to utilize the related tax benefits. If we
determine in the future that we will not be able to fully utilize all or part of
the related tax benefits, we would derecognize any portion of the liability
related to the benefits not expected to be utilized.
Additionally, we will estimate the amount of Tax Receivable Agreement Payments
expected to be paid within the next 12 months and classify this amount as
current on our consolidated balance sheets. This determination is based on our
estimate of taxable income for the next fiscal year. To the extent our estimate
differs from actual results, we may be required to reclassify portions of our
liabilities under the Tax Receivable Agreement between current and non-current.
During years ended December 31, 2020 and 2019, the Company acquired an aggregate
of 0.5 million and 9.5 million common units of FAH, LLC , respectively, in
connection with the redemption of common units, which resulted in an increase in
the tax basis of our investment in FAH, LLC subject to the provisions of the Tax
Receivable Agreement. As a result of these exchanges, during the years ended
December 31, 2020 and 2019, the Company recognized an increase to its net
deferred tax assets in the amount of $0.5 million and $48.1 million ,
respectively, and corresponding Tax Receivable Agreement liabilities of $1.0
million and $59.0 million , respectively, representing 85% of the tax benefits
due to the Continuing Equity Owners. In addition, during the year ended
December 31, 2020 , the Company recognized $0.1 million of expenses in other
expense (income), net on our consolidated statements of operations related to
remeasurement adjustments of Tax Receivable Agreement liabilities.
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