Private Equity Incentive Structures: What Management Needs to Know

If a private equity buyer is exploring an acquisition of the company you manage, and you anticipate remaining involved in the business after the sale, there are a number of options that may be appealing to you. It is likely that you will be negotiating your post-sale compensation package. As discussed in a prior article, there are three main options that private equity buyers typically present key members of the company who are planning to stay involved post-sale: offering you a rollover of part or all of the equity you currently hold in the company; asking you to co-invest in the company alongside the buyer; or offering you some type of equity, or equity-like, incentive compensation. This article delves deeper into those options, further showcasing some of the advantages and pitfalls of each form of incentive structure that you should consider during negotiations.

Rollover

In private equity transactions, management members who hold equity in the company pre-sale, may be offered equity of the private equity buyer in exchange for a percentage of or all of their outstanding equity in the company pre-sale. This aligns your interests with that of the buyers, ensuring continuity, motivation, and a vested commitment to future growth of the company. Rollover equity is often a key component of deal structuring, as it signals confidence in the business and mitigates risk for the private equity firm. The percentage of equity rolled over varies by deal and typically depends on transaction specifics and the level of involvement you will have post-sale.

If a rollover is being considered by you and the private equity buyer, it is important to understand the motivations of the private equity buyer as well as the benefits and downsides that could affect the negotiations. A rollover enables the private equity buyer to offer a reduced percentage of upfront cash capital at the time of the sale. For you, if properly structured, the rollover can be tax deferred which would reduce your tax burden at closing. If the rollover meets the requirements for tax deferral, the management team will only pay taxes on the cash received, if any, while the amount rolled over will only be taxed upon a subsequent exit event, such as a subsequent sale or an IPO. The rollover structure also allows you to participate in the success of the company post-closing. Private equity buyers might be hesitant to offer rollover equity if they are concerned about dilution of ownership or if they have concerns over control of the company. These concerns can be mitigated through proper structuring from the management team and their advisors in addition to ensuring the private equity buyer is aware that your goals align with theirs.

Co-Investment

Co-investment opportunities allow management teams to invest alongside private equity buyers in the company they help operate. From a private equity perspective, this aligns management with the private equity buyer, ensuring that key executives have skin in the game and are motivated to drive growth and profitability. By offering management a direct ownership stake, the private equity buyer fosters a culture of accountability and shared success, often leading to stronger financial performance and value creation. Additionally, co-investment can serve as a powerful retention tool, reinforcing long-term commitment from leadership while balancing risk and reward between the firm and its management members.

One of the main hurdles to this structure is the cash intensive nature of a co-investment. You must be able to meet the capital contribution requirements to invest alongside the private equity buyer. The other hurdles include how your involvement in the company will be structured going forward. Will you be actively involved in the management of the company post-sale or will you take on a more passive role? Will your co-investment allow you to maintain any level of control in the company post-sale? You must also be aligned with the private equity buyer on the exit strategy post-closing. You must consider the private equity buyer’s expected timeline of investment, which typically ranges between three- and seven-years post-sale. These issues should be addressed early in the process to avoid potential issues post-sale.

Equity or Equity-Like Incentives

There are a number of incentive compensation plans that can reward you for post-closing success. However, there are many issues that must be addressed at the outset to properly structure this form of management incentives. First, you and the private equity buyer must agree on the form. Options include stock options, restrictive stock units, stock appreciation rights, profits interests, and phantom stock. We review each of those below.

Stock Options: Stock options in private equity serve as a key incentive mechanism to align management’s interests with those of investors. Unlike publicly traded options, private equity stock options are often structured as part of a broader equity compensation package, including profits interests or restricted stock. These options typically vest over time or upon achieving performance milestones, ensuring that executives and key employees remain committed to the company’s long-term growth. Because private equity firms focus on value creation and exit strategies, stock options are designed to maximize returns upon specified liquidity events, such as a sale or an IPO, rather than short-term stock price movements.

Restricted Stock Units: Restricted Stock Units (RSUs) in private equity are a tool used to align management and employees with long-term value creation. Unlike stock options, RSUs represent a grant of company shares that vest over time, often tied to performance milestones or liquidity events like an IPO or subsequent sale. In private equity-backed firms, RSUs are structured to reward executives for driving growth and maximizing exit valuations. However, their illiquidity before an exit and potential tax implications make careful structuring essential to ensure they serve as a strong retention and motivation mechanism.

Stock Appreciation Rights: Stock Appreciation Rights (SARs) are a popular incentive tool in private equity, offering key executives and employees the upside of equity ownership without requiring them to purchase shares. SARs grant recipients the right to receive a cash (or stock) payout proportionate to the appreciation in the company’s value over a set period, aligning their interests with investors by rewarding value creation. Unlike traditional stock options, SARs do not require an upfront purchase, making them particularly attractive in leveraged buyouts (LBOs) and high-growth private companies. Private equity firms use SARs to drive performance while managing dilution, often structuring them with vesting schedules, performance hurdles, and exit-based payouts to maximize alignment with investor returns.

Profits Interests: Profits interests are a powerful equity compensation tool used in private equity transactions to incentivize key executives and employees. These interests grant holders a share of the future profits and appreciation of a company without requiring an upfront capital contribution or immediate tax liability. Unlike traditional equity, profits interests have no value at issuance but become valuable as the company’s value increases beyond a pre-determined threshold. Commonly structured within LLCs, they align management’s incentives with investors by tying rewards to income, long-term growth, and successful exits.  Under certain circumstances, profits interests may receive the preferential long term capital gains treatment. However, if not carefully structured, profits interests may be taxed as ordinary income.

Phantom Equity: Phantom equity is a compensation structure used in private equity to align the interests of key executives and employees with the company’s success — without granting actual ownership. Unlike traditional equity, phantom equity provides recipients with the economic benefits of ownership, such as profit-sharing or exit proceeds, without the private equity buyer surrendering control. Private equity firms often use phantom equity to incentivize management teams in portfolio companies, ensuring they remain motivated to drive growth and maximize valuation. Typically, phantom equity units track the value of real shares and pay out upon a liquidity event, such as a sale or IPO. Since these awards don’t confer voting rights or direct control, they offer firms a way to retain top talent while maintaining strategic control over decision-making. For investors, phantom equity is an effective tool for structuring compensation without altering cap tables, making it a flexible alternative to traditional equity-based incentives.

Obstacles for Equity and Equity-Like Incentives

These types of incentives can provide for a unique set of obstacles which must be negotiated with the private equity buyer. Many of these incentive awards are calculated by some measure of growth. Private equity buyers will use specific benchmarks to measure the payout under the incentive plans. Typical benchmarks include meeting a specific internal rate of return, reaching a specific return on the private equity buyer’s investment, or meeting revenue or EBITDA growth markers post-sale. The next hurdle will be negotiating the incentive bonuses that will be offered, whether as a pool of incentive bonuses or as individual awards. Pool incentive bonuses allow for a specified group of individuals, usually high-level management, to participate in the incentive bonus plan. The company will typically allocate a set number of incentive units, either SARs, RSUs, phantom stock, or options, to the pool which will then distribute to management members based on their percent interest in the pool. It can also be structured in a way to reward each individual key member with their own units of incentive equity or equity-like units. The last major hurdle is structuring for tax considerations. Depending on the type of incentive unit, the recipient may be able to reduce taxes by receiving capital gains treatment on the incentive units, as opposed to treating the incentive compensation as ordinary income.

Conclusion

When considering management incentive compensation in private equity transactions, there are many factors to consider, including structure, measurement of value, tax considerations, and exit strategies. When negotiating these management incentive structures, you should consult with business, legal, tax, and other advisors to navigate the obstacles presented to the management team in connection with the sale.

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