Private equity portfolio companies, like public companies, see chief executive officers depart for many reasons—death, disability, retirement, disagreements on approach and lack of performance (perceived or real).
One consistent on all departures is that a new chief executive officer is going to be necessary. Sometimes the successor is already within the company or has already agreed to join the company at the time of termination. At other times an interim chief executive officer is necessary. The interim chief executive officer can be a current executive or a group of current executives or a designee from the board. At times it is an operating partner or advisor from the sponsoring private equity firm who has been involved with the company. The interim chief executive officer is likely to receive a boast in compensation for the temporary service period if internal promotion or a fixed stipend if from the Board or an advisor or operating partner. Additional equity is not usually provided in the private equity portfolio company structure, although it is quite common with public companies.
Since interim title is just that, a new chief executive officer will eventually be appointed and an equity opportunity will need to be provided to the new full-time chief executive officer. Simply giving the new chief executive officer the same equity package as the prior chief executive officer had, but starting at the then current value of the company will not generally work. The company is likely very different from when the departing chief executive officer started, with different revenues, earnings, valuation and period until contemplated exit. This is different than in a public company where incentives are usually based on peer review and not geared to exit. In that situation, a similar level and style of grant to that historically used in the company can be made, with perhaps an additional sign on make-up grant. In the private equity model, however, a new analysis is necessary. A similar review will generally be required when hiring any new executives, but in the case of a chief executive officer it will be even more important.
One of the first issues to be resolved will be to determine the likely timing until the next exit and the contemplated form of exit. This will, to a degree, help size the award to be made since a longer work period before realization would require a larger award opportunity. The contemplated service period will also impact the time vesting period. The original chief executive officer probably had time vesting over four or five years. Depending on contemplated exit, that may or may not be appropriate to duplicate for the successor. In some ways, however, it is of lesser importance because in most instances there is full acceleration of time vesting equity on a change in control.
The performance vesting structure for a successor chief executive officer is a more complicated issue. It will greatly depend on how the company has changed from acquisition. It is likely that the level of earnings and revenues have changed, there may have been acquisitions or dispositions, the sponsor may have invested new dollars, debt could have been paid down or new debt incurred. All make for a different capital structure, different projected return and different timing. In addition, the old criteria, especially if based on MOIC, may no longer be suitable.
Another issue to be considered is whether additional new executives will be brought in and how to align performance goals for existing executives, new executives to be brought in and the new chief executive officer, in addition to aligning all of these goals with the goals of the private equity firm.
If the prior goals are no longer realistically achievable, minimum guarantees may have to be provided to the new chief executive officer, as well as an upside in the equity plan commensurate with market. If prior goals have been achieved, a new structure of goals may need to be created for the chief executive officer and other new hires, while evaluating if there is still alignment with existing executives working on the existing plan. Sometimes a fully time vesting based grant is appropriate.
If the company is successful and the replacement is because of death, disability, retirement, departing to take another job or moving up to Chair or Executive Chair, the issues are different than when the chief executive officer has been terminated for non-performance; primarily because the company in the latter situations is likely underachieving against its vesting targets.
If the successor is an existing executive, he or she will already have a grant. On promotion that grant will need to be increased to award appropriately for the period from the promotion to the exit. It will not be the same as that for the prior chief executive officer because the likely period to be covered is different and the status of the company is different. To maintain alignment with other executives, the same goals may be maintained, but the size of the grant is likely to be different than for the predecessor. Current value will need to be taken into consideration, as well as possible use of a catch-up mechanism. Generally, the sum of the original equity and mid-term equity granted to a promoted executive will not equal the potential amount of that of the original chief executive officer because he or she is being awarded for a lower job for a portion of the period and the higher job for a portion, rather than all in the higher job.
If the new chief executive officer is an external hire, there is no prior award to increase, and a fresh award is necessary. In designing the award, time to exit is important as well as the status of the company with regard to whether the “heavy lifting” has been done on the business thesis for restructuring and growth. The contemplated growth track at the time of the change and the work necessary to get there may be quite different from the work that originally had to be completed. This may limit the targeted multiple from where the company currently stands from that originally being awarded and raise questions as to continued use of those multiples to measure the award. In designing the new equity package, it needs to be recognized that the value is now higher or lower, but unlikely the same. Therefore, if profits interests are being used, the new executive’s threshold must be equal to the liquidation value on date of grant (although catch-up profits interests can also be used if it is desired to reward from a lower base). If options are being used, the exercise price must be at least fair market value at the time of grant, generally using a 409A valuation. So once again it is an analysis of how much compensation is fair for what expected period of time and growth and how to maintain alignment between existing executives and the new chief executive officer and any other new executives.
Each situation is unique and both the sponsor and the executive need to be realistic about the existing condition of the company, the new projected growth feasibility to exit and the realistic period of time to exit.
Another issue to address before the hiring process is where the new equity for the individual is coming from and whether the size of the pool will need to be increased. This may also be necessary if the new chief executive officer intends or needs to replace some of the existing team, which is not an uncommon occurrence with a new chief executive officer.
A departing chief executive officer may retain some of his or her units, especially if moving up to an executive chairman, chairman or director role. In any event, there is usually a timing issue on granting the new chief executive officer equity and repurchasing the vested equity of the departing chief executive officer. Therefore, depending on the size of the reserve, the pool may need to be increased. An increase of the pool size will usually dilute everyone’s percentage of the company (including existing management).
In addition, care must be taken to avoid misalignment of goals of the existing executive awards and goals of the new awards to the new chief executive officer and any other new executives, especially if the company is performing below original expectations and exit expectations are delayed. In this case, thought must be given to redesigning all of the incentive levels and targets for consistency. This is likely easier with profits interests than options, but can be done in either instance.
Every new chief executive officer situation is unique, but they all require analysis of the company’s current situation verse initial situation, projected returns, time to exit and how to align the new chief executive officer and other new hires with the goals for the existing team.
Jamieson Corporate Finance US, LLC is an SEC-registered broker-dealer, member of FINRA (www.finra.org) and member of SIPC (www.sipc.org). This article is for information purposes only and is not to be construed as a solicitation to invest in any securities. Jamieson Corporate Finance helped create the management advisory business and its affiliates have offices in New York, San Francisco, London, Frankfurt, Madrid, Milan, Stockholm and Sydney.
For further information, please contact Mike Sirkin at msirkin@jamiesoncf.com or Mark Wasserberger at mwasserberger@jamiesoncf.com.
