Weil, Gotshal & Manges LLP A Comparison of Management Incentive Equity Arrangements in Private Equity Transactions Across the United States, Europe and Asia By Timothy Gardner, James Harvey, Michael Nissan, Sumit Ram and Amanda Rosenblum Introduction A key feature of private equity transactions is ensuring that management, who will be asked to deliver on the company’s business plan, are appropriately incentivized and aligned with the sponsor to share in the future growth of the company. This is typically achieved with incentive equity arrangements put in place at the time of the sponsor’s acquisition of, or investment in, the company. In this article we look at the approaches taken to management incentive equity arrangements for sponsor-backed transactions in the United States, Europe and Asia. Observations Europe: The common position across the vast majority of European jurisdictions is for managers to be issued ordinary (sweet) equity, sitting alongside the sponsor’s interest held across a mix of securities, including for example ordinary and preferred equity and shareholder loans (the institutional strip). The subscription price for the sweet equity is often set at a low amount, with some form of performance ratchet or hurdle, such that there is little or no value in the sweet equity on subscription. The sweet equity then only provides a return to the managers on an exit if the sponsor realizes a minimum return on its investment. This often allows the managers to minimize income tax costs on acquisitions while ensuring that exit proceeds are taxed at the prevailing capital gain rate rather than as ordinary income. United States: In the United States the nature of the securities or interests held by managers is more varied, with managers typically holding either options exercisable into ordinary equity, profits interests or, occasionally, leveraged common equity (common equity subordinated to preferred equity so as to depress entry value), with vesting of these interests subject to continued service and the overall performance of the business or investment. The choice between these different interests is driven by tax considerations and the negotiating strength of management: options giving rise to ordinary income treatment but a compensation deduction benefit in the hands of the company, and profits interests and equity giving rise to capital gains treatment for the managers, but no compensation deduction for the company. Asia: The position across Asia is also more varied, and in general there is no settled market standard for management equity incentive arrangements, although it is more common for management in transactions in Private Equity UPDATES 2015 Private Equity UPDATE Q 3 2015 GLOBAL Weil, Gotshal & Manges LLP 2 China to be given equity incentive awards that vest purely over time with no performance requirements, whereas in the Hong Kong market managers are commonly issued with a mix of ordinary equity as well as options exercisable into ordinary equity and which are linked to future business performance. In other markets we see features similar to both Europe and the United States. Pooling Vehicles The use of a pooling vehicle controlled by the company (and ultimately the sponsor) to hold at least more junior managers’ equity interests is becoming increasingly common in European transactions. This allows for greater control of management’s incentive equity as well as easing the administrative burden, since the company will only have one management shareholder entity to deal with, as opposed to many individual management shareholders. Use of such vehicles is not common in the United States with managers typically holding their interests directly with, less frequently, junior managers holding phantom equity through a profits interest structure. Across Asia transactions, pooling vehicles are sometimes used in larger transactions but (in some markets, like China) are often controlled by the company’s founders rather than the company itself. Transferability Ensuring that management incentive interests are held only for the benefit of management is also important and, therefore, general prohibitions on transfers by a manager of equity or other incentive interests are an almost universal feature in arrangements across the United States, Europe and Asia. Similarly, if a manager ceases to be employed by the company (i.e., becomes a “leaver”), that manager may no longer be allowed to retain some or all of his/her incentive interests. Across Europe it is typical for the leaving manager to be required to transfer equity (for example to a new incoming manager, or perhaps a warehouse vehicle to be recycled later). In the United States, unvested options or equity will typically lapse, with any vested equity being subject to a repurchase right by the company. The price paid for equity being transferred or repurchased is determined by the circumstances of the manager’s leaving, with a “good leaver” typically being entitled to receive a higher amount than a “bad leaver” on vested equity. While each transaction is different, there are a number of areas where it is possible to find a generally settled position and, accordingly, we set out below a summary of certain of the key terms and some of the more common positions adopted. Right Europe United States Asia Type of Interests Held Class of Security ■ Rollover of existing equity: ordinary equity or into a strip of ordinary equity and preferred equity and/or shareholder loans alongside sponsor ■ Incentive equity: ordinary equity, sometimes with a ratchet or hurdle, or similar, such that the sweet equity only provides a return once a minimum return has been achieved by the sponsor on exit ■ Rollover of existing equity: same mix of securities as sponsor (pari passu save for company’s call right over manager held equity on becoming a leaver) ■ Incentive equity: non-qualified stock options (exercisable into common stock), profits interests or, occasionally, leveraged common stock (common stock subordinated to preferred stock to depress value) ■ Rollover of existing equity: typically ordinary equity or equity-linked securities ■ Incentive equity: varies, but, e.g.: (i) in Hong Kong, options linked to future performance or equity with a hurdle linked to a minimum sponsor return on exit; or (ii) in China, shares and not options Global Private Equity Update Q3 2015 Weil, Gotshal & Manges LLP 3 Right Europe United States Asia Vesting for Incentive Equity ■ Time vesting over e.g. a four or five year period, annually or on a straight line basis (see also leaver price below) ■ Combination of both time vesting and performance vesting for both options and other incentive equity: ■ Time-vesting component: four to five years ■ Performance vesting component: return-based (multiple of investment and/or IRR) and/or operating based (e.g. EBITDA) performance metrics ■ Combination of both time vesting and performance vesting: ■ Time vesting over e.g. a four or five year period ■ Performance vesting: return-based and/or operating based (e.g. EBITDA) performance metrics Voting Rights ■ Varies but often voting ■ Varies but often voting ■ Usually voting Anti-Dilution Rights ■ None (although see preemption rights below) ■ None (although see preemption rights below) ■ None (although see preemption rights below) Pre-emption on New Issues of Securities ■ Pro rata pre-emption rights, with exceptions for: ■ Acquisition issues ■ Emergency issues (for example to avoid imminent default under the company’s financing arrangements) with managers having a subsequent catch-up ■ Issues under a management incentive plan up to a certain percentage of equity ■ Usually for rollover equity only ■ Sometimes for vested incentive equity ■ Usually for rollover equity only Terms of Loan Notes / Preference Shares / Shareholder Debt ■ Varies, but between 10% and12% interest, PIK often seen ■ N/A ■ N/A in most cases Management Rollover Percentage ■ Often about 50% of post-tax proceeds ■ Determined on a case-by-case basis (50% post-tax proceeds would not be unusual) ■ Determined on a case-by-case basis Use of a Pooling Vehicle to Hold Management Interests ■ Senior managers hold directly, with more junior managers holding through a pooling vehicle/co controlled by the company ■ Use of pooling vehicles not common. Senior managers usually hold equity interests directly; junior managers hold either directly or, occasionally, may have phantom equity interest instead ■ For larger transactions management’s equity is sometimes held through a pooling vehicle controlled either by the founder (if applicable) or the company Global Private Equity Update Q3 2015 Weil, Gotshal & Manges LLP 4 Right Europe United States Asia Leaver Provisions Which Securities are Subject to Leaver Repurchase Provisions? ■ Incentive equity only ■ Incentive equity and typically rollover equity ■ Varies, but incentive and rollover equity often subject to leaver provisions Types of / Reasons for Becoming a Leaver ■ Good leaver – manager who leaves due to: ■ Death or incapacity ■ Redundancy or retirement ■ Wrongful dismissal ■ Sale of that manager’s part of the business ■ Designated by the board as a good leaver ■ Bad leaver - a manager who leaves due to any other reason such as resignation or summary dismissal ■ “Cause” or when “cause” exists ■ Resignation without Good Reason ■ Death ■ Disability ■ Termination without Cause ■ Resignation with Good Reason ■ Retirement (not as typical) ■ No fixed position–both United States and European positions seen in recent deals Disenfranchisement ■ Until a leaving manager transfers incentive equity under the leaver provisions or if the leaver rights are not exercised such that a leaving manager retains incentive equity, the manager will no longer be able to attend and vote at shareholder meetings or vote on shareholder matters ■ N/A ■ Depends on whether United States or European style leaver provisions are adopted Price Paid to a Leaver for Incentive Equity ■ If departing manager is a good leaver: ■ Fair market value for vested equity; and ■ The lesser of cost and fair market value for unvested equity ■ If departing manager is a bad leaver: the lesser of cost and fair market value ■ Call on incentive equity: fair market value for vested equity unless departing manager has been terminated for cause or breached restrictive covenants, in which case the lesser of fair market value and cost ■ Any unvested incentive equity forfeited and options lapse ■ Rollover equity: fair market value unless terminated for cause or breached restrictive covenants, in which case, the lesser of fair market value and cost ■ Deal specific, but price paid will distinguish between good leavers and bad leavers and often see positions similar to Europe and the U.S. Payment for Leaver’s Shares ■ Company usually has the right to pay in cash or defer payment until an exit by issuing a note, with interest sometimes accruing, e.g. at LIBOR or otherwise, company required to pay in cash unless financing restricts cash payment, in which case, a note is issued ■ Typically cash unless financing restricts cash payment, in which case, may pay with subordinated notes due when restrictions are lifted or upon a change of control (with interest accruing at an agreed upon rate) ■ Typically cash unless financing restricts cash payment, although some deals give right to defer payment until exit by issuing a note Global Private Equity Update Q3 2015 Weil, Gotshal & Manges LLP 5 Right Europe United States Asia Board Rights Constitution of the Board of Directors ■ Usually as is determined by sponsor, with managers (CEO, CFO etc.) appointed by the sponsor, as the case may be. No entrenched right for managers to sit on the board unless perhaps where managers have a significant rollover equity stake ■ CEO may receive board right pursuant to employment contract or if CEO owns a significant stake, but only while employed ■ Usually determined by sponsor together with the company’s founders/senior management. If a founder retains a significant interest, the founder would normally retain board seats Share Transfers and Exit Permitted Transfers ■ General prohibition on transfers, save for estate planning purposes such as a portion (e.g., up to 50%) to spouse or family trust ■ General prohibition except for estate planning purposes ■ General prohibition on transfers, save for estate planning purposes such as a portion to spouse or family trust Drag-Along Rights ■ Sponsor has right to drag management into an exit on the same terms (purchaser may sometimes be able to offer different forms of consideration (e.g., rollover equity) to the dragged shareholders, so long as economically equivalent) ■ Sponsor has the right to drag management into an exit on same terms for typically the same form of consideration ■ Sponsor typically has the right to drag management into an exit on same terms (purchaser may sometimes be able to offer different forms of consideration (e.g., rollover equity) to the dragged shareholders, so long as economically equivalent) Tag-Along Rights ■ If sponsor is selling e.g., more than 50% of its shares, then managers have a right to tag along, pro rata on the same terms ■ If sponsor is selling, then managers have right to tag along on (i) rollover equity and (ii) sometimes vested incentive equity ■ If sponsor is selling (sometimes with a requirement that a certain amount of its shares are being sold) then managers may (but not always) have the right to tag along Tax Matters Particular Tax Structuring / Relief ■ Will be jurisdiction specific, but arrangements may be structured so as to allow managers to qualify for local reliefs or exemptions on disposal (for example, U.K.- resident managers may avail themselves of the employee shareholder scheme, allowing 0% tax rate on capital gains on compliant equity or entrepreneur’s relief, allowing a 10% tax rate on capital gains up to a lifetime limit of £10m) ■ Non-qualified options result in ordinary income to management and tax deduction to employer company. Profits interests and leveraged common stock are eligible for long-term capital gain treatment if certain criteria are met and no deduction for appreciation to the employer company ■ Will be jurisdiction specific Global Private Equity Update Q3 2015 Weil, Gotshal & Manges LLP 6 Global Private Equity Update Q3 2015 Weil’s Global Private Equity Practice 20 offices worldwide, of which 16 are recognized as top tier for Private Equity by Chambers and Legal 500 Ranked Band 1 for Global Private Equity by Chambers The global private equity team acts for more than 200 private equity clients worldwide, including more than 80% of the world’s top 10 funds and 70% of the top 25, as ranked by PEI 300 2015 Ranked Top 5 for Global Private Equity for the last 5 years — Bloomberg; mergermarket 33 Chambers-ranked private equity lawyers worldwide, including 10 ranked Band 1 Market Recognition Private Equity Practice Group of the Year — Law360 2012 and 2014 Band 1 for Private Equity Global-wide, Asia-Pacific-wide, and Across Europe — Chambers Global, Chambers AsiaPacific, Chambers Europe, Chambers UK Tier 1 for Private Equity in the U.S., U.K. and Asia — IFLR1000 2016 Band 1 for Private Equity – U.K. — The Legal 500 UK 2015 Band 1 for Private Equity – Hong Kong — Legal 500 Asia Pacific 2015 Shortlisted for Business of Law Category for Developing the Global Private Equity Watch — Financial Times’ North America Innovative Lawyers Report 2015 Recipient of “Private Equity Deal of the Year” Award — China Law & Practice 2015 Weil, Gotshal & Manges LLP 7 The Gores Group American Securities LLC Recent Weil Representations Advent International Corporation/Bain Capital Avolon Holdings Limited/ Cinven Partners/CVC Capital Partners/Oak Hill Capital Partners Baring Private Equity Asia Berkshire Partners LLC Centerbridge Partners L.P. CCMP Capital Advisors/ PQ Corporation CVC Capital Partners EQT Infrastructure Genstar Capital LLC Limited JAB Holding Company Global Private Equity Update Q3 2015 Global Private Equity Update provides updates on current topics and trends in global private equity and is published by the Private Equity practice of Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY 10153, +1 212 310 8000, www.weil.com. If you would like more information about the contents of this issue, or about Weil’s Private Equity practice, please contact your relationship partner at Weil, or one of the authors below: Editors: Marco Compagnoni (London) Bio Page [email protected] +44 20 7903 1547 Doug Warner (New York) Bio Page [email protected] +1 212 310 8751 Contributing Authors: Timothy Gardner (Hong Kong) Bio Page [email protected] +852 3476 9218 James Harvey (London) Bio Page [email protected] +44 20 79031070 Michael Nissan (New York) Bio Page [email protected] +1 212 310 8169 Sumit Ram (Hong Kong) Bio Page [email protected] +852 3476 9267 Amanda Rosenblum (New York) Bio Page [email protected] +1 212 310 8283 © 2015 Weil, Gotshal & Manges LLP. All rights reserved. Quotation with attribution is permitted. This publication provides general information and should not be used or taken as legal advice for specific situations that depend on the evaluation of precise factual circumstances. 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