Private Equity-Backed Companies

Executive compensation design is fundamental to how private equity (PE) companies look to create value in their portfolio companies. Private equity companies typically invest in businesses with the intent of improving their operational and financial performance with the goal of taking them public or selling them to another party at a significantly increased valuation. To support the objective of increasing the value of the firm’s equity, private equity portfolio companies typically grant large, front-loaded equity awards to the senior executives of the management team. They may also require members of senior management to purchase shares of the company outright so that they are co-invested in the business alongside the private equity sponsor. In this chapter, we will focus on private companies that are majority owned and controlled by one or more PE sponsors.

In many cases, the compensation committee for portfolio companies is mostly made up of private equity sponsor executives. These private equity executives often have clear ideas about how to structure the compensation plan and may have template approaches that they apply to most of their portfolio companies. However, as private equity backed companies approach a liquidity event, they will often add independent directors to the board. Independent directors need to have an understanding of private equity compensation practices, particularly long-term incentive design, as they are quite different from traditional public company pay programs.

The design of the compensation program for a PE portfolio company varies on a number of situational factors, including: the status of the company prior to being owned by PE, the investment timeframe of the PE sponsor and the maturity of the PE portfolio company’s business.

PE companies often take a public company private by buying the shares of the company outright (e.g., through a leveraged buyout). In this case, management may participate in the buyout along with the PE sponsor and be expected to co-invest in the purchase alongside the PE sponsor. The PE sponsor may purchase the company from another PE firm, and the executives of the acquired portfolio company may be expected to co-invest some of the proceeds from the sale into the ongoing business along with the new sponsor. A third common approach is that the PE firm buys into a privately held business (e.g., a family-owned business or a partnership) that expects to take the business public or sell the business in the near future (e.g., 5–10 years). In this scenario, co-investment may be less of an expectation, as management members are likely already partial owners of the business.

The timeframe for the PE sponsor is critical to understand in designing the compensation plan. In most cases, the PE sponsor expects to sell the business in a 5–7-year timeframe. However, if the PE sponsors are one of the few that expect to hold businesses for the long-term (e.g., 10–20 years), that will have major implications for the long-term plan design. In most cases, liquidity for the executive team is contingent upon liquidity for the PE sponsor. That is, management will typically not be allowed to exercise stock options or sell shares until the PE sponsor either takes the company public and can sell shares or sells the company to another PE sponsor or company. It is reasonable to expect executives in a PE held business to wait 5–7 years for liquidity, but 10–20 years is another matter, and will likely require the PE sponsor to create a liquidity mechanism for management.

The third fundamental consideration is the maturity of the PE portfolio company’s business. Unlike early-stage companies, PE portfolio companies are frequently revenue-generating businesses that are profitable. In these situations, PE portfolio companies are less cash-constrained than early-stage companies and will likely have more traditional cash compensation in combination with a highly leveraged long-term incentive plan in the form of stock options or profit interests. However, in private equity portfolio companies that are less mature and are closer to VC-backed companies in their stage of development, compensation packages will be low in cash and higher in equity, more similar to those of a VC-backed business.

For more mature private equity-backed companies, we would expect compensation practices to conform to the following structure:

As mentioned above, long-term incentives are typically provided in the form of stock options or profits interests. In the chapter on VC-backed businesses, we provide a brief discussion on profit interests. For practical purposes, they function much like a stock option in that they reward management for increases in the value of the company’s equity. The key difference with profits interest is that the executive will be taxed at capital gains rates rather than ordinary income. In order to have profits interests, a company must be structured as a partnership, and the executives receiving profits interests will be taxed as partners in the business, rather than as employees. For this reason, profits interests tend to be used only for the most senior executives.

Like at VC-backed businesses, long-term incentive design tends to be the most critical aspect of compensation for the committee to address. Below is a discussion of each of the key elements of long-term incentive design at PE-backed companies:

• Participation: Typically limited to senior executives of the company; could be as few as ten participants in a smaller portfolio company to 30–40 in a larger portfolio company. In companies that operate in the technology sector, there may be greater pressure to expand participation more broadly to match competitive practices within the industry
• Vehicle: As discussed above, for executives, the most common vehicle is stock options or profits interests. If the corporate structure allows for it, profits interests are very attractive to executives because of the preferential capital gains tax treatment they receive. Where profits interests are used, we tend to see a narrow participant group receive profits interests (e.g., <10 employees). Other participants will likely be granted a cash-settled stock appreciation right where the value is based on the appreciation in the company’s stock value from the date of grant until exercise; however, the value at settlement is delivered in cash rather than in equity in the company. This allows the employees to share in the appreciation in value of the company without having to be treated as a partner for tax purposes. Any gains from a cash-settled stock appreciation right will be taxed at ordinary income rates upon exercise.
• Performance Criteria: In private-equity portfolio companies, stock options (or profits interests) are frequently subject to more than just time-based vesting restrictions. Frequently, vesting for at least a portion of options may be subject to meeting specific performance hurdles. For example, a stock option may be separated into three tranches with different vesting criteria:
  • 1/3 of stock options granted may vest at each of the first three anniversaries of grant;
  • 1/3 may vest upon a liquidity event contingent on the private equity sponsor receiving a multiple of invested capital of at least 2.0x upon the liquidity event;
  • 1/3 may vest upon a liquidity event contingent on the private equity sponsor receiving a multiple of invested capital of at least 3.0x upon the liquidity event.

A wide variety of performance criteria are used in private equity. Rather than a multiple of invested capital, vesting can be tied to the rate of return that the private equity sponsor receives. This approach implicitly rewards management for speed to a liquidity event as the internal rate of return is a “running meter” that requires an increasing multiple of invested capital as time passes. The performance criteria can be set as a condition for vesting where once the criteria are achieved, the management team participates in any appreciation above the value at grant, or the criteria could be set as an adjustment to the exercise price so that management only receives value to the extent that the price has appreciated above the expected rate of return or multiple of invested capital.

A key balance to strike in setting performance objectives for portfolio company management is setting goals that align with the private equity sponsor’s expected return but are not viewed as so onerous or challenging that they are no longer motivational to the portfolio company’s management team. It can be frustrating for management to operate under performance hurdles that were established with a very optimistic view of what is achievable in terms of a valuation when market conditions have become much less favorable.

Typical equity terms at PE-owned companies follows below:

• Option Term: Typically, stock options will have a ten-year term to provide greater flexibility. Profits interests do not necessarily have a term as they are ownership rights.
• Vesting: In addition to the potential for performance vesting criteria, options typically vest over three to five years. The most common structure is to vest ratably over the vesting period. For example, four-year vesting would be 25% per year over each of the first four anniversaries of grant.
• Grant Frequency: Most private equity portfolio companies grant stock options (or profits interests) at the time of hire that are expected to cover multiple years — potentially the full timeframe between grant and liquidity. Follow-on grants may be made once the initial grant is fully vested or if an employee receives a material promotion or increase in responsibilities. The rationale for the up-front grants is to provide the employee with upside from any increases in value from the time they were hired. If the value of the company steadily grows, the employee is much better off receiving the grants up-front than through annual grants where the exercise price will be restruck each year at a new higher price. The potential downside under this approach is that if the value of the company decreases from the date of grant, all stock options will be underwater without the opportunity to receive a new grant of options at a lower exercise price.
• Grant Determination: In public companies, long-term incentives are typically delivered as a target annual dollar value of an award. In private-equity portfolio companies, the common benchmark is a percentage of the total shares of the company. The CEO may receive an up-front grant in the range of 1% to 3% of the shares outstanding, and other C-suite executives may receive an option grant in the range of 0.5% to 1.0% of the shares outstanding. It is common to also test these values relative to public company dollar value benchmarks for equity grants. The company can estimate a Black-Scholes value for the stock option grant based on the initial valuation of the company’s stock and then amortize it over a longer period (e.g., 3–7 years) to estimate an annualized value.
• Total Share Reserve: Private equity backed companies tend to reserve in the range of 8% to 12% of shares for grants to management. These companies typically grant 75% of their equity pool at the time it is established and hold back the remaining 25% for new executive hires or executives who are promoted or take on additional responsibilities.
• Exercisability: In traditional public companies, options typically become exercisable as soon as they are vested. In a private equity portfolio company, exercisability could be restricted until the occurrence of an IPO or another liquidity event (e.g., sale or partial sale of the company). This allows the company to restrict the number of owners of shares of the company’s stock and avoids the employees triggering tax liability when their shares are not liquid.
• Valuation: In a public company, no valuation methodology is needed as the stock market provides a continuous valuation of the company’s stock. In a private company where the company’s shares typically do not trade unless there is a fundraising event, an alternative approach for valuation is needed. Under IRC Section 409A, an independent, third-party valuation is accepted as a safe harbor approach for valuing a company’s shares. These valuations are performed by specialist valuation firms that follow established valuation approaches (e.g., comparable transactions, discounted present value, etc.). While there is potential to comply with Section 409A using other valuation approaches, in our experience, almost all private companies with stock options engage an independent third party to do the valuation. For a private equity-backed portfolio company, the value is likely more tangible than that of a venture capital-backed company, as discounted cash flow projections and earnings multiples can be applied more easily to more mature businesses.
• Company Call Right: Companies may have the right to force the exercise of the stock option and repurchase the underlying shares. In most cases, this is triggered by an employee’s exit from the company and a desire for the company to limit the number of shareholders who are no longer affiliated with the company. One downside of exercising the company call right is that departing employees get liquidity on their shares that is not available to continuing employees. In a company friendly design, the call right could be to repurchase the shares at the original grant value. This would significantly devalue the options as they would have no value once an employee departs from the company. For profits interests, it is also common for the company to have a mechanism to repurchase the interests, particularly following a termination of employment.
• Treatment of Options Upon Termination: Typically, in a private equity backed company, all unvested stock options will be forfeited when an employee leaves the company. There may be exceptions for death or disability and retirement. There is more variance in the treatment of vested but unexercised stock options. A common provision among public companies is to require that the unvested stock options be exercised within 90 days of termination. If this same provision is applied in a private company, terminated employees will be forced to exercise an illiquid stock option and pay the taxes out of their own funds. An alternative approach is to let vested but unexercised stock options remain outstanding for the remaining option term. This is an employee-friendly alternative; however, it may result in former employees receiving considerable value from the company’s performance following their departure. Private equity portfolio companies tend to be reluctant to share ongoing value creation with former employees.
• Tag-Along Rights: In the event that a portion of the shares held in the company by its current owners are sold to a third party, some option plans will provide that option holders can participate in the sale of shares on a pro rata basis. For example, if 20% of the shares of the company were sold by the private equity sponsor to a third-party, the company would allow the option holders to sell up to 20% of the shares underlying their vested stock options to the third party as well.

Key Questions for Committee Members to Ask:

• How do our cash compensation levels compare to other private equity-backed companies?
• Do our executives understand the value of their outstanding equity? Are there clear expectations for liquidity event timing?
• What is our strategy for handling the equity of terminated employees?