September 5, 2008


Investment of private equity capital means investment in a management team.  Despite this focus on management, identifying "standard" or "market" management equity arrangements in private equity transactions is difficult.  Some private equity investors develop their own style and parameters for management equity, typically formulated over time and across investments.  But with each new investment, unique circumstances may warrant a fresh look at equity arrangements for the target management team.

Accordingly, we thought it would be timely to discuss "typical" issues that arise when considering the treatment of management equity.  In this newsletter, we will address the treatment of management's existing equity and any new equity purchased by management at the time of the private equity investment.  We will discuss compensatory equity awards in our next newsletter.

Treatment of Existing Equity

If the target's existing management team and/or lower level employees already hold target equity, a basic question at the time of the private equity investor's initial investment is the extent to which the existing equity will be "cashed out" or "rolled over."  Is the private equity investor willing for members of management to receive liquidity for their existing compensatory equity, or is it preferred that the equity stay illiquid?  Or is there a hybrid approach where some equity is cashed out and some is rolled over?  Different approaches may be appropriate for different members of management.  We highlight below a number of considerations with each approach.

  • Cash out:
    • is often the default approach if the deal consideration is cash;
    • "cleans up" the existing equity;
    • may be desirable for options if roll over would be overly dilutive or if the options are underwater;


    • may enrich management and impact retention and performance; and
    • may create litigation risk if underwater options are canceled without payment, depending on the provisions of the equity award documents.
  • Roll over generally:
    • keeps management invested in the company; and
    • may present a tax-deferral opportunity for the holder, although this generally requires that the decision to roll over equity be made when the transaction agreement is signed (not later).
  • Roll over of options into options:
    • generally can be done on a tax-free basis if the decision to roll over is made when the transaction agreement is signed, but the entire option appreciation is subject to ordinary income tax treatment upon eventual exercise; and
    • the aggregate option spread cannot be increased in connection with the rollover; otherwise, the adjusted options will run afoul of provisions of the Internal Revenue Code (i.e., IRC § 409A and IRC § 422).
  • Roll over of unrestricted stock into unrestricted stock:  properly structured, may be rolled over on a tax-free basis, with capital gains treatment on built-in and future appreciation.
  • Roll over of restricted stock or restricted stock units into restricted stock or restricted stock units
    • should be able to be rolled over on a tax-free basis;
    • however, if the restricted stock or restricted stock units are scheduled to vest in connection with the transaction and the parties wish to defer vesting and roll over the award into an unvested award in the continuing business, tax rules require any deferral of vesting to be done pursuant to an arrangement in which the award is materially increased as a quid prop quo to the executive for agreeing to the deferral of vesting; and
    • the award would be treated as ordinary income as and when it eventually vests.
  • Roll over of unrestricted stock into restricted stock:  properly structured, may be rolled over on a tax-free basis, with capital gains treatment on future appreciation, but requires election under Section 83(b) of the Internal Revenue Code (this can be a trap for the unwary).  However, to the extent an award has become unrestricted because it vested as a result of the private equity transaction, the vesting would typically be a tax event for the executive and the executive may need liquidity to pay the applicable tax.
  • Roll over of LLC interests into other LLC interests or into stock:  may roll over on a tax-free basis, but highly dependent on the terms of the initial LLC interests and the terms of the new LLC interests or shares.

Management Equity Going Forward

New equity for management in connection with a private equity investment generally comes in two flavors: "purchased" equity and compensatory equity awards.  We discuss "purchased" equity below and will address compensatory equity awards in our next newsletter.

"Purchased" Equity

When management co-invests with the private equity investor, it is often because the private equity investor wants management to fully commit to the company by exposing themselves to downside risk, as well as upside gain.  Generally, "purchased" equity also gives management an opportunity to realize capital gains, rather than ordinary income, for federal income tax purposes as the portfolio company and therefore management prospers.[1]  Questions that arise when considering management's "purchased" equity in a transaction include: (1) who will be permitted (or who will be required) to purchase equity, (2) how will the equity purchase be funded, (3) what will the terms of the equity be and (4) what are the securities laws implications for the purchase?

  • Who will purchase the equity?  This is a business issue, but has securities laws implications.  Typically, purchased equity is limited to a small number of individuals.  The initial investment required and the exposure to downside risk may not appeal to many members of management, particularly those who are not among the company's founding members.  The private equity investor also may want to limit the number of co-investors and retain the opportunity for itself.  If the private equity investor is willing and there is high demand among members of management to purchase equity, securities laws may be a limiting factor on who can invest (as discussed below).
  • How will the equity purchase be funded?  The following methods of payment are typical:
    • Equity purchased with the cash proceeds from the sale of existing equity in the private equity investor's acquisition transaction.  Although this may not be the most tax-efficient method of payment because the sale of the existing equity would be a taxable transaction for management, it does allow the purchased equity to receive capital gains treatment going forward.
    • Existing equity rolled over into new equity (see above under "Treatment of Existing Equity").  Roll over of equity may be considered the most tax-efficient treatment for management because it should create the opportunity for tax deferral, though the opportunity for future capital gains treatment will depend on the form and terms of the rollover equity.
    • Equity purchased with a loan from the portfolio company, collateralized by the purchased equity.  This method of payment does not require an initial cash outlay by management.  However, if the entire purchase price is financed with a note from the executive and the company has recourse only to the executive's "purchased" equity if there is an event of default under the note, the purchase by the executive is less likely to be respected as a real transfer of property for tax purposes.  As a result, the "purchased" equity financed in this manner will generally not receive capital gains treatment going forward.  Alternatively, if the purchase is only partially financed with a loan from the company or if the note is recourse to the personal assets of the executive (beyond the "purchased" equity itself), the "purchased" equity is more likely to be respected as a transfer of property for tax purposes that is eligible to receive capital gains treatment going forward.  Financing the purchase of the equity through a loan from the portfolio company has become a less popular method of payment in recent years for portfolio company management teams, perhaps because of the requirement for the executive to either go out-of-pocket for some portion of the purchase price or agree for the loan to be recourse to the executive's personal assets in order to receive capital gains treatment going forward.[2]
  • Will management's "purchased" equity be subject to the same terms as the equity held by other shareholders?  Often, members of management with "purchased" equity will be party to a shareholders' agreement along with all other shareholders.  The shareholders' agreement will typically cover terms such as transfer restrictions, put/call rights, tag-along and drag-along rights and voting rights.  Particularly in the case of senior management, the provisions that apply to the private equity investor's equity generally will often apply to management's "purchased" equity, although management is generally subject to more onerous transfer restrictions. 
    • Company call rights on purchased equity.  The company's right to "call," or buy, management's "purchased" equity is less common than call rights on management's compensatory equity awards.  If the company does have call rights, they are typically triggered only if the executive is terminated for "cause" or resigns without "good reason" ("bad leaver" terminations).
    • Executive put rights on purchased equity.  Private equity investors typically resist giving management the right to "put," or sell, their "purchased" equity to the portfolio company.  Management put rights, if any, are typically granted only in cases where an executive is terminated without "cause" or resigns with "good reason" ("good leaver" terminations). 
    • Repurchase price for call rights and put rights.  The repurchase price for call rights and put rights is often contentious.  Often both "good leaver" terminations and "bad leaver" terminations to have a purchase price for "purchased" equity that is equal to the fair market value of the stock as determined by the portfolio company's board of directors in good faith, which may be subject to pre-established parameters such as any prior valuations performed of the stock within a 12-month period.  In some cases, however, "bad leaver" terminations have a more punitive purchase price that is the lower of (i) the cost of management's initial purchase and (ii) the fair market value as determined by the portfolio company's board of directors in good faith.
    • Call rights, put rights and the portfolio company's debt agreements.  When negotiating call rights and put rights, the private equity investor should be mindful of the portfolio company's debt agreements (and conversely, when negotiating the portfolio company's debt agreements, the private equity investor should be mindful of the portfolio company's repurchase rights and obligations).  If granted, the private equity investor should limit call rights and put rights to circumstances when a buyback of shares will not breach the portfolio company's obligations under its debt agreements (although the private equity investor may consider settlement of the call or the put using a note if required and/or permitted by the portfolio company's debt covenants).
  • What are the securities laws implications for the purchase?  Federal and state securities laws may be a limiting factor on who can participate in the "purchased" equity.  The federal Securities Act of 1933 (the "Securities Act") requires an exemption from registration for a purchase of equity from a private company.  Regulation D under the Securities Act offers the following exemptions from registration that may be available for management to purchase equity without registration:
    • Rule 504. Rule 504 permits offering of securities to any person without qualification, but limits to $1 million the aggregate amount of all such offerings during any 12-month period.
    • Rule 506.[3] Rule 506 permits an unlimited offering of securities to any "accredited investors" and up to 35 non-"accredited investors."
      • "Accredited investors" include (i) directors and executive officers of the company and (ii) any individual who had income in excess of $200,000 individually or $300,000 in the aggregate jointly with a spouse, in each of the two most recent calendar years.
      • Offerings to non-accredited investors under Rule 506 will require extensive disclosure, including the company's financial statements.

Using a Regulation D exemption will require the company to file a Form D with the SEC no later than 15 days after a purchase is made.  "Purchased" equity may also be structured to comply with Rule 701 under the Securities Act, which we will discuss in our next newsletter.

In addition, state securities laws, also known as "blue sky" laws, may require notification of and/or consent from and/or registration in the state where the company is located and the state where the purchaser resides.  California and Arizona have particularly onerous "blue sky" law requirements.

If you have any questions regarding this newsletter, please do not hesitate to call your Davis Polk contact.

This newsletter is limited to the federal tax issues addressed herein.  Additional issues may exist that are not addressed in this newsletter and that could affect the federal tax treatment of the matter that is the subject of this newsletter.  This newsletter cannot be used by any person for the purpose of avoiding penalties that may be asserted against such person under the Internal Revenue Code.  Taxpayers should seek their own advice based on their particular circumstances from an independent tax advisor.

* This newsletter is Part I of a two-part series. Part II will be distributed next month.

1. In circumstances where the "purchased" equity is subject to a "substantial risk of forfeiture" (e.g., if the "purchased" equity is subject to the company's call rights at a price that could potentially be less than fair market value), the holder should make an election under Section 83(b) of the Internal Revenue Code at the time of the purchase in order to receive capital gains treatment for federal income tax purposes.

2. In addition, the Sarbanes-Oxley Act of 2002 prohibits a public company from extending, maintaining or arranging credit to or for its directors or executive officers.  For a portfolio company with an initial public offering on the horizon, any outstanding loans between the company and its executive officers will need to be repaid or otherwise terminated before the time of the initial public offering.

3. Rule 505 is generally not helpful for offerings to employees, because it imposes additional limitations without offering any added benefits beyond Rule 506.