Michael Sirkin, Chairman and Managing Director of Jamieson USA, discusses the impact on management equity incentives when private equity firms exit portfolio companies.

Private equity firms invest in portfolio companies with the goal of improving the company results and then exiting the investment within a projected period. They generally exit their portfolio company investments in one of three ways:

• they sell the company to another private equity firm (sometimes staying in the investment either by rolling over a portion of their investment or by investing with a later fund);
• they sell the company to a strategic either for cash or stock;
• they take the company public through an initial public offering.

The method likely to be utilized for an exit needs to be contemplated by management in agreeing on the plan at the time of the initial private equity firm acquisition and the creation of the plan in order to understand when they will receive liquidity of their incentives.

Most portfolio company equity incentive plans in the United States are structured with a portion (usually fifty percent or less) vesting on a time basis over 4 or 5 years and the remaining portion vesting on a performance achievement basis.  While a limited number of plans will use an annual EBITDA achievement as the performance vesting measurement, the bulk of equity incentive plans will utilize a measurement based on return on investment of either the multiple of money received over invested amount (“MOIC”) or internal rate of return (“IRR”). Many plans that use an EBITDA factor also will have a vesting management catchup at exit using either MOIC or IRR.

The issues that must be addressed are when and how to measure the realization on exit. Most private equity firms will want realization to be measured as the private equity fund sponsor receives cash. Furthermore, they will want management to be committed to staying with the company until that occurs.

While this answer is perhaps logical for the sponsor, it is not necessarily so for management.  The points to be addressed are: What is the definition of an Exit Event?  Should management receive full realization of the incentive arrangement on a change of control?  Is management required to continue with their incentive arrangement until the sponsor fully cashes out?  What should occur if management’s employment ends after the change in control or IPO but before final exit of the sponsor?

The most common exit event from a private equity portfolio company investment is a change in control on a sale, whether the sale is to another private equity firm or to a strategic entity. Initial public offerings are much more limited as exit events since the market capitalization level needed to go public and permit the sponsors to fully liquidate their interests or even a majority stake may be too high for the bulk of private equity owned companies.

In an increasing number of transactions, sponsors sell down a majority or minority interest in portfolio companies or even sell from one of its funds to another of its funds.   In such circumstances thought needs to be given as to whether or not these transactions should be treated as a change in control and how management incentives should be treated.

If the exit event is a sale of the entire company for cash paid on closing, a measurement factor of cash as and when received by the sponsor will cause little concern.   A more complicated case would be if there was an escrow or earnout in addition to the amounts paid in cash. Since it is hard to estimate at closing the expected value of earnout and, to a lesser degree, escrow when paid, measurement of these amounts is often delayed until they are turned into cash.

The most difficult case is when property is received or a material interest in the entity (the “Stub”) is maintained. From the sponsor’s point of view, they have not yet fully realized on their investment in these situations and they do not know the ultimate MOIC or IRR that will be received. From management’s point of view, they have brought the company to an exit event and have earned their payment.

Waiting out full cash receipt by the sponsor to measure and/or receive payment, can raise other issues for management.  If the equity interest remains in stock of the new entity, it will eventually be vested or paid at a time when it may well not be liquid and also could be subject at the time to taxes. In addition, if the time period is lengthy, the stock value of a Stub may well be subject to adjustment based on the post change in control operations of the company. The other alternative for delayed vesting is to liquidate the value and have the value held by the sponsor entity for later payment or placed in an escrow that will be paid either to the executives or the sponsor when realization value is determinable.  These issues are somewhat lessened if the MOIC or IRR for vesting is measured at the change in control date and only payment is delayed. Note that there are tax Code Section 409A and other possible tax issues in structuring these delayed payment options.

However, the biggest issue is a requirement for continued employment until the delayed payment is made or the property or Stub is turned into cash.  This problem is especially acute for the senior executives because they are suddenly being required to work for a new owner (be it a sponsor or trade party).

The requirement of continued employment is especially sensitive if the executive is terminated without cause or for disability, leaves for good reason or dies prior to full realization after the change in control but prior to full cash realization by the sponsor.  Fairness argues for the continued employment requirement to be waived in these situations since the exit event has occurred and it is only timing until the measurement date is achieved.

A more difficult situation is the ability to voluntarily leave without Good Reason.  The issue is that management has achieved the change in control goal and why should they have to continue to work to receive the realization or the payout.  This is especially true since a new equity plan will have been established to award management for the next sponsor’s return.  An argument can be made to require staying for a short transition period, but the transition argument exists whether or not equity is tied to it and most executives will agree to some type of limited transition period even if they want to leave.

The issue of a continued employment requirement is particularly difficult if the sale is for control, but not for all of the company, or a material minority sale or a sale from one of the sponsor’s funds to another. In these cases the original sponsor may be staying on for another 5 year run before it receives all of its money. By extending the hold on management employment as a condition of receiving their full value, what was a 5 year or so planned involvement becomes a 10 year or so required involvement and is often hard to justify. In fairness, the initial plan often should be measured and paid out and a new equity incentive plan established based on the new company value.

If the liquidation event is an initial public offering (an “IPO”), the cash measurement provides similar problems.  In most U.S.  IPO’s, 10% to 20% of the company is initially taken public and then there is a secondary six months or so later in which the insiders start to sell down.  Sometimes the private equity firm will sell heavily down in the IPO and secondary, but other times they will continue to stay in or sell down at a much slower pace.

In the United States, the IPO generally is not treated as a Change in Control and, hence, not even the time based equity vests on the IPO itself. This is often because of the need to tie up management for a period after the IPO to “market” the IPO company to investors and the preference to do it by leaving amounts unvested instead of, or as well as, making new equity grants.  Often the vesting period is shortened or protection is given to top management on a Good Leaver situation with regard to the time based vesting equity.

In addition, the IPO itself is not a realization event and management needs to wait until the private equity firm realizes on its investment to measure the performance achieved. Of concern again is the additional requirement to be employed at the time of the realization such that persons who leave either voluntarily or involuntarily after the IPO will not fully realize.  This can be dealt with by dropping the service requirement altogether after an IPO.  However, this is not common.  Sometimes the senior executives will be able to obtain Good Leaver protection or even Good Leaver protection and the right to voluntarily quit at a point after the IPO and have the service requirement waived.

Ideally, in any event, there should be a valuation of the company for vesting valuation purposes at an earlier stage after the IPO as an alternative or in addition to traditional realization with interim Good Leaver protection. The possibilities commonly utilized are valuing the shares held by the sponsor shortly after the IPO, six months after the IPO when the lockup has ended or one year after the IPO to give the sponsor more time to liquidate its interest after the lock up is over.  The valuation is usually on a multi trading day weighted average.  Sometimes management is able to negotiate multiple measurement dates.

The key issue for management is whether once the private equity firm has sold control of the portfolio company either to another entity (i.e. private equity firm or strategic) or taken it public, management should still have to be fully aligned with the private equity firm’s decisions on when to realize or should they be in a position to be rewarded for their efforts even if they don’t continue employment.

Jamieson Corporate Finance US, LLC is a member of FINRA/SIPC

Michael Sirkin, Chairman and Managing Director of Jamieson USA, discusses the impact on management equity incentives when private equity firms exit portfolio companies.

Private equity firms invest in portfolio companies with the goal of improving the company results and then exiting the investment within a projected period. They generally exit their portfolio company investments in one of three ways:

• they sell the company to another private equity firm (sometimes staying in the investment either by rolling over a portion of their investment or by investing with a later fund);
• they sell the company to a strategic either for cash or stock;
• they take the company public through an initial public offering.

The method likely to be utilized for an exit needs to be contemplated by management in agreeing on the plan at the time of the initial private equity firm acquisition and the creation of the plan in order to understand when they will receive liquidity of their incentives.

Most portfolio company equity incentive plans in the United States are structured with a portion (usually fifty percent or less) vesting on a time basis over 4 or 5 years and the remaining portion vesting on a performance achievement basis.  While a limited number of plans will use an annual EBITDA achievement as the performance vesting measurement, the bulk of equity incentive plans will utilize a measurement based on return on investment of either the multiple of money received over invested amount (“MOIC”) or internal rate of return (“IRR”). Many plans that use an EBITDA factor also will have a vesting management catchup at exit using either MOIC or IRR.

The issues that must be addressed are when and how to measure the realization on exit. Most private equity firms will want realization to be measured as the private equity fund sponsor receives cash. Furthermore, they will want management to be committed to staying with the company until that occurs.

While this answer is perhaps logical for the sponsor, it is not necessarily so for management.  The points to be addressed are: What is the definition of an Exit Event?  Should management receive full realization of the incentive arrangement on a change of control?  Is management required to continue with their incentive arrangement until the sponsor fully cashes out?  What should occur if management’s employment ends after the change in control or IPO but before final exit of the sponsor?

The most common exit event from a private equity portfolio company investment is a change in control on a sale, whether the sale is to another private equity firm or to a strategic entity. Initial public offerings are much more limited as exit events since the market capitalization level needed to go public and permit the sponsors to fully liquidate their interests or even a majority stake may be too high for the bulk of private equity owned companies.

In an increasing number of transactions, sponsors sell down a majority or minority interest in portfolio companies or even sell from one of its funds to another of its funds.   In such circumstances thought needs to be given as to whether or not these transactions should be treated as a change in control and how management incentives should be treated.

If the exit event is a sale of the entire company for cash paid on closing, a measurement factor of cash as and when received by the sponsor will cause little concern.   A more complicated case would be if there was an escrow or earnout in addition to the amounts paid in cash. Since it is hard to estimate at closing the expected value of earnout and, to a lesser degree, escrow when paid, measurement of these amounts is often delayed until they are turned into cash.

The most difficult case is when property is received or a material interest in the entity (the “Stub”) is maintained. From the sponsor’s point of view, they have not yet fully realized on their investment in these situations and they do not know the ultimate MOIC or IRR that will be received. From management’s point of view, they have brought the company to an exit event and have earned their payment.

Waiting out full cash receipt by the sponsor to measure and/or receive payment, can raise other issues for management.  If the equity interest remains in stock of the new entity, it will eventually be vested or paid at a time when it may well not be liquid and also could be subject at the time to taxes. In addition, if the time period is lengthy, the stock value of a Stub may well be subject to adjustment based on the post change in control operations of the company. The other alternative for delayed vesting is to liquidate the value and have the value held by the sponsor entity for later payment or placed in an escrow that will be paid either to the executives or the sponsor when realization value is determinable.  These issues are somewhat lessened if the MOIC or IRR for vesting is measured at the change in control date and only payment is delayed. Note that there are tax Code Section 409A and other possible tax issues in structuring these delayed payment options.

However, the biggest issue is a requirement for continued employment until the delayed payment is made or the property or Stub is turned into cash.  This problem is especially acute for the senior executives because they are suddenly being required to work for a new owner (be it a sponsor or trade party).

The requirement of continued employment is especially sensitive if the executive is terminated without cause or for disability, leaves for good reason or dies prior to full realization after the change in control but prior to full cash realization by the sponsor.  Fairness argues for the continued employment requirement to be waived in these situations since the exit event has occurred and it is only timing until the measurement date is achieved.

A more difficult situation is the ability to voluntarily leave without Good Reason.  The issue is that management has achieved the change in control goal and why should they have to continue to work to receive the realization or the payout.  This is especially true since a new equity plan will have been established to award management for the next sponsor’s return.  An argument can be made to require staying for a short transition period, but the transition argument exists whether or not equity is tied to it and most executives will agree to some type of limited transition period even if they want to leave.

The issue of a continued employment requirement is particularly difficult if the sale is for control, but not for all of the company, or a material minority sale or a sale from one of the sponsor’s funds to another. In these cases the original sponsor may be staying on for another 5 year run before it receives all of its money. By extending the hold on management employment as a condition of receiving their full value, what was a 5 year or so planned involvement becomes a 10 year or so required involvement and is often hard to justify. In fairness, the initial plan often should be measured and paid out and a new equity incentive plan established based on the new company value.

If the liquidation event is an initial public offering (an “IPO”), the cash measurement provides similar problems.  In most U.S.  IPO’s, 10% to 20% of the company is initially taken public and then there is a secondary six months or so later in which the insiders start to sell down.  Sometimes the private equity firm will sell heavily down in the IPO and secondary, but other times they will continue to stay in or sell down at a much slower pace.

In the United States, the IPO generally is not treated as a Change in Control and, hence, not even the time based equity vests on the IPO itself. This is often because of the need to tie up management for a period after the IPO to “market” the IPO company to investors and the preference to do it by leaving amounts unvested instead of, or as well as, making new equity grants.  Often the vesting period is shortened or protection is given to top management on a Good Leaver situation with regard to the time based vesting equity.

In addition, the IPO itself is not a realization event and management needs to wait until the private equity firm realizes on its investment to measure the performance achieved. Of concern again is the additional requirement to be employed at the time of the realization such that persons who leave either voluntarily or involuntarily after the IPO will not fully realize.  This can be dealt with by dropping the service requirement altogether after an IPO.  However, this is not common.  Sometimes the senior executives will be able to obtain Good Leaver protection or even Good Leaver protection and the right to voluntarily quit at a point after the IPO and have the service requirement waived.

Ideally, in any event, there should be a valuation of the company for vesting valuation purposes at an earlier stage after the IPO as an alternative or in addition to traditional realization with interim Good Leaver protection. The possibilities commonly utilized are valuing the shares held by the sponsor shortly after the IPO, six months after the IPO when the lockup has ended or one year after the IPO to give the sponsor more time to liquidate its interest after the lock up is over.  The valuation is usually on a multi trading day weighted average.  Sometimes management is able to negotiate multiple measurement dates.

The key issue for management is whether once the private equity firm has sold control of the portfolio company either to another entity (i.e. private equity firm or strategic) or taken it public, management should still have to be fully aligned with the private equity firm’s decisions on when to realize or should they be in a position to be rewarded for their efforts even if they don’t continue employment.

Jamieson Corporate Finance US, LLC is a member of FINRA/SIPC