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Management incentivisation in private equity transactions

Corporate and M&A, Private Equity
corporate office
A common issue that arises for private equity (PE) funds when acquiring a closely held company is ensuring that the existing management team remains incentivised following completion of the acquisition.

PE funds will usually invite (and often require) the target company’s management shareholders to roll a portion of their existing shareholding stake into the new equity capital structure put into place by the PE fund. This helps align the interests of the PE fund and the existing management team, and ensures management continues to have ‘skin in the game’ following the acquisition. Management rollovers will generally be put in place regardless of whether there is an earn-out arrangement in effect, which usually only incentivises management shareholders in the shorter term.

Considerations for rollover terms between PE fund and management

Our Private Equity team has summarised below some of the issues that may arise in negotiating the rollover terms between a PE fund and management:

Dealing with leaver scenarios

PE funds need to consider the way in which management’s rollover shares will be dealt with if managers decide to leave the company during the life of the investment. This will usually depend on the circumstances in which the management shareholder leaves –as a ‘good’, ‘bad’ or potentially ‘intermediate’ leaver. A key point for negotiation in the shareholders agreement will be the way that these terms are defined and the associated consequences.

Management shareholders will often argue for less harsh consequences upon leaving than might be expected under a traditional management equity plan, for example, that their rollover shares get bought back at market value (or only a modest discount to market value) rather than nominal consideration. It is important that any consequences for leaver scenarios should apply not only to the management shareholder’s shares, but also to any shares transferred by the management shareholder to affiliates or other permitted transferees.

Management will also need to consider how to deal with restraints and non-solicits in these circumstances, ensuring they are carefully drafted to maximise the prospects of being enforceable.

Further funding and dilution

PE funds should consider how the business will be funded going forward, including in relation to anticipated bolt-on arrangements and other growth initiatives. They should consider the extent to which management will be granted anti-dilution protection rights, (for example, pre-emptive rights in relation to the issue of securities) and any related carve-outs that apply to these rights (for example, in emergency funding circumstances, or in relation to an issue of securities to a third party as consideration for the acquisition of a bolt-on business).

A third consideration is whether the PE fund will provide any debt to the business (for example, through a growth loan), and the way that this will interact with other funding requirements, including equity funding through the issue of shares to shareholders.

Exits, drags and tags

PE funds should consider up front what their short term sell-down and longer term exit strategy is likely to be. If, for example, the PE fund intends to syndicate a portion of its investment in the short term, it should ensure that it has the ability to do so without management’s consent and that management is required to assist to the extent necessary.

It is important that a PE fund has clear rights to effect an exit, including by having the ability to drag management shareholders into a share sale to a third party, or to require management to participate in, and provide all required approvals for, an IPO or asset sale.

Management shareholders will often be given the benefit of a corresponding tag along right attaching to a share sale by the PE fund. Consider pre-agreeing provisions to help make an exit as efficient as possible, particularly where there is a large number of management shareholders involved. This may include requiring management shareholders to provide an irrevocable power of attorney, allowing the PE fund to enforce the exit provisions upon management default, or using a management shareholder pooling vehicle to facilitate a cleaner exit.

It is also important that the exit provisions are drafted comprehensively so that it is clear from the outset what a management shareholder is required to do (or not do) in an exit (for example, in relation to escrows, restraints and providing warranties). Without this certainty, management shareholders may attempt to derail the exit by refusing to agree to the proposed terms, even if they are considered standard. Ensure that the definition of IPO is drafted broadly enough to capture different potential IPO scenarios (eg, a top hat pre-IP restructure).

PE funds should also think carefully about pre-agreeing that management may transfer their interests to affiliates and other permitted transferees, and ensure that these remain easily traceable and subject to compulsory transfer (including leaver) provisions and exit rights. It is also important that the PE fund has rights in relation to upstream changes in control in any management shareholder, and that snap-back provisions are included (ie, so that, where a management shareholder transfers shares to an affiliate and the transferee subsequently ceases to be an affiliate of the management shareholder, the transferee must transfer the shares back to the management shareholder).

From a tax perspective, tag and drag rights may result in the loss of the capital gains tax discount for managers where they have exercised their option and acquired shares within 12 months of the exit (unless the options were granted to the managers under the start-up Employee Share Scheme (ESS) rules).

Decision-making, veto and information rights

Typically, a PE sponsor that has acquired a majority interest in a company will expect to have the ability to take control at board and shareholder level. Management will usually expect to be represented on boards and board committees, and to have minority protection veto rights. The extent of the board protection and veto rights may depend on management’s shareholding – different rights might be provided in a 10% rollover vs. a 40% rollover. In all cases, it is important to ensure that conflicts of interest are dealt with appropriately (eg, a management shareholder should not be able to veto a decision relating to the termination of their employment with the company).

Consider whether any board appointment or veto rights should only apply for so long as management shareholders collectively hold a specified minimum percentage of shares in the company. It is also important to ensure that the quorum requirements for director and shareholder meetings are drafted such that management cannot effectively veto decision making by refusing to attend meetings.

Most PE sponsors expect a full suite of information rights, and will usually have access to the company’s information as both a shareholder and through their nominee directors. In considering what information rights to provide to management, sometimes it is appropriate for key management (such as founder shareholders) to benefit from a fuller suite of information rights while they remain involved in the business, noting that they would likely have access to much of this information through their management positions in any event.

Management incentive plans

In addition to incentivising existing management shareholders through a rollover, consider whether to develop a management incentive plan that applies to the broader management team, regardless of whether the manager also holds rollover shares. The treatment of these incentive shares in exit and leaver scenarios are likely to differ from the treatment of rollover shares.

In our experience, Loan-funded Share Plans (LFSP) and Premium Priced Options (PPO) are commonly used by private equity. Generally, LFSP involve employers providing interest-free loans to employees who use the funds to subscribe for equity in the company. PPO involve the granting of options with an exercise price significantly higher than the market value of the underlying equity. These regimes fall outside of the ESS rules and the tax consequences for each regime is different.

Ongoing relationship, warranties and W&I insurance

It is important to bear in mind that there will be an important, continuing relationship between the PE fund and the management shareholders. Avoid ‘point scoring’ and arguing over technical points in negotiating the initial transaction documents, especially if these are unlikely to be of commercial importance, but may cause lasting damage on the relationship and trust between the parties.

Consider how to deal with potential warranty claims. It can be awkward and damaging to the relationship if a PE fund finds itself suing management shareholders for breaches of warranties. One solution may be to obtain buy-side W&I insurance so that the PE fund brings any warranty claims against the W&I insurer rather than the management shareholders directly, although some PE funds prefer that management shareholders are on the hook for the warranties they are providing.

Tax considerations

In the context of ‘founder’ shares, where management has been involved in the company since its inception and acquired ordinary shares for nominal consideration outside of the ESS) rules, there may be tax preferred rollover provisions under Australia’s capital gains tax (CGT) regime which could apply (i.e. scrip for scrip rollover relief). The effect of this rollover is to defer the tax on management’s disposal of their equity until they dispose of the replacement equity received in the acquirer. In the same vein, management will be focused on ensuring the CGT 50% discount, if available, is preserved on these shares. It is not uncommon for ‘back-to-back rollovers’ to occur in PE acquisitions, which present tax risks to management in the form of the potential loss of the CGT discount or loss of the benefits of the rollover (i.e. upfront taxation). This is a current focus area for the Australian Taxation Office.

Alternatively, if management has acquired their equity under an ESS, there are specific rollover provisions which need to be carefully considered. A key requirement is that the replacement equity must be ‘reasonably regarded as matching’ the rolled equity. In the context of acquisitions, this requirement may be hard to satisfy if the rights and obligations attaching to the share are different.

Overlaying the above consideration is how management holds their equity (i.e. individually, through a company, family trust, etc). Where loan benefits are provided by the company to management to facilitate their acquisition of shares in the company, it is important to remember that the employer can only rely on the ‘otherwise deductible rule’ for FBT purposes if the interest-free loans are made to the managers personally and not to an associated entity. Where the company is a private company and the manager already holds shares, LFSP may trigger the application of Division 7A resulting in a ‘deemed dividend’ to the manager so it is critical this is considered prior to rolling out the plan.

How we can help

Arnold Bloch Leibler is renowned for advising clients – including local and international private equity firms and investors – on complex corporate transactions, commercial issues and disputes. To find out more about Arnold Bloch Leibler’s private equity practice, click here.

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