Management incentive plans (MIPs) can be modelled to three decimal places, and breeze through HMRC approval, but if CFOs don’t trust them and the management team don’t believe in them, they’re doomed from the start. Burges Salmon partner Nigel Watson and Francis Moore of Wyvern Partners, explain how to plan to succeed.
Nigel Watson (1) and Francis Moore (2)
Too many management incentive plans (MIPs) are conceived as deal-compliant mechanisms, designed to tick boxes rather than drive successful outcomes. Some are over-engineered for tax purposes. Others are bolted on post-deal and too complex to be transparent.
A good MIP should incentivise – even excite – management with a credible, well thought-out, clearly communicated structure. It should blend economic realism with documented fairness. If either of these are ignored, the structure will at best underperform – and at worst actively create risk. Fairness without realism breeds frustration. Realism without fairness breeds distrust. Both are fatal flaws in an MIP.
Aligning capital and risk
At the heart of any credible MIP lies a structural foundation – cap tables, share classes, performance ratchets, exit mechanics and tax integrity. These elements should combine to tell management what they have got, when it pays out and how they could lose it. The best MIPs answer those questions openly and without evasion, demonstrating structural clarity, behavioural alignment and tax integrity.
A strong MIP should:
- offer the management team real equity with genuine upside;
- ensure management invest on equal terms, with each other and investors;
- clearly define all exits, (including edge cases such as continuation funds or refinancings);
- offer synthetic liquidity where the anticipated hold period is long;
- have performance ratchets that don’t distort incentives at arbitrary points on the return curve; and
- incorporate tax compliance as part of the design, not as a bolt-on.
When management co-invests in the institutional strip, alignment must be genuine. That means no liquidation preference ranking ahead of them, no leaver provisions affecting their strip investment and no protections for the investor that increase management’s risk. If the investor’s capital is at risk, management’s should be too, and on the same terms. The only possible exception to this is a clearly defined bad-leaver scenario; even then, such leaver provisions must be commercially plausible and clearly communicated.
Five-point test
If you can’t immediately answer ‘yes’ to all five, there’s more work to do:
- Are upside and downside risks clearly modelled and shared?
- Does the senior team understand the performance ratchet?
- Can leaver provisions be explained in 60 seconds and still sound fair?
- Are all exit scenarios clearly defined?
- Does the MIP feel like a real investment or just a document?
Sweet equity
The ordinary shares available to management only, excluding the institutional strip, are known as the sweet equity. If the institutional strip is the foundation, sweet equity is the concrete. It’s what management put at risk at the bottom of the capital structure and where they normally stand to make the largest gains.
Returns come through capital growth, sitting behind investor preference shares in the economic stack. They only generate value on repayment and are sometimes subject to a ratchet if a multiple of invested capital (MOIC) and/or an internal rate of return (IRR) is achieved.
Done well, sweet equity can deliver asymmetric upside to management when the business covers its debt and preference obligations. Done badly, it can feel like a valueless perk with restrictive covenants attached.
To be credible it must have a single-entry price for all participants, and contain a realistic performance hurdle (typically 10–12% IRR). Where ratchets are used, they should reward collective achievement rather than individual negotiation.
An independent management adviser should, at the very least, verify the numbers for management to confirm they are realistic and achievable in the indicated circumstances.
Fairness under pressure
Even the best modelling collapses if the legal drafting lacks coherence. Complexity destroys confidence faster than any tax flaw, so a credible MIP should be comprehensible as well as compliant. Moreover, specialist legal documentation should either confirm what the spreadsheet promised or expose it as fiction before the deal is signed.
Legal drafting should empower, not confuse. Management need more than protection – they need to understand what they own and why. A credible MIP should:
- reflect real-world leaver scenarios – not just underperformance, but illness, business transitions and office politics;
- define exit options completely, including IPOs, refinancings, continuation funds and secondaries;
- allow management an exit after a reasonable period, which may include the requirement for synthetic liquidity if long hold periods are anticipated;
- test performance hurdles in a plain-English term sheet; and
- include worked examples.
Recurring issues
Some MIPs are overly sensitive to returns. A relatively small underperformance can leave management underwater, requiring time-consuming renegotiations. Often it is better for management to receive a lower sweet equity percentage behind a smaller preference coupon, so reward and risk are balanced more sustainably.
Many transactions suffer from ‘waterfall ambiguity’ – where information gathered at earlier points in the due diligence process leads to ambiguous or incomplete drafting. Currency inconsistencies, cliff ratchets and missing definitions can all cause disputes. In one deal, an investor’s return fell just below a ratchet cliff, eliminating their incentive to negotiate the EV-to-equity bridge – a completely avoidable stalemate.
When secondary transactions occur mid-cycle, their impact on the MIP is often overlooked. In such a scenario, the original management adviser should be engaged early on to revalidate the modelling assumptions and ensure alignment will continue.
Recreating a financial model from the legal documents, and testing every clause, is essential. In roughly a third of reviews, we find material discrepancies in how waterfall drafting has been run.
Timing matters way more than many people think as well. The most common failure point for MIPs isn’t economics, legals or tax – it’s timing. Too often, investors finalise equity terms before management have even seen the structure. By the time management advisers (legal and financial) are involved, management’s trust in the process is already starting to erode.
Build trust
The best investors will design an MIP alongside heads of terms, and invite legal and tax input early. They will share term sheets and illustrations for feedback, and use equity discussions to build alignment, rather than impose outcomes. They will also encourage management to have independent advice – and will often pay for it.
Investors who engage early and document clearly don’t just de-risk the deal; they make a clear statement that they are going into a genuine partnership with the management team.
When investors fail to engage with a management team until very late in the transaction process, it tends to cause significant delays, waiting for management to process the offer before getting independent advisers up to speed and then starting renegotiations.
A great MIP doesn’t rely on goodwill. It earns trust through clarity, consistency and commercial fairness, setting up a genuine partnership between investor and management.
Build the MIP you’d want to sign. Draft it like it matters. And explain it to management like you want them to stay.
About the authors
Nigel Watson is partner and head of the share plan and incentives practice at Burges Salmon.
Francis Moore is a partner at corporate finance advisory firm Wyvern Partners.
