Originally published in PE Hub

By Joanne Baginski

When a private equity buyer acquires a company, a key concern is ensuring that the management team, with all the knowledge and experience, sticks around to grow it.  That factor alone can be the difference between a great investment and a lackluster return. So it is critically important to create incentive compensation plans that align management with the new owners by giving them a meaningful stake in the company.

PE investors want to give management incentives for three principal reasons: to minimize transition risk by ensuring the company runs smoothly after the change of ownership; to retain critical knowledge and relationships of key executives, and to ensure that the management team feels aligned with the new owner’s goals and long-term objectives.

Here are 10 things that should be considered when structuring these incentives:

1. Participation: Incentive plans should be restricted to those employees who can drive financial performance, i.e., C-suite executives and other critical employees such as technical experts, relationship builders and operations managers. In roughly two-thirds of PE deals, about 15 percent to 20 percent of equity is set aside as incentives for managers (independent of those previous equity owners who elect to roll over equity post-closing). Best practice, however, is not to grant the 15 percent to 20 percent in the first year, but to grant amounts over a few years to maximize retention (see below under Vesting) and adjust award grants based on individual performance post-closing.
2. Type of incentive: Plans generally come in three types: stock options, profit interests (which are limited to LLCs and partnerships), and stock-appreciation rights, which give managers the upside in the stock-value appreciation but doesn’t grant them the underlying shares. Profit interests are taxed entirely as capital gains, making them the most tax-advantageous of the three choices. Stock options can be taxed partly as ordinary income or entirely capital gains and stock-appreciation rights are taxed entirelyas ordinary income.
3. Vesting: A great way to ensure retention is to apply a vesting schedule to any award grant. Typically, vesting schedules in PE deals are four to five years. If owners want to encourage managers to stay even longer, they can apply a rolling vesting schedule to each annual grant over a few years, which can draw out the compensation incentive for a longer period. In the event that PE investors sell the firm, the vesting schedule is typically accelerated 100%.
4. Performance: In addition, plans can tie a performance condition to either vesting (i.e., performance vesting) or adjust the award amounts based on the company’s overall performance.  Performance targets vary from company to company and even from year to year. Common performance targets include, however, EBITDA, organic revenue and return on investment capital.
5. Distribution: The plan must spell out what happens in the case of termination of employment, death and disability. Termination of employment, for example, can be treated differently under varying circumstances: Termination for cause typically voids the incentive award. A resignation to work elsewhere may result in a 50% reduction of payout, while an employee who is terminated without cause might receive a 100% payout.
6. Dividends: Most PE investors don’t pay dividends. But if the company does pay dividends, incentive plans need a process to deal with them. A common practice is to have dividends paid into an escrow account and released in line with the vesting schedule.
7. Voting: PE firms are sometimes reluctant to give up voting rights, so they may want to create two types of shares, one with voting and another with non-voting rights. By creating a non-voting-share award, the key employees will not be distracted by sale negotiations and shareholder approvals thereof and can focus on their jobs.
8. Exit rules: Plans should specify what happens in the event the firm is sold, either a so-called drag-along, where management shares are pulled into accepting any deal the majority owner accepts, or a tag-along, where management has the option to receive the same deal as the owner.
9. New talent fund: As the PE portfolio company grows, it will inevitably need to hire some key employees down the road. Often times, executive talent will require an equity stake in the company as part of the initial compensation package. Therefore, retaining at least 5% of the equity pool to attract top talent is a good idea.
10. Tax concern: Incentive plans can create tax issues. For example, Section 280G of the Internal Revenue Code, the golden-parachute-payment rule, can penalize employees and companies if there are “excess parachute payments” in connection with the sale transaction. These payments do not necessarily have to be cash; in fact, the bulk of parachute payments for executives are typically vesting acceleration on account of a change in control. Solutions that can avoid this problem are available: For example, an employee can contribute equity into a rollover in the new company that maintains the original vesting schedule. Another potential tax issue is Section 409A of the Internal Revenue Code, which governs deferred compensation. For equity incentive plans, this would require awards to be priced at fair market value at the time of grant (or else be subject to strict and onerous distribution rules). Using an independent valuation firm to value equity in connection with award grants should mitigate such problems.

A McKinsey study found that offering the right incentives — giving 15 percent to 20 percent of the total equity to a company’s leading officers and a handful of key staff who report directly to the chief executive — was a crucial factor in successful PE deals. The report found that in 83 percent of the best deals, firms also strengthened the management team before the closing. With that in mind, having the right incentive plan in place is a great way to get an acquisition off on the best footing.

Joanne Baginski leads the transaction-advisory-services area at EKS&H. She has been involved in more than 200 transactions, on both the buy and sell sides, and her expertise also includes business finance, financial planning and analysis, and capital financing. Reach her at jbaginski@eksh.com or at +1 303-846-3309.