Post-Closing Incentive Structures for Key Management in Private Equity

If you own or manage a company that a private equity firm is looking to acquire, and you plan to stay on after the closing, you’ll likely need to negotiate two key points: rolling over some or all of your equity and determining the incentive compensation you want to receive. In most acquisitions, but particularly in private equity buyouts, retaining and incentivizing key executives is often critical to the long-term success of the transaction. As a result, the management compensation structure generally has a significant performance-based component. Key players on the management team may be awarded a number of incentives, both in cash and in equity-based incentives.

What’s Involved in a Private Equity Transaction?

A private equity acquisition generally involves a private equity firm acquiring an operating company by using its equity funds and borrowing to finance the acquisition. The private equity firm, referred to as the sponsor, is acquiring the company with the goal of making a profit in the next 3-7 years. The acquired company will become one of the private equity sponsor’s portfolio companies. A private equity buyout differs from the acquisition of a business by a strategic buyer, who acquires a company to permanently improve, change, or expand its own operations.

Retaining the existing management team or hiring a new management team is particularly important in the private equity sponsor context. While the sponsor will be providing overall strategic direction for the acquired company, the sponsor typically will not be running day-to-day operations of the business. The management team will be critical to the company’s success, and performance-based incentives are a key way to retain and motivate talented executives.

The 3 Main Categories of Management Incentives

The specific mix of management equity incentives used in buyouts varies widely from sponsor to sponsor and deal to deal, with many sponsors developing preferred programs over time. In addition to cash-based incentives, there are three main categories of management equity incentives: (i) management exchange or rollover of existing equity in the company, (ii) management co-investment in new equity on the same terms as the sponsor, and (iii) granting compensatory equity awards in the post-buyout company or its parent. The management compensation structure used in a particular transaction will depend on the specific facts and circumstances, and varies from sponsor to sponsor.

• Rollover Equity

Management rollovers are common in sponsor-backed transactions. If the current management team owns equity in the existing company, they can “roll over” their existing equity into shares of the new company in the acquisition. This is a useful technique when management already owns a significant amount of equity in the existing company. A key consideration in a management rollover of existing equity is whether the rollover will be tax deferred, which can usually be accomplished in a properly structured transaction. The amount of management rollover may also depend on how much dilution in its ownership percentage the sponsor deems acceptable.

• Management Co-Investment

Another method used by private equity sponsors to incentivize management in a buyout involves allowing management to purchase new equity alongside the sponsor. This benefit is usually only offered to top executives such as the CEO and CFO because it requires a substantial up-front advancement of cash that most others in management may not have. Management co-investment also carries downside risks if the portfolio company does not perform well. In some cases, the sponsor may lend funds to the executives to purchase the equity on favorable terms, which can have downsides if the company does not perform well.

• Equity or Equity-Like Incentives

Management incentives through equity-based compensation makes up the bulk of performance-based compensation in private equity buyouts. The compensatory equity awards can come in many forms, including as stock options (ISOs and/or NQSOs), restricted stock, restricted stock units (RSUs), stock appreciation rights (SARs), and profits interests depending on the entity type used (corporation/LLC/partnership) and the goals of the private equity firm. The management equity incentives provide key executives with potential upside gain if the portfolio company performs well, while protecting them from downside risk. There are several different tax implications of using the various types of equity awards. Management will generally request the type that best meets the individual’s potential personal goals — whether he/she intends to remain with the company long-term or what fits their current tax situation. If the granting entity is an LLC, profits interests are increasingly popular because they are attractive to executives from a tax perspective.

The equity securities in a management incentive program are subject to vesting provisions, which can be time-based, performance-based or a combination thereof. Time-based vesting means that the equity shares granted to the executive vest according to a schedule. The executive must continue to be employed on the applicable vesting dates to receive the equity award. This is intended to motivate key executives to stay with the company for a certain number of years. Performance-based vesting means that the equity awards vest only upon satisfaction of specified performance goals. The executive must remain employed with the company until achievement of the operational goals. If the executive’s employment with the portfolio company is terminated, unvested equity awards may be subject to forfeiture. Acceleration can occur upon certain events such as a further sale of the company, an initial public offering or other liquidity event.

Conclusion

The choice of which management program(s) to use in any buyout is a complex one involving significant business, legal, tax, and accounting considerations for both the portfolio company and the management team. Counsel to the sponsor and the management team should involve tax, ERISA, and accounting specialists early in the transaction process to structure the proper management incentive programs for the particular buyout.

 

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