Private Equity Newsletter

Management Equity Arrangements in Private Equity Transactions
Part II: Compensatory Equity Awards*

January 26, 2009

In a previous newsletter, we discussed the treatment of the equity owned by management prior to a private equity investment, as well as any new equity purchased by management, at the time of a private equity investment.  In this newsletter, we discuss compensatory equity awards that are typically granted to management in connection with a private equity investment.

Compensatory equity awards give award recipients the opportunity to experience upside gain with the success of the portfolio company, without the exposure to downside risk.  It is fairly common for a private equity investor to reserve 10% to 15% of its portfolio company's fully diluted equity for awards to members of management (and to lower-level employees in some cases).  In formulating an equity award program, private equity investors should consider certain issues, including (1) equity award design, (2) vesting provisions, (3) forfeiture provisions, (4) the terms of the shares underlying the equity award and (5) securities laws implications.  Following is a discussion of each of these issues:

• Equity Award Design.  Equity awards may take a variety of forms, including nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock and phantom shares.  A link to a summary that highlights some of the differences among these forms of equity awards is available at the end of this newsletter.
  
  The historically favorable accounting treatment given to options was phased out in 2004, and other forms of equity have increased in use.  However, options continue to be used by both public and private companies.  Compensatory options are often preferred by investors because they deliver value to management only if the value of the enterprise increases and liquidity is made available.
  
  If a portfolio company is treated as a partnership for tax purposes, members of management may be awarded "profits interests" in the partnership.  Profits interests are partnership interests that entitle the recipient to a specified share of future profits in the partnership.  Properly structured, the recipient of a profits interest is not taxed at the time of receipt of the profits interest.  After issuance of a profits interest, its owner becomes a partner of the partnership for tax purposes and is taxed on a pass-through basis on his or her allocable share of the partnership's income.  Accordingly, if the partnership generates tax-advantaged income or gain - such as long-term capital gain - the recipient may receive a partnership allocation of the tax-advantaged income.  This pass-through treatment makes "compensatory" equity in the form of profits interests attractive from a tax perspective and a common structure for portfolio company management teams.  However, partnership profits interests have been the subject of proposed tax legislation that, if enacted, may make the tax treatment to recipients less attractive. 
  
  The economic flexibility that profits interests provide is also a reason why a private equity investor may want to offer profits interests to management.  The terms of a profits interest may be customized to the particular portfolio company.  For example, the private equity investor and management recipients may agree that management will not participate until after the private equity investor receives a specified return on its initial investment (which may be formulated as an IRR hurdle, a multiple of capital or some other relevant metric). 
  
  If the portfolio company is taxed as a corporation, it may be possible to achieve flexibility in the economic allocation between the private equity investor and members of management by creating different classes of equity.  In such a structure, members of management (or lower-level employees) typically receive traditional equity awards in the form of options, stock appreciation rights, restricted stock and/or phantom shares, but the awards relate to a different class of stock with different economics from the class of stock held by the private equity investor.  For purposes of compensatory equity awards, the use of different classes of stock is becoming increasingly popular with private equity investors. 
  
  The use of profits interests and various classes of equity is often highly customized to the particular transaction and must be carefully considered; these structures can be quite complex, requiring significant business, legal and tax analysis.

• Award Vesting Provisions.  A compensatory equity award will typically include vesting provisions as an incentive for the holder to stay with the portfolio company for at least a minimum period of time and, in the case of performance vesting, to help the portfolio company achieve target performance levels.
• Time vesting.  Time vesting means that an award will vest as long as the holder is employed by the company on the applicable vesting date(s).  A full vesting term of three to five years is fairly common, with vesting varying within that period.  For example, it is not uncommon to see any of: (i) pro rata annual vesting over the period (most typical), (ii) pro rata monthly vesting over the period or (iii) no vesting until the end of the full term when the award vests 100% (i.e., "cliff vesting").
• Performance vesting.  For members of management, performance vesting is fairly common (but less so for lower-level employees whose decision-making is believed to have less impact on the performance of the portfolio company).  Performance vesting awards will vest upon achievement of predetermined company performance targets so long as the holder continues to be employed by the portfolio company on the applicable measurement or payment date.
• Yearly performance targets are common.  For example, annual performance targets over a five-year period may correspond to 20% vesting of the award each year if applicable performance targets are achieved. 
• "Catch-up" performance vesting (e.g., predetermined cumulative performance targets over the vesting period for each year after the first year) may also be incorporated into the award design.
• Performance targets may be tied to a company operating metric (e.g., EBITDA) or a notional return on the private equity investor's investment in the portfolio company (e.g., a notional enterprise value target measured as of one or more scheduled future valuation dates).  If the latter approach is taken, the measure of the notional enterprise value is often derived from a formula agreed upon in advance, such as a multiple of EBITDA or a similar metric (e.g., average three year trailing EBITDA times a stated multiple), so that the metric is not actually intended to be a true enterprise value metric but instead simply translates back to EBITDA or another key operating metric.  But even this type of vesting, and certainly vesting based on more complex or uncertain measures of notional enterprise value, might be less commonly adopted for ordinary course vesting in the current economic environment, in which enterprise values and the horizon for actual exits at the notional enterprise values are much less certain.  As described below, vesting based on the internal rate of return achieved by the private equity investor in an actual liquidity event may still be appropriate in many cases.  However, performance vesting in the ordinary course prior to an exit event might best be tied to one or more key targets of the business plan, such as revenues, EBITDA, cost reductions, etc.
• Combination of Time Vesting and Performance Vesting.  It is not uncommon for management of a portfolio company to receive a mix of time vesting awards and performance vesting awards.  Other possible approaches to incorporating time vesting and performance vesting features in equity awards may include the following:
• A portfolio company may grant performance vesting awards that will ultimately vest if the holder remains at the portfolio company, even if targets are not achieved.  For example, the award will be subject to performance vesting for the first five years, but any portion of the award that is not vested on the eighth anniversary of the date when the award was granted will vest on the eighth anniversary.  This design was more common when favorable accounting treatment was available for options, because time vesting at an outside date was critical for this treatment.  As a result, this design has decreased in popularity so that a performance option today will more often terminate if the performance targets are not met.  There remain cases, however, where vesting at some outside date is retained - based on the view that if the option holder remains with the portfolio company through the eventual vesting date, then he or she is entitled to the option, whatever it may be worth.
• A portfolio company may grant a time vesting "premium" option (i.e., an option with a per share exercise price that is higher than the fair market value of the underlying share on the date of the option grant).[1]  Although the option will vest over time, if the fair market value of the shares underlying the option does not increase above the exercise price, the option will remain "out-of-the-money."
• Although not common, a portfolio company may reserve a pre-determined number of shares for grants of compensatory equity awards (which are typically based on a percentage of fully diluted equity), but wait to grant individual awards and determine the size of those awards based on future company performance.  Once granted, such awards may be fully vested at the time of grant or they may vest over time following their grant date.
• Acceleration of Vesting.  It is not unusual for an equity award's vesting provisions to provide for earlier vesting upon certain events, most commonly a liquidity event for the private equity investor.  There is no standard "liquidity event" that typically results in accelerated vesting of management equity.  The definition of "liquidity event" varies, ranging from the sale of 100% of the investment by the private equity investor to a sale that results in a return to the private equity investor above a certain percentage of its investment.  In formulating return targets, it is important, of course, to require that the stated return must be achieved on all the capital that is invested in the portfolio company, both before and after the employee equity award is granted.  Time vesting awards are often treated differently from performance vesting awards for this purpose (e.g., time vesting awards will often fully vest upon a sale by the private equity investor, while performance vesting awards will vest only if the private equity investor obtains a predetermined return on its investment).  Although acceleration of vesting in connection with liquidity events is fairly common, it is not common for equity awards to treat termination of employment or the occurrence of the company's initial public offering as vesting acceleration or payment events.
• Vesting Versus Exercisability.  If a portfolio company grants an equity award that requires exercise of the award in order for the holder to receive the underlying equity interest (i.e., stock options or stock appreciation rights), the company may consider limiting the holder's ability to exercise the award, even if fully vested, until the occurrence of a liquidity event.  In so doing, (i) shareholder rights (e.g., voting rights and rights to dividend payments) will not accrue to the holder prior to the liquidity event and (ii) the portfolio company will defer the need to value its shares in connection with exercises of equity awards (e.g., for purposes of taking a compensation deduction and for tax withholding and reporting).  Although at first blush limiting the exercisability of a vested equity award may seem unappealing from the award holder's perspective, at least in the case of nonqualified stock options, these holders rarely intend to exercise their awards before the occurrence of a liquidity event because the holder must pay taxes upon exercise of the award (please see Attachment A to this newsletter).  If award holders are permitted to exercise their awards before the occurrence of a liquidity event, a private equity investor may want to consider limiting such exercises to designated window periods when share valuations are performed.
• Award Forfeiture Provisions.  Questions regarding forfeiture typically arise in connection with terminations of employment.  Although by no means "standard," the following provisions in connection with termination of employment scenarios can be described as "typical."
• Termination of employment by the portfolio company for "cause" or resignation by the employee without "good reason":
• all unvested equity awards immediately expire and are forfeited;
• if the employee is terminated for "cause," his or her vested equity awards immediately expire and are forfeited; in the case of a resignation by the employee without "good reason," he or she may keep vested awards.
• Termination of employment by the portfolio company without "cause" or resignation by the employee with "good reason":
• all unvested equity awards immediately expire and are forfeited (alternatively, termination of employment may result in vesting of otherwise unvested awards);
• all vested awards expire in a relatively short time (e.g., 30 to 90 days) following termination of employment to the extent that they remain unexercised.[2]
• Termination of employment due to death or permanent disability:
• all unvested awards immediately expire and are forfeited;
• all vested awards expire within a time frame that may be slightly longer than the post-termination exercise period (e.g., one year) following termination of employment to the extent that they remain unexercised.[3]
• The definitions of "cause" and "good reason" are often negotiated.  This is especially the case when the executive is also negotiating the terms of his or her employment agreement (if any).  In fact, the definitions of "cause" and "good reason" in a management equity plan may cross-reference the corresponding definition in the applicable executive's employment agreement.  Lower-level employees who receive compensatory equity awards often do not receive the benefit of "good reason" termination of employment protection (i.e., all quits by the employee are treated as "voluntary" or "bad leaver" terminations).  The broader the definition of "cause" and the narrower the definition of "good reason," the more leverage the company has in an actual termination of employment situation.  Typical triggers include:

• "cause":
• the executive's commission of a fraud or an intentional act of dishonesty that results in personal enrichment of the executive or has a [material] detrimental effect on the company;
• the executive's commission of [/indictment for/conviction of] a felony;
• the executive's material breach of any provision of his/her employment agreement or any other agreement between the executive and the company [, which is not cured within 10 days of written notice];
• the executive's intentional wrongful act or gross negligence that has a [material] detrimental effect on the Company; or
• the executive's failure to follow the reasonable instructions of the company's board of directors or the executive's direct supervisor following notice of such failure from the company's board of directors or the executive's direct supervisor, [only if such failure is not cured within  10 days of receipt of notice].
• "good reason":
• a reduction in the executive's base salary or the executive's annual incentive compensation opportunity [(other than a general reduction in base salary or annual incentive compensation opportunity that affects all members of management equally)];
• a material reduction in the executive's duties and responsibilities;
• an adverse change in the executive's title [or the assignment to the executive of duties or responsibilities materially inconsistent with his or her title(s)]; or
• a transfer of the executive's primary workplace by more than [25] miles from [current location].
• Terms of Underlying Award Shares.  Generally, the shares underlying compensatory equity awards, once exercised or vested, are subject to the same terms as shares of the same class of stock held by other shareholders.  For example, if an executive exercises an option to purchase shares, the executive will be required to become a party to the company's shareholders' agreement (if the executive was not already a party).  It is fairly common, however, for the company to have call rights on management award equity (even more common than call rights on "purchased" equity) in all termination of employment scenarios (not just in the case of "bad leaver" terminations of employment).  Generally, management put rights on award equity are limited.
• Securities Laws Implications.  As is the case with "purchased" equity (discussed in our previous newsletter), grants of equity awards to employees require an exemption from registration under the Securities Act.  The same Regulation D exemptions discussed for "purchased" equity (Rules 504 and 506) may also be used for compensatory equity awards.  In addition, the more flexible Rule 701 under the Securities Act may also be available for "purchased" equity and for the grant of compensatory equity awards to employees of a private company:
• Rule 701 does not require recipients of the compensatory equity awards to be "accredited investors";
• Rule 701 requires that the compensatory equity awards be granted pursuant to a written compensatory benefit plan established by the company (or its parent or majority-owned subsidiaries);
• The aggregate sales price or amount of securities sold pursuant to Rule 701 in any 12-month period must not exceed the greatest of:
• $1 million;
• 15% of the total assets of the company, measured at the company's most recent balance sheet date (if no older than its last fiscal year-end); and
• 15% of the outstanding amount of the class of securities being sold pursuant to Rule 701, measured at the company's most recent balance sheet date (if no older than its last fiscal year-end);
• If the aggregate sales price or amount of securities sold pursuant to Rule 701 in any 12-month period exceeds $5 million, the company must deliver certain disclosure to the award recipients, including:
• the company's financial statements; and
• risk factors associated with an investment in the company.
• Time constraints are often an issue in negotiating private equity acquisitions and arrangements with management.  Assuming that signing and closing of the private equity investment are not simultaneous, the private equity investor may consider signing management equity term sheets describing the material terms of the equity awards, to be followed by a more comprehensive equity plan document and award agreements at closing or as soon as practicable thereafter.

See a copy of Equity Compensation Award Designs table.

If you have any questions regarding this newsletter, please contact either of the lawyers listed below or your regular Davis Polk contact.

Edmond T. FitzGerald, Partner
212-450-4644 | edmond.fitzgerald@dpw.com

Ada Dekhtyar Karczmer, Counsel
212-450-6054 | ada.karczmer@dpw.com

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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.

           

 

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