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What is a private equity management team deal?

When a private equity sponsor acquires a target company, the CEO and other executive officers of the target (“management”) often negotiate new deals with the sponsor. While some private equity sponsors replace existing management, most sponsors retain some or all of management and look to incentivize them to work towards a successful liquidity event (an event where owners receive cash for their equity holdings). 

What is typically involved in a private equity management team deal?

Management negotiations typically focus on (i) employment agreements, (ii) equity-based incentive compensation arrangements (e.g., stock options or profits interests), and (iii) the owners’ agreement, such as an operating agreement or shareholders’ agreement. There is an important interplay between each of the foregoing agreements, and both the sponsor and management should be mindful to ensure that the agreements properly work together. 

What makes a private equity management team deal different than an ordinary course executive hire?

A private equity management team deal is different than other executive negotiations because a private equity sponsor is different than other owners. An executive negotiating with a private equity sponsor is fairly certain that his or her new employer will be sold, likely in the near term. Because this sale is a liquidity event, the employer is able to offer more flexible compensation programs and typically contemplate a shorter employment relationship. In this regard, management is often offered the opportunity (or encouraged) to co-invest alongside the private equity sponsor in addition to being granted some form of equity-based compensation. While both the purchased equity (or rollover equity) and incentive equity are initially illiquid, because of the sponsor’s desire to convert its investment into cash, management is aligned with the sponsor in working towards a liquidity event. Thus, the parties undertake the employment and compensation negotiations with a shorter term view and with an eye towards the eventual liquidity event.

By contrast, the owners of a closely-held company may have no expectation or desire to sell their equity ownership, which for management means that any equity investment or equity-based award may remain illiquid. As a result, the motivating factor related to either invested capital or incentive equity is significantly diminished as there is no liquidity event on the horizon. Many closely-held companies implement different forms of cash-based incentives focused on specific financial targets and utilize “phantom” equity arrangements, which raise their own set of complications such as tax, cash flow, and valuation issues (see "Beware of the Phantom...Equity"). Accordingly, management is generally less aligned with the owners, particularly with respect to equity value. In this context, the compensation and employment negotiations tend to be framed by an understanding that management may be employed for an indefinite period, with an emphasis on cash compensation.

What are the major considerations for management in a private equity deal?

First, management must be mindful of taxes, as the tax impact on a given compensation arrangement may significantly decrease the value realized. Whether management wants to be eligible for capital gains treatment or avoid excise taxes, management should work with the sponsor to create efficient compensation structures and analyze proposed and outstanding arrangements for potential tax issues, such as IRC Section 409A (which may accelerate income inclusion and impose a 20 percent excise tax on the executive with respect to nonqualified deferred compensation) and IRC Section 280G (which imposes a 20 percent excise tax on the executive and a loss of a deduction for the company on certain compensation received in connection with a change in control transaction). With proper planning and advice, management should be able to receive compensation on a tax-efficient basis and avoid excise tax issues. 

Second, management should ensure that the documents accurately memorialize the business deal. Executives often focus on the big picture items like base salary, bonus opportunity, and the amount of equity granted. Members of management should understand, however, that the terms of severance, the scope and duration of restrictive covenants, the vesting conditions on incentive equity, the size of the incentive equity pool, the terms of call rights, and minority equityholder protections, among other items, may have a significant impact on their overall employment and compensation.

Finally, management should understand that most private equity sponsors are reasonable and open to understanding management’s concerns. Management teams without direct experience with private equity sponsors often have preconceived notions regarding sponsors’ focus on results. In practice, however, the interests of management and the sponsors are generally aligned, and sponsors benefit when they have a positive reputation of treating management fairly.

What are the major considerations for the sponsor in a private equity deal?

Sponsors must understand the particular issues raised with respect to the individual management team in question. Most sponsors have a general framework for the management teams of their portfolio companies. For example, most sponsors have a construct for their equity-based incentive program that is implemented at each of its portfolio companies. Depending upon the type of management team involved in the deal, sponsors may need to tailor their programs in order to appropriately retain and motivate management.

For instance, founder deals, where the management team is also a primary selling equityholder, can create unique obstacles for the sponsor with respect to retention and motivation. Founder management teams often struggle with the new dynamic of no longer owning and controlling “their” business. Moreover, if the founder has taken significant capital off-the-table, typical compensatory incentives may not appropriately motivate the founder. Under these circumstances, sponsors and management should flesh out how business operations will work in practice in order to avoid post-closing tension and misunderstandings. Sponsors may also consider trying to negotiate for meaningful rollovers, structuring part of the purchase price to be subject to an earn-out to incentivize management to remain employed, adopting a stay bonus program to pay a cash bonus if management is retained for a specified period of time, or marketing its own equity program as an opportunity to realize another significant liquidity event. Usually, if the ground rules are established up front, both the sponsor and management will benefit.

A management team in a carve-out transaction, where the sponsor is buying a division or subsidiary of a larger conglomerate, can create different hurdles, particularly if management was previously part of a public company affiliated group. In this case, the management team may be accustomed to being granted incentive equity on an annual basis and receiving equity that is readily tradeable. In this instance, the sponsor will need to educate the management team on the upside of the equity program and the other benefits they are receiving by being a private equity portfolio company. Further, a management team working for a company previously owned by another private equity sponsor may have a specific view of “market” terms and expect certain rights not afforded to other management teams of the buying sponsor’s other portfolio companies. 

In any event, private equity sponsors should focus on how to retain and motivate management. Ultimately, the management compensation program should be designed to enhance a potential deal rather than create an obstacle.