United States: [Podcast]: Nuts And Bolts On A Management Buyout (Part 6 Of 7)

Last Updated: October 29 2018
Article by Michael J. Album and Joshua Miller

In this episode of The Proskauer Benefits Brief, partners  Michael Album and  Josh Miller discuss the incentive equity package that management will be offered in the buyout, including the structure of the incentive pool, vesting, and favorable tax treatment of incentive grants. Tune in and listen for the latest insights and perspective on management buyouts in this sixth of a seven part series.

Listen to the podcast

Mike Album: Hello, welcome to the Proskauer Benefits Brief, nuts and bolts of a management buyout, what management needs to know. I'm Mike Album, and on today's episode I'm joined by my partner, Josh Miller, and we're going to discuss management's incentive equity packages and pools, in the context of a management buyout.

In our prior podcast, we spoke a little bit about rollover equity, so-called direct equity that the management team is putting into the new company, going forward. The management incentive equity is a little different, Josh. It's sometimes referenced as options or profits interest. Can you explain a little bit why it's different from the actual investment that's being made with a rollover equity?

Josh Miller: The management incentive equity, the sweat equity, whether in profits interest or another form, is really incentive equity. It's granted, not sold. It's not something that was preexisting. This is your new incentive award that's subject to vesting, based on continued service, performance, and other criteria. It generally provides upside, as opposed to immediate value. So for example, a capital interest in a partnership has an immediate right to participation, typically, in distributions from the partnership. Whereas a profits interest  only has value to the extent that the company appreciates in value, to participate in distributions above the liquidation value of the company on the date of grant. So they're a partnership analog of options, in that an option in a corporation only has real value to the extent that the trading price exceeds the exercise price of the option.

The form of interest is very important, Mike, as you know because of income tax recognition. Profits interest, if properly structured, will have a value for tax purposes of zero on the date of grant, and will constitute property, subject to code section 83, and as a result enable a section 83 B election, the effect of which is that a profits interest can be granted, even if subject to risk of forfeiture, vesting conditions, forfeiture conditions. It can be granted and the participant can make an 83 B election on the date of grant, to take into his or her income the value of those interests on the date of grant. That value, if structured properly is zero, so you're left with a equity incentive form that results in no taxable income to the holder, and a potential for capital gains on distributions and subsequent transfers.

Mike Album: Right, so if I'm a senior management executive, there are two aspects to the incentive equity that I really care about. One is I'm not paying anything for it. Unlike my rollover equity, this is an award that I don't pay for. The second is if it's in the form of a profits interest, it could be structured properly so I can make a technical tax election called an 83 B election, that has no immediate tax impact to me, no cash tax impact to me because I'm not getting any baked in value with this award. But it allows me, if I hold the profits interest long enough, to have capital gains associated with any payments I receive with respect to that interest. So it's a two part play, if you will. It's a grant that I receive, that gives me upside in the company at no cost, and it may well give me preferred tax treatment on the appreciation. So it's a very good arrangement. The only wrinkle of course is there's got to be appreciation in the company going forward, but of course I'm part of senior management, and I'm being paid to do that post closing, so I'm fully confident that it's going to have that value. Josh, talk a little bit about the size of the equity pool. Because we know that there are a lot of market aspects to what is the right size of the pool.

Josh Miller: The size of the pool varies. You typically will look at the total fully diluted common interest, and come up with a percentage. The percentage does vary, quite a bit, depending on the business. For example, a health care managerial services organization might have a larger pool because they're compensating not only the management team and the directors, but also individual physicians, whether it's physician owners or associate physicians. Whereas a purely operational company might have a slightly smaller pool, but still something substantial, something that gives management real upside and alignment to share in the appreciation of the company.

Mike Album: Right. Also the size of the deal will have an impact on the size of the incentive equity pool, huge multi-billion dollar deals will have a smaller equity pool than a smaller deal because the value of the pool is worth a lot more because of the size of the deal. Josh, can you talk a little bit about vesting and acceleration events associated with these awards?

Josh Miller: Sure. The award as incentive compensation, are generally subject to vesting. Those vesting terms can be a combination of time and performance conditions. The time typically will be anywhere from 40 to 60% of the pool, although it varies. Vesting over time, based on continued service. So this could be over a period of three, four, five years. It could be of ratable vesting, where vesting occurs every year, every quarter, or even every month. Or it could be a cliff vesting, where at the end of a specified period, 100% of the time vesting units become vested. On the other hand, you have performance vesting. The performance vesting units can be based on financial performance on a year to year basis, things like revenues or EBITDA or sales, or they could be tied to an exit: The IRR or the "money on money" return at the time of an exit, measured based on the sponsor's capital investment in the business. Or a combination. For example, you could have a portion subject to only service over time, a portion that vests based on EBITDA on a year to year basis, but with full acceleration of the entire reward, both time and performance, to the extent that certain returns are met in a liquidity event, such as a sale or change of control event.

Mike Album: Right, we can't cover all the aspects of the incentive pool arrangement, but a couple of take home points that you should at least be thinking about. One is, whatever the size of the equity pool, some of it's not going to be allocated at the time of closing. There'll be a hold back reserve. Senior management should try to have as much control over that reserve allocation as possible, and they should also try to have as much control over any forfeited units that come back into the pool. Because those could have real value, if there were to be a deal done, and they haven't been previously allocated. The second thing to think about is to make sure you get whatever distribution units might take place on unvested units, that they are somehow put aside or held, so that when the units do vest, they can receive the distributions that were made when they were previously unvested. And the last thing to be thinking about is, Josh mentioned various acceleration events, change of control, multiple on invested capital, IRR returns, that would somehow trigger a full vesting of any unvested units at the time of the transaction. Also make sure you try to get yourself a tail. Management should be thinking about a tail, so that if they're terminated, but one of these trigger events were to happen within six months, nine months of their termination, they would get the same economics, had they been there. Now that won't apply to a pure resignation, but that type of tail protection could apply in a good leaver situation, where they'd been forced out without cause, or perhaps had good reason to leave.

So we're going to save the next podcast to deal with employment agreement issues. Thank you for joining us on the Proskauer Benefits Brief. Stay tuned for more insights on our next pod cast on iTunes, dealing with employment agreements, and be sure to follow us on iTunes. Thank you.

Listen to The Proskauer Benefits Brief

[Podcast]: Nuts And Bolts On A Management Buyout (Part 6 Of 7)

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions