Once a private equity firm determines to buy a company, one of the earliest
Once a private equity firm determines to buy a company, one of the earliest
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"Skin in the Game"

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July 5, 2022 | Jamieson USA

Deepest thanks to our friend and colleague Michael Sirkin

Once a private equity firm determines to buy a company, one of the earliest topics that arise in discussing with management their equity and other compensatory issues, is how much the chief executive officer and other senior managers will invest in the new acquiring entity. While the management is primarily interested in learning the size and structure of the equity pool in these early discussions, the rollover issue is often the primary focus of the private equity firm. Indeed, it is not uncommon for private equity firms to try and have the rollover commitment locked in prior to any detailed discussions on the pool.  Management, on the other hand, often believes that one of the levers in negotiating the pool details is the rollover commitment.
Sponsors often take the position that the rollover amount should be at least 50 percent of the net after tax proceeds received by the executive, without regard as to the source of the funds. Proceeds from prior investment or rollover are generally treated the same as proceeds from the prior incentive plan in calculating the amount. Some private equity firms want the benefit of any tax free rollovers, while others will calculate the amount assuming no tax free rollover and give the benefit of the tax free rollover to the executive in calculating the 50 percent.
The point no one seems to be able to answer is why the 50 percent level for rollover. It almost seems that the number comes from “a dollar for you and a dollar for me” approach or a common investment compromise of “take out half of the pot and leave the other half in to run.”
The concept of a rollover starts with the “skin in the game” theory of making management decisions.  It is logical  that someone who has their own money to lose and not just to lose sharing in an upside is likely to give more thought to, and make better, management decisions. There is also logic to the argument that the “skin in the game” needs to be sufficient, either in absolute terms or compared to a person’s net worth, to make it have an impact on the potential business decision. Private equity buyers want to know that the executives have confidence in the company and in the projections given to buyer and, accordingly, that the executive is also willing to be a buyer as opposed to only a seller.
Having investment in the company may also make a senior executive less likely to terminate employment and/or join a competitor. They will have money invested in the company with no assurance as to when they will get it back and won’t want to hurt the potential value of that investment.  In addition, if the executive competes, he or she is likely to receive back only what he or she invested and lose any growth if he or she competes.
Generally, the private equity firm does not need the managements investment to make the deal financing work and that is not a factor in the skin in the game request.
However, one can also recognize that for many executives this is the first opportunity that they have made more than normal base and bonus and, therefore, want to be able to put some wealth into savings and diversified investments. Perhaps that is where “the one for you, one for me” approach comes from.
In publicly traded companies, the concept is more often expressed as alignment of interest with the shareholders, but the goal is the same. The amount of ownership required is usually a multiple of base salary (5 to 6 times for the chief executive officer and usually 2 to 3 times for other executives). The executives usually have 5 years to reach this goal and can often achieve this level by retaining company granted equity (net of taxes) after they vest in the grants. Occasionally, an executive will buy stock when joining a company, but this is not common and, when done, is,  generally, done because the executive feels it is a good message to the market or wider team and not required. Therefore, in the public situation, unlike the private equity company, there is no requirement to invest formerly earned money. The distinction is probably because of the different time tables for exit.
Despite the logical need for rollover in private equity situations, the one rule fits all approach for amount does not really work and is not appropriate.  It is fair to acknowledge that many private equity firms start lower than 50 percent and that almost all will discuss the amount with the executives on an individual basis.  But many start at the 50 percent level and strongly advocate it.
The difficult question is what is a significant enough investment to impact decision making. If an executive makes $25 million pre-tax on a transaction, does his or her decision making really change if he or she invests $5 million instead of $9 million.  And what, if he or she already had a $25 million net worth before this transaction, but only made $10 million on this transaction and invests $3.5 million as his or 50% after tax. Clearly, the 50% level is not really an absolute method of achieving the right level to impact decision making.
In addition, if an executive joins a portfolio company laterally and not as part of a transaction, the amount will, of course, not be related to an amount the executive made out of the prior transaction. Indeed, it is likely to be substantially lower than the amounts that the prior executives would have been “requested” to rollover. It will be focused on the executive’s net worth, stage in life and other obligations (e.g. upcoming college tuitions, a new house, support of elderly parents, etc.). At times the sponsor will even lend money to the lateral executive so he or she can make some investment. The situation is somewhat the same for the executive who joins the selling company midstream and, hence, has a smaller return on the incentive growth.  He or she could have a very senior roll but be “requested” to rollover less than a lower level employee who had been with the portfolio company from the beginning.
The 50 percent after tax rollover level isn’t a “magic” formula.  Sometimes it is argued that the executive should show confidence in the Company and his projections by rolling over everything he is receiving and that reducing it to 50% is an accommodation.  Executives may have all the faith in the world in the Company and the projections, but recognize that they do not control the wider economic environment and may want to diversify their investments and have more liquidity.
It is likely that the 50 percent starting point has become a custom for many plan sponsors. A potential alternative  starting point would be to treat the situation the same as a lateral hire and evaluate the individual situation. The real focus should be on net worth (including what is received on the prior transaction), family income, absolute dollar amounts and the executive’s other obligations.  The goal would be to find a level that is significant to impact the specific executive’s decision making, but permits the executive to feel comfortable for providing for his or her other needs.  It may take additional individual analysis and be more personalized (and, in the heat of a deal, may seem burdensome), but it is more equitable than merely using a percentage of after tax proceeds from the prior transaction for all executives and will create a better relationship with the key executives.
As noted above, many, if not all, private equity firms will start with a desired percentage of after tax rollover, but be open to arguments that the executive makes to reduce the amount (usually the same arguments discussed above). However, this puts the executive on the defensive, makes him or her feel that they will receive less incentive equity if they don’t comply (which is sometimes the case) and will be less favorably looked upon by the sponsor. Instead, if the discussion starts out with asking the executive what they are prepared to rollover and why (as is often the case with the lateral), the dialogue will be significantly different in tone and create a better feeling of partnership, although, one can suspect, that the outcome in many cases will be significantly the same.
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