The Devil’s In The Deal Terms

The most significant consideration for management in any PE transaction is management’s participation in company growth through exit via equity. Management generally participates in such growth in two ways: rollover and/or incentive equity. Rollover equity constitutes an economic investment in the company alongside the PE sponsor, which may be required—or optional—sometimes at levels of 50 percent or more of management deal proceeds. Incentive equity constitutes an “investment” of hard work (“sweat”) earned based on time and performance of the executive through an approved pool of equity (e.g., 10 percent). Each type of equity has unique considerations, whether corporate, tax or compensatory, and thus should be duly analyzed by management and competent, experienced legal counsel for management (as compared to company or seller counsel) to ensure that an equitable and competitive set of terms and conditions applies to both rollover and incentive equity.

Rollover: Since rollover equity, or invested cash, is an actual investment in a portfolio company and may constitute potentially millions of dollars and significant portions of individuals’ net worth, management should strive to be treated on terms substantially similar to other investors, including the PE sponsor (e.g., pari passu). As a result, understanding the terms of the PE sponsor’s investment is critical.

For example, is the sponsor receiving common or preferred equity with a liquidation preference? What about a preferred rate of return? What governance rights does the sponsor possess with its investment? What are its board, information and access rights?

Management would be wise to understand the PE sponsor’s investment terms to make an informed decision about the economics for its investment, including rights and restrictions applicable to management’s rollover investment. That said, management, as service providers, differs in their role relative to a pure investor, and additional considerations are present.

Relatedly, is rollover equity being made subject to vesting, forfeiture or other punitive repurchase rights on certain events? What happens when employment terminates or death occurs? Are restrictive covenants tied to rollover equity? Management counsel should identify the sponsor’s rights and restrictions and advise management on its investment and rights (e.g., liquidity) and restrictions that may (or should) apply to its investment. These, together with the tax efficiency, are generally the most key considerations in rollover equity analyses by management counsel.

Incentive: Distinct from rollover equity is management’s participation in future growth via incentive equity. Incentive equity terms, including definitions, taxation (ordinary income vs. capital gains) and vesting, are heavily negotiated and critical to management.

What size is the equity pool and when, by whom and how is it allocated? What are the vesting terms (both time and performance), what portion is tied to performance, and how is performance measured and defined? What happens upon termination of service, whether voluntary or involuntary? Is vesting accelerated upon a change in control? While these are unique issues applicable to incentive equity, many of the rollover equity considerations may also apply to incentive equity—for example, liquidity and participating when the sponsor participates.

Management Counsel: If involved at the early stages of a transaction (even before the company is marketed), management counsel can take point or ride shotgun to management and advise management what to look for, what to ask and how and what to relay to potential suitors for the business when management’s roadshow and follow-on discussions occur. Not being armed with proper market perspective and key information has proved detrimental to management.

Given the tax and corporate complexities, together with the various vesting and forfeiture considerations for management, successful management teams have reaped rewards by engaging stand-alone management counsel to educate and represent management in these complex areas, and primarily advocate for management in the transaction arena. Failure to engage management counsel puts management in the precarious position of falling into pitfalls that could have been avoided or managed.