The exit market for private equity owned portfolio companies in the United States has been very active in the last several months and the exit route has encompassed sales to new buyers–both strategic and financial, sale to continuation funds and other funds of the existing sponsor, SPAC’s and initial public offerings (“IPO’s”). One of the factors for private equity firms in exploring the public market with an IPO is whether the recent higher multiples in the public market than the private market is significant enough to justify the longer timetable to liquidity.
Many management incentive plans “(MIP”s) and related documents never specifically contemplated the IPO exit route and do not address any special treatment in that situation, other than perhaps an authority and tax oriented provision on tax free conversion to a C corporation or a partnership to be used in an Up-C tax structure. This leaves the MIP to basically be treated the same in a public situation that it was as a private company and continue equity vesting on the same measurement basis.
IPO treatment needs to be addressed at exit if not dealt with earlier. We believe, however, that it is advisable to address the IPO exit (as well as SPAC’s and direct listings) in the initial documents so that implementation at exit will not require a new set of negotiations on treatment of the existing MIP.
Traditionally there are three ways (with variations) in which portfolio companies go public–conversion to a C corporation, use of an UP-C tax structure involving the partnership remaining in existence but the profits interests converting to whole units and continuation of the partnership, with a lower tier entity being taken public (with retention of the profits interests in the partnership or conversion of them into whole units that are distributed to management). All have their own issues. Generally, if the MIP grants are options, the conversion dilution issue is avoided, but the other issues discussed below need to be addressed.
Conversion of profits interests into whole units or shares requires that any profits interests be valued and compared to the value of the corporation at the time of the conversion. This results in the percentage interest of the former profits interest in the future growth of the company being less than they would have been if the profits interest structure had been continued. The impact of this lower sharing of value will vary depending on the value of the corporation. The higher the value, the smaller the impact of the waterfall threshold on the future growth interests. Usually, the earlier after acquisition the IPO is pursued, the larger the impact. Thus, without a makeup discussed below, the issue of profits interests or options need to take into consideration whether IPO is the contemplated exit and the timetable until that will occur, as well as the spread in tax rates between options and capital interests.
Assuming the parties agree that this impact should be addressed (which is usually an active discussion with reasonable points both ways), it can be partially addressed by the issuing of stock options to the participants with a strike price equal to the conversion price so as to maintain percentage of growth interest. It does, of course, shift taxes from capital gains to ordinary income on the top up, but this generally has been accepted as cost of the conversion. For true maintenance of interest, the top up grants should have vesting from the initial creation of the management incentive plan on the same schedule that originally existed. This will result in the options being partially vested and partially unvested in the same proportion as the converted profits interests. However, in some cases this is not done, and vesting is forward looking to maintain retention.
If the partnership is maintained and a lower-level entity is taken public with no distribution of units to MIP participants, the conversion impact is avoided, but there is an additional series of issues related to liquidity, as well as the issues described below relating to vesting measurement.
Most management incentive plans of portfolio companies have a portion of the interests time vesting and the remaining portion performance vesting. Management has now gotten the entity and the sponsor to a liquidity event–the IPO. However, from the sponsor’s point of view, they still have a period until they can effectively sell into the public market and realize on their investment. Most sponsors do not sell on the IPO. Usually only the company is selling and usually 10-20% of the Company shares. The sponsor exit usually starts with a secondary about six months after the IPO, when IPO lockup ends. After that, it depends on the market and the sponsor’s desire to maintain a position in the Company. It should be noted that in European offerings the sponsors often sell into the offering and the IPO is usually treated as an Exit event.
The time-based incentive units usually either continue to vest on the remaining schedule from the original grant or have some acceleration at the back end so everything vests within a two year period. There are more variances in the treatment of the performance units. Sometimes these are just changed to time vested units. In other situations, they continue to vest based on the MOIC or IRR formula in the MIP based on sponsor sell down. However, this is often unsatisfactory to management since they have brought the company to a liquidation event and should not now have to be dependent on the long-term investment approach of the sponsor.
This leads to variances where there is measurement as cash is received, but a final measurement using market values at the earlier of a time period (e.g. 18 months or 2 years) or sell down (e.g. 80% of initial holdings). In other cases, there is an interim measurement at the IPO at the IPO price and then future measurement on a 20-trading day weighted average. The key for most management is that, now that they are dealing with a public company board and quarterly earning pressures, they want to be fully vested on time measured units and have continuing measurement on performance measured units if they are a good leaver, i.e. death, disability, without cause or good reason. They generally are willing to take the risk of voluntarily resignation so long as there is a reasonable outside measurement date. Alternatively, voluntary termination is permitted after a specified period and still retain future measurement. This is often more of an issue for the CEO and top executives than for lower-level executives.
In the IPO situation there are two other grants to be considered. The first is an IPO retention grant. Management often receives grants on an IPO as both appreciation for the efforts to get the company to that point and, more importantly, for retention for several years after the IPO. This is important to the potential investors in the company and, hence, to the underwriters of the IPO. These grants tend to be time based restricted stock units, options, or in many cases, a combination of the two. This grant is not negotiated at the time of the creation of the MIP, but at the time of the IPO. Often this is combined in some manner with any dilution grants. They are often a multiple of the projected annual grant level or of based salary.
The final incentive grants related to the IPO is the future annual grants. These will initially be made at the first compensation committee grant meeting after the IPO. This usually occurs in the first calendar quarter of the following calendar year. They may be traditional public company grants, but because of the difficulty in determining accurate projections and the more limited interest in these grants by proxy advisors and institutional investors, they also may be more heavily time based than future annual grants. After the initial grants, however, the company always shifts to traditional public company grants. At least fifty percent will be performance based and the remaining portion time based over 3 or 4 years. The committee, with the assistance of a compensation consultant, will identify a peer group of companies and a targeted percentile to target the grants. As noted above, these grants will tend to attract attention from the proxy advisors and governance reviewers of public company compensation arrangement and be much more prescribed in size and form.