In negotiating management equity incentive plans for chief executive officers and other senior management, there are issues that often get left for resolution if and when they happen because there is a reluctance to try and address all the contingencies, especially if it is unclear whether and how they will happen. While this may in the end workout with everyone having an open mind, often the views of the sponsor and management are different at the later time and what one thinks is fair the other may disagree with. Later resolution also often leaves management at a disadvantage since the documents then tend to be written in favor of the sponsor discretion.

We usually recommend addressing the issues on an upfront basis. Even when knowing there are no perfect answers, it is usually best to try and at least have preliminary resolutions at the time of creating the management incentive plan.

The three issues that most often fall into this category that ideally should be addressed upfront are

• what happens if the company goes public?
• what happens on a sale to a continuation fund or another fund of the sponsor in whole or in part; and
• what happens on a sale of a large minority interest

IPO: In many situations because of the size of a company, type of business or other factors, an IPO is a very unlikely exit. In these cases, it may well make sense to put off any discussion of what happens on an IPO, other than perhaps a commitment to discuss in good faith at the time. However, when an IPO is a likely or even a possible exit, it is preferable to try and address the concerns at the time of creation of the plan. Among the issues that need to be addressed are:

— If incentives are structured in the form of profit interests and, as part of the IPO, the profits interests are converted into whole units, the management incentive’s percentage of share of growth of the company will be diluted by conversion of the profits interests into whole units or shares because of the impact of the waterfall. This is in addition to the loss of leverage in the private equity model when the company becomes public. The issue of whether dilution protection should be built into the plan or just addressed if and when IPO grants are made at the time of the IPO needs to be considered.

— The vesting criteria after an IPO needs to be addressed. Should they remain the same as prior to the IPO or be changed. Service based measurements usually continue. Often EBITDA performance-based measurements need to be adjusted because of the extra costs of being a public company and sometimes all performance measurements are converted to pure time service measurements. If MOIC (equity value at sale/investment) based measurements are retained, the question arises whether they should still be measured on a cash actually received basis or whether a 20 day weighted market average or other similar concept should be introduced as an alternative. (whether this be on an ongoing basis or after period of time, such as a year or two) since the equity now has a market value that could be realized on. Sponsors will, somewhat fairly, argue that it will be subject to a lock up and even thereafter, there is a limit to how much it can realistically sell into the public market without heavily impacting the price it will receive. However, from the executive’s point of view, he or she has created the value that would vest the equity and shouldn’t have to wait until the sponsor decides to liquidate to have the benefit vested.

— Should the CEO and, possibly, the CFO/COO be better protected immediately prior to and after the IPO, since they got the company to that point, and may be somewhat vulnerable to not taking the company forward (especially if they do not have public company experience, are older or are not ready for the next multi year commitment). If they are a good leaver in contemplation of, on or after the IPO, should they vest in the time measured units and continue to be eligible to be measured on the performance measured units.

— After the lock up has expired, should management be able to sell at will (subject to securities laws) in the public market vested interests, or be locked in to selling proportionate to the portion sold down by the sponsor.

RELATED FUNDS. In the last several years sales to continuation funds administered by the same sponsor or retention of large portions of a company by successor funds of a sponsor have become common. This is often because of an inability to agree with outside buyers on the appropriate price and/or the sponsor needing to close out the fund the asset is in but wanting to stay invested in the asset. Most sponsor’s initially took the position that these kind of transactions should not be a change in control crystallizing the MIP since it is the same sponsor family owning the company. More recently sponsors have tended to recognize that there needs to be some recognition of value for management on these transactions. The original position was based on the fact that the same sponsor is involved and probably has rolled over significant portions of its investment and carry into the new vehicle. On the other hand, management is focused on the fact that the LP’s of the original fund likely got a distribution based on the transaction if they did not choose to roll it forward and that the sponsor’s investment team likely at least crystallized their carry even if they have to roll it forward. Otherwise, management will be concerned that the 4-6 year targeted exit company they joined just became an 8-to-10-year hold until exit for them.

In these cases, management will want to take the position that the new sponsor family funds need to be treated the same as outside investors and, if there is a change of greater than 50% of equity or voting combining the truly outside investors and the new same family fund investors, the MIP should be crystallized and paid out (perhaps with some required rollover).

MINORITY SALE. This is perhaps one of the hardest issues to address up front because there are so many variations, e.g. a 50% sale, sale of 40% but with veto rights, multiple minority buyers, or just one smaller minority position. What needs to be dealt with is both what happens on the initial sale of the minority interest and what happens on a later exit by either one or all the sponsors. Management probably should have a tag right at both stages, but query what is to be vested on such a sale. First, whose MOIC is being measured needs to be established—the original investors, the group as such or proportionally each investor. Generally, keying to the original investor is likely to be most efficient. However if there is a top up in connection with a tag or a new investment into the company, perhaps there should be some focus on return to the new investor with regard to those MIP units. These provisions are complicated, but should try to be addressed based on the initial situation and, then likely, adjusted when the minority investment is made and again at any partial exit. However, upfront there should be a structure that protects management in these situations.

In all of the situations discussed in this article there are likely to be additional discussions at the time of the exit event or a new investment. Since all variations cannot be predicted, but it is usually better to try to address and find agreement at least to some degree at the time of creation of the MIP, rather than ignore and rely on working it out later.

In negotiating management equity incentive plans for chief executive officers and other senior management, there are issues that often get left for resolution if and when they happen because there is a reluctance to try and address all the contingencies, especially if it is unclear whether and how they will happen. While this may in the end workout with everyone having an open mind, often the views of the sponsor and management are different at the later time and what one thinks is fair the other may disagree with. Later resolution also often leaves management at a disadvantage since the documents then tend to be written in favor of the sponsor discretion.

We usually recommend addressing the issues on an upfront basis. Even when knowing there are no perfect answers, it is usually best to try and at least have preliminary resolutions at the time of creating the management incentive plan.

The three issues that most often fall into this category that ideally should be addressed upfront are

• what happens if the company goes public?
• what happens on a sale to a continuation fund or another fund of the sponsor in whole or in part; and
• what happens on a sale of a large minority interest

IPO: In many situations because of the size of a company, type of business or other factors, an IPO is a very unlikely exit. In these cases, it may well make sense to put off any discussion of what happens on an IPO, other than perhaps a commitment to discuss in good faith at the time. However, when an IPO is a likely or even a possible exit, it is preferable to try and address the concerns at the time of creation of the plan. Among the issues that need to be addressed are:

— If incentives are structured in the form of profit interests and, as part of the IPO, the profits interests are converted into whole units, the management incentive’s percentage of share of growth of the company will be diluted by conversion of the profits interests into whole units or shares because of the impact of the waterfall. This is in addition to the loss of leverage in the private equity model when the company becomes public. The issue of whether dilution protection should be built into the plan or just addressed if and when IPO grants are made at the time of the IPO needs to be considered.

— The vesting criteria after an IPO needs to be addressed. Should they remain the same as prior to the IPO or be changed. Service based measurements usually continue. Often EBITDA performance-based measurements need to be adjusted because of the extra costs of being a public company and sometimes all performance measurements are converted to pure time service measurements. If MOIC (equity value at sale/investment) based measurements are retained, the question arises whether they should still be measured on a cash actually received basis or whether a 20 day weighted market average or other similar concept should be introduced as an alternative. (whether this be on an ongoing basis or after period of time, such as a year or two) since the equity now has a market value that could be realized on. Sponsors will, somewhat fairly, argue that it will be subject to a lock up and even thereafter, there is a limit to how much it can realistically sell into the public market without heavily impacting the price it will receive. However, from the executive’s point of view, he or she has created the value that would vest the equity and shouldn’t have to wait until the sponsor decides to liquidate to have the benefit vested.

— Should the CEO and, possibly, the CFO/COO be better protected immediately prior to and after the IPO, since they got the company to that point, and may be somewhat vulnerable to not taking the company forward (especially if they do not have public company experience, are older or are not ready for the next multi year commitment). If they are a good leaver in contemplation of, on or after the IPO, should they vest in the time measured units and continue to be eligible to be measured on the performance measured units.

— After the lock up has expired, should management be able to sell at will (subject to securities laws) in the public market vested interests, or be locked in to selling proportionate to the portion sold down by the sponsor.

RELATED FUNDS. In the last several years sales to continuation funds administered by the same sponsor or retention of large portions of a company by successor funds of a sponsor have become common. This is often because of an inability to agree with outside buyers on the appropriate price and/or the sponsor needing to close out the fund the asset is in but wanting to stay invested in the asset. Most sponsor’s initially took the position that these kind of transactions should not be a change in control crystallizing the MIP since it is the same sponsor family owning the company. More recently sponsors have tended to recognize that there needs to be some recognition of value for management on these transactions. The original position was based on the fact that the same sponsor is involved and probably has rolled over significant portions of its investment and carry into the new vehicle. On the other hand, management is focused on the fact that the LP’s of the original fund likely got a distribution based on the transaction if they did not choose to roll it forward and that the sponsor’s investment team likely at least crystallized their carry even if they have to roll it forward. Otherwise, management will be concerned that the 4-6 year targeted exit company they joined just became an 8-to-10-year hold until exit for them.

In these cases, management will want to take the position that the new sponsor family funds need to be treated the same as outside investors and, if there is a change of greater than 50% of equity or voting combining the truly outside investors and the new same family fund investors, the MIP should be crystallized and paid out (perhaps with some required rollover).

MINORITY SALE. This is perhaps one of the hardest issues to address up front because there are so many variations, e.g. a 50% sale, sale of 40% but with veto rights, multiple minority buyers, or just one smaller minority position. What needs to be dealt with is both what happens on the initial sale of the minority interest and what happens on a later exit by either one or all the sponsors. Management probably should have a tag right at both stages, but query what is to be vested on such a sale. First, whose MOIC is being measured needs to be established—the original investors, the group as such or proportionally each investor. Generally, keying to the original investor is likely to be most efficient. However if there is a top up in connection with a tag or a new investment into the company, perhaps there should be some focus on return to the new investor with regard to those MIP units. These provisions are complicated, but should try to be addressed based on the initial situation and, then likely, adjusted when the minority investment is made and again at any partial exit. However, upfront there should be a structure that protects management in these situations.

In all of the situations discussed in this article there are likely to be additional discussions at the time of the exit event or a new investment. Since all variations cannot be predicted, but it is usually better to try to address and find agreement at least to some degree at the time of creation of the MIP, rather than ignore and rely on working it out later.