The world of information and data has exploded over the past decade and we’re now well-versed in harnessing such complexity in order to make choices for ourselves – choices that take into account a vast range of possibilities and variables. Increasingly, the expectation is for solutions that are bespoke. To simply accept a standard offer without first assessing it against a wider backdrop and considering possible alternatives is no longer the done thing.
Thinking differently about management equity plans for private equity-backed businesses is definitely on the rise. Management incentives should be aligned with the goals of the company and the private equity investor. It’s vital to ensure that the private equity backer is offering a package that will win the deal.
In a traditional buy-out, institutional investors establish an equity plan for the senior management team. The purpose is dual: to encourage management to think like business owners, and to enable them to share in the risks and rewards of the group they will be responsible for running on a day-to-day basis.
In Europe, such plans typically require management to acquire a stake in the ‘sweet equity’ – simple ordinary shares at market value. This ordinary equity will accrete value only after the institutional investors have received a preferred return on their investment.
Private equity-backed management teams are key to the success of any investment, delivering the returns and growing the business to the right amount and in the right direction. A well-considered equity plan to incentivise them is fundamental to the value-creation strategy. In some transactions, a traditional ‘straight’ management equity plan remains appropriate. It’s pretty clear and simple, but it’s important to understand when a more nuanced and customised management share incentive structure is required.
An institutional investor’s edge in competitive negotiations may well depend on its ability to be innovative and consider this aspect of a transaction more strategically. So, what are the factors that influence the final design of the management equity plan?
The approach to equity incentives offered to management varies significantly by geography. In Europe, by and large, an equity plan will commonly take the form of ordinary shares that participate after preference shareholders have received their required return. However, in other regions, a stock option plan or indeed a cash-based alternative may be more common. For a financial sponsor/sophisticated private equity manager, the firm’s usual approach to incentivising management teams is likely to dictate the structure and similarly for a corporate buyer, the structure will be heavily dictated by existing schemes it has in place.
However, this approach may need to be carefully balanced where investors operate outside their home market and local market practice for equity plan design differs. In this case, it might well be necessary to have some frank discussions to ensure everyone is on board. If management are not wholly on board with the plan from the start, that would be likely to act contrary to the aims of the incentive scheme.
Appetite for risk
A key concept in a management equity plan is that management pays ‘fair market value’ for its equity. That may be affordable for senior management, but for more junior managers, the sums they might be expected to invest could be much more substantial relative to their wealth. A well-considered equity plan should provide for a reasonable level of risk for more junior managers. An equity plan that is considered overly risky for certain groups of managers can distort behaviours and create disharmony among the team. In these instances, a fundamentally different approach to incentivisation may be more appropriate.
Traditionally, it has been more common for only the very senior members of a management team to be invited to participate in an equity plan. However, given the increased focus on ‘fairness’, and particularly in relation to executive pay, an equity plan is now frequently extended to mid-
tier managers. In addition, a separate long-term incentive plan, such as a shadow equity plan, will often be established for a wider pool of managers to align their objectives and enable them to share in the value they help to create. In the private sector, plans are relatively light in relation to clawback provisions in equity plans, but this is gradually changing to follow on a more light-touch basis some of the provisions now mandated for public company executive schemes.
As a business grows in value at a rate exceeding the required preferred return, the cost of the equity will increase. This increase can be sizeable and can result in the economic interests between managers who acquired their shares at different points in time being misaligned. Where the value of the equity has increased to an unaffordable level, alternative structures may be considered for new joiners. Most often, this takes the form of a cash-based, long-term incentive.
The value attributable to the ‘sweet equity’ is by its very nature subject to the performance of the business. With higher multiples being paid, it’s key to ensure that the investment has the ability to deliver and management understands what this means for its equity plan. In some instances, it may be appropriate to provide for additional value in an equity plan where management has succeeded in achieving exceptional growth of the business. When used in the appropriate context, such potential additional value can be a useful tool to bridge the expectation gap between parties over business performance.
The tax treatment of an equity plan will depend upon its form. In some jurisdictions, specific favourable tax regimes may apply. These special regimes typically require that a number of conditions are met, so the position should be carefully considered in the context of each transaction. In other cases, tax rates may be the same, or very similar, regardless of the form of the plan. Nonetheless, congruence of the plan with commercial objectives remains the overriding factor.
Management equity plans are complex. Multiple dynamics usually influence the final arrangements. Given the importance of management to driving business growth, it’s critical to give sufficient consideration to the equity plan early in the process. A useful starting point might be to dust off the house’s standard blueprint. But, more often than not, specialist input and a high degree of customisation are required to successfully and efficiently get the equity plan over the line with key stakeholders.
Widening the options
In a recent acquisition of a European-based multinational that had significant operations outside of Europe, the overarching equity plan was set up as a traditional European private equity plan. But a number of separate bespoke plans were established alongside – one as a cash-based plan, both to incentivise lower-tier managers (as it required no upfront investment) and in recognition of constraints on individuals acquiring equity in foreign entities in certain territories. Other incentive plans were put in lower down the structure to incentivise specifically the employees working in strategic divisions within the wider operating group. A more holistic approach was adopted, resulting in a wider equity and incentive plan mirroring the set-up of the group, including a range of grades and recognising strategic areas of business.