As a director, you may wish to recruit new management in the later stages of a portfolio company. However, the company’s capital structure might make the opportunity less than enticing for new management. Perhaps significant preferred stock and/or debt is outstanding, making the likely purchase price proceeds available to new management under traditional stock options less than appealing. Of course, your goal is to build stockholder value.
A management retention plan ("MRP") may be an ideal tool to provide newer management with a meaningful incentive. An MRP allows participants to receive a bonus when the company is sold. The bonus amount varies, and usually is paid as a percentage of the excess of the purchase price over the current company valuation. These payments typically continue until a specified dollar limit is reached. At that point, options or other equity incentives provided to new management take over.
MRP participants are typically new management whose efforts can help create a higher value for the business. Unlike stock option plans, which are often broad-based, MRPs are used to reward the senior levels of management. Also, while founders might participate in the MRP, most often, these plans focus on newer management.
For example, a company may have a liquidation preference for a participating preferred stock of $60 million (with a 5% annual coupon) and a current company market value of $65 million. Providing new management an option to acquire 7% of the company’s common stock with options vesting over three years may not be a terribly attractive proposition if the goal is to sell the company in 12 to 18 months. However, offering an MRP which provides new management with 10% of the amount by which the company is sold in excess of $65 million, up to (for example) $100 million, provides a tremendous incentive.
Often, these MRPs work on a reverse sliding scale. For example, using the illustration above, MRP participants might receive 10% of the amount by which the purchase price exceeds $65 million up to $100 million, when the MRP then pays 5% of the amount between $100 and $125 million. After $125 million, MRP payments cease. In some MRPs, these cash payments are tied into a formula that also includes any return on an equity incentive, such as stock options, to produce a blended payout to management. In some instances, such as management in an operating subsidiary of a larger company or in a closely-held family business, where equity ownership is not available, the MRP may have no cap and may even provide for an increasing percentage payout as the company’s purchase price increases.
Luckily, MRPs are not the creation of any provision of the tax code, are not qualified plans under ERISA laws, and are exempt from the draconian provisions of Section 409A (if structured appropriately). This allows tremendous flexibility in creating a unique plan designed to meet the company’s specific objectives.
Of course, there are issues to address when adopting an MRP. Holders of common stock who may be adversely effected by an MRP might/will grumble. Also, an MRP participant will pay ordinary income tax on any gain, unless you are able to structure the MRP as a junior preferred stock (not always an easy task, although possible under the right circumstances) that can be held for at least one year. Finally, payments under an MRP plan may trigger "golden parachute" tax treatment under Section 280G so holders of 75% of the company’s voting stock will need to approve the MRP.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
