Trends in Executive Comp for Private Equity Portfolio Companies - with Andrew Skowronski

Speaker A: You're listening to Deal by Deal, a um, Meguiar woods podcast. Deal by Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join Meguiar woods partners Greg Havre and Jeff Brooker as they explore middle market private equity M and A to provide you with timely insights and relevant takeaways.

Speaker B: Hello and welcome to Deal by Deal, a podcast for independent sponsors and other investors in the lower half of the middle market. My name's Greg Havre. I'm a private equity lawyer based here in McGuire Woods Chicago office. And I'm excited to be joined by my partner Andrew Skaranski who sits in our New York office and focuses his practice on employee benefits and executive comp matters. We are going to talk about some exciting trends in incentive equity and other matters relating to the executive team with respect to private equity platform companies. First Couple Housekeeping notes Our independent sponsor conference In Dallas, the McGuire Woods Independent Sponsor Conference is coming up October 14th and 15th of this year. We are really excited. I think it's going to be the best conference ever. It will likely be the, the biggest conference ever. We're having more growth as well. Last year we had 1500 attendees at the conference who were all either independent sponsors or capital partners writing checks into those deals. This year we expect 1600, maybe even 1700 total. It'll be at the Fairmont in Dallas. We're excited to expand a couple of the offerings and a couple of the programs and panels we have this year. So all exciting things. You can find information on that just by googling McGuire woods event, sponsor conference or reach out to uh, any of us lawyers here at McGuire Woods. So with that, Andrew, do you want to give a little more fulsome overview of your practice?

Speaker C: Sure, absolutely. Greg, thanks for having me on for my debut podcast, the first ever in my career. So this is very exciting for me. Nice. Uh, yes. So I am an executive compensation partner here at McGuire woods based in the New York office. I focus particularly on um, exec comp in the M and A context, particularly for private equity sponsors, typically in the lower middle market to middle market size. I work with management teams closely to incentivize them properly in the context of, you know, following a deal and then upon exit on the deal. So that's kind of uh, where my practice lands.

Speaker B: Great. And uh, Andrew and I actually worked together back at Winston and Strachan back in our formative years. So it's good to be here over

Speaker C: 11 years ago, Greg.

Speaker B: Yeah, we were young pups, but it's good to be Back with him at McGuire Woods. So we thought for this episode it might be interesting to sort of go through the life cycle of a transaction from start to finish and just think about, you know, what are the executive comp issues that may come up and what should deal professionals be thinking about. So we're going to, our hypothetical example is going to be a independent sponsor private equity fund acquiring a, for a $50 million enterprise value, a manufacturing company. We'll call it a nuts and bolts manufacturing company. I usually use widget, but so we've got a manufacturing uh, company. First things first, we've got to get our LOI in place with the seller. And usually executive comp matters are not super top of mind. You know, when you're drafting that two to three page loi, other than maybe circling with the target and signaling what sort of pool you're going to put in place for management. Um, Andrew, do you want to talk us through kind of initial thoughts around size of the pool and sort of those initial um, matters?

Speaker C: Yeah, absolutely. So I think you're exactly right in that executive compensation doesn't really play any sort of focus in the loi except for the management incentive pool. And you know, when you look at the typical size for a Met, you would sort of uh, you know, market would sort of lead you to say, you know, we see ranges all over the place. However, market would kind of fall between 10 and 15% of the uh, target on a fully diluted basis. Now.

Speaker B: And that's the 10 to 15% of the post closing cap table, right?

Speaker C: Correct. Yes. And how that 10 to 15% is split up is usually one of the key focuses of ah, sellers and the management team in particular.

Speaker B: Andrew, before we go into what's typical here as far as the breakdown of the pool between the CEO and others, talk about some other important assumptions that'll come up later in our hypothetical here. Let's assume that there's rollover in this transaction of a meaningful amount. Let's assume that that rollover is from a founder who is not going to be the CEO. They're going to be maybe board level, post close, but they're taking chips off the table and not going to run the business. And let's assume there's a CEO in place that uh, the buyer likes and we want that CEO to be the leading force in improving the business going forward.

Speaker C: Sir, with, you know, with those parameters set, the CEO is going to look for a meaningful portion of the management incentive pool to incentivize him to stay with the business. And then grow the business. Because oftentimes in a founder led business, the executive team is compensated quite highly in terms of cash compensation. When you are trying to align the interests of the fund with that of the executive team, the shift becomes less focused on cash to the executives, more focus on long term incentives such as profits interest because that aligns with enterprise growth and the value at ah exit.

Speaker B: So does that usually mean that the cash compensation, you know, W2 wages, do those actually go down in a fair number of PE deals or those. Yeah, okay, got it.

Speaker C: They frequently go down or stay static. It's very rare, at least in my experience, that cash compensation increases. So these businesses are all focused about maximizing growth and not necessarily distributing cash on an annual basis to employees via wages or annual bonuses or the like. So in order to properly incentivize that stellar CEO that we like, the way to do that is to give them a large chunk, so sort of incentive equity. So that's why we typically see CEOs receiving sort of half the management incentive pool, so that they're focused on really growing the business.

Speaker B: Got it, got it. And when do you start? Okay, so you've got again, we're back to our hypothetical. We've got our $50 million company and we're just in the LOI phase. We're circling 10 to 15%. We know we've got a incentivize our stellar CEO for independent sponsors. We are having discussions with our equity capital partners about, you know, what does their investment look like in the platform. And at that point you need to signal to your capital partners, well, that here's the debt we plan to use, here's your form of equity, and here's what we plan to circle for the um, you know, for the executive team. So fast forward, I guess we've got our deal humming along. When do you start negotiating with the management team? Is that pre closing? Is that post closing? Then what are some of those main components of that executive compensation package?

Speaker C: Right, so yeah, usually the discussions happen pre closing and there's sort of three key elements that uh, all executives tend to focus on, which is what is there going to be their annual salary, what's going to be their annual bonus, and what's going to be their incentive equity. So also they're going to negotiate sort of what severance protections they could have in sort of a downside scenario moving forward. The annual salary, annual bonus, as I mentioned before, is, you know, typically not an issue or not something that's sort of discussed at length. The real Key issues are incentive equity and then severance on, um, a downside scenario. And in terms of incentive equity, a lot of that is going to be dictated by the corporate structure moving forward and whether or not there's going to be a C Corp, an LLC taxed as a C Corp or an LLC taxed as a partnership, which are sort of the three main ways that we see these acquisitions happen. And when an executive is looking for that sort of ideal equity award, what does an executive really want out of an equity award? Well, they want something that provides for tax deferral of any gain until they actually sell the equity. Obviously they want capital gains treatment. And lastly, they don't want to put any of their personal money at risk. So when you'd want to tick off those three items, the only form of incentive equity that satisfies those three things would be profit centers.

Speaker B: Got it. And let's take a step back here. Fully agree with everything. So the issue that we see, and it, uh, comes up in some deal structuring conversations and especially now. So there's better rules around the 1202 QSBS tax break for certain small businesses. And that tax break requires that there is a C Corp in the structure. Many times there's a C Corp that sits a level below a partnership. And so the difference for listeners is that, you know, in a C Corp, in a traditional C Corp, you're going to be awarding stock options to the executive team, similar to what executives at public companies get. But when you're using an LLC that stacks as a partnership, you can use profits, interests. And so, Andrew, would you mind just going through a quick comparison of those two from a recipient's perspective and also from an issuer's perspective, right?

Speaker C: Yeah. So in the context of a C Corporation, you're exactly right in that, you know, stock options are generally the preferred form of equity that's awarded. Now when you grant a stock option, uh, to a participant, it's the right to purchase stock at some future point in time after it's vested, or something along those lines. However, a stock option also requires that there's a strike price such that the executive has to come out of pocket and buy the stock options in order to own them. And so where that becomes an issue for many executives is one, where do they come up with the cash to fund that stock option exercise? And there's various ways you could handle that. But then two, the next issue is that you have to exercise the stock option and hold it for a period of time in order to get Capital gains treatment upon an exit event. And what you see frequently is that a lot of executives don't want to exercise stock options in a private company because it's an illiquid asset and you don't know when it's going to ever pay out, if ever.

Speaker B: And if you own options in a public company, you have some additional tools, Right. To exercise, because that's a liquid investment. Right. So you can exercise some of it and there's a market for that, and you can use some of those proceeds to pay the strike price. You don't have that in the private settings. That.

Speaker C: Right, right. So, exactly. In a public company, you have options to fund the purchase of the stock by purchasing it and then selling some on a liquid market. In contrast, you can't do that in the private company context. The primary way that companies can sort of mitigate the issue of the executive having to come out of pocket and pay that strike price so that they can start the capital gains clock is via, uh, a promissory note, whereby the executive borrows from the company an amount equal to purchase the stock options. Now, one thing to note is that a lot of times companies will say, hey, we'll forgive that amount over time. If you do forgive that promissory note, that's taxable income to the individual. So they truly do have to pay it back in order to not have any sort of tax obligation. I think that that's the key difference between a stock option and a grant of profits interest is that there's real money at stake with a stock option, because the, uh, exercise price could be $1 per share, you pay it, and then three years from now, the stock is worth 50 cents a share. So you can lose money, you can lose value, and you also have to come out of pocket with money to exercise to get the equity. In contrast, a profits interest, by definition is worth $0 on the date of grant. So you can file something known as an 83B election, which I'm sure we'll get to later, whereby you recognize as income the value of the profits interest on day one, which is $0. So. And you have $0. So you have $0 in any form of income.

Speaker B: Great. Yeah. I mean, so in light of all these complications with the stock options, are there any silver linings here from the issuer's perspective with respect to stock options? Or. I mean, I'm overwhelmingly seeing profits interest, but are there any. Again, silver linings, Right.

Speaker C: So there is a deduction that the company can take with respect to stock options, while there's no deduction when you grant a profits interest because the profits interest inherently has no value while the stock option does.

Speaker B: Right, Yep. And I've heard of that as a benefit, but I mean, I think at the end of the day most of my clients are saying, look, we're putting this program in place at the end of the day to get our management team excited, uh, about growing the platform and aligned with us. And so let's use the form of incentive equity that's going to be most friendly to the executive team. Is that, is that what you're seeing as well?

Speaker C: Uh, 100%. Which is why virtually the nearly all or the vast majority of the deals that I work on, profits interests are the tool to incentivize the management team.

Speaker B: Got it, Got it. Yeah. And thanks for going down this little structural conversation. I just with, you know, I've been seeing C corpse on almost every deal I've had come across my desk in the last months since the new tax modification. So I thought it was worth revisiting and that's super helpful. Okay, so we've got our manufacturing company, we're charging towards closing. We've got a partnership, we'll call it, that sits above the C corp because we're going for qsbs. And now we got to have our negotiations with our management team about what are the vesting terms of these uh, awards. So what are you seeing in the market, Andrew? Maybe just, you know, the basics and then what are some trends you're seeing out there?

Speaker C: Right, yeah. So the basics investing is, is that, you know, first of all it can be bespoke amongst participants. So not every single management team member needs to have the same vesting schedule. Also, pretty much any vesting schedule is sort of permitted. So you can, A uh, sponsor can do whatever they really want with respect to vesting. So historically what we have tended to see is you of the profits interest would be subject to time based vesting whereby the profits interest would vest. Traditionally it would be in equal installments over four years such that on um, the first anniversary of Grant you get 25% vested. Second anniversary, another 25% vested such that you're 100% vested as of the fourth anniversary of the date of grant. What we have seen over time is that granted one time based vesting has changed to sort of a cliff base for the cliff based vesting for the first tranche such that, you know, in our four year scenario here you would still vest 25% after the date of grant. However, after that we are now more frequently seeing quarterly vesting for the remaining 36 months. Or you know, on the more aggressive side, if the executive has more leverage, they often will push for even monthly vesting. So we're seeing that with increasing frequency. On the flip side though, what we're also seeing is that is a decrease in the percentage of units that are only subject to time based testing. There's been an increased focus on sort of performance criteria in order to sort of receive the benefits of, in order to invest in the profits interest. So those performance criteria are generally based on things like IRR or a multiple on invested capital and the like. And to the extent that, you know, at this point in time I'm generally seeing, oftentimes it's a 50, 50 split. 50% is just purely time based testing. 50% is performance based testing.

Speaker B: And historically was it more 70, 30 on the time versus performance?

Speaker C: Yeah, I would even. Yeah, 80, 20 or a lot of, you know, if you go 10 years back it was almost only time based vesting historically.

Speaker B: And so now you're seeing about 50, 50. And then with the performance based the executive just needs to be with the platform at the time of exit, full stop. Is that right?

Speaker C: Yeah, that's one criteria. But the other criteria is, you know, in order to invest the sponsor may need to get a return on their invested capital of 3x or 4x or even 5x. I've seen.

Speaker B: Right, right, right. And there's no. Yeah, but uh, yeah, and the point I was trying to raise with there's, there's no credit for time vesting for being with the platform. If you're looking at the bucket that is performance vesting, it's just the company to do well.

Speaker C: That's correct.

Speaker B: And you need to be there when the closing of the exit occurs.

Speaker C: Yep, that's correct. And there's one way in which sponsors often build in performance based sort of criteria without expressly doing so. And that way is, is that all profits interests when they're granted are subject to something called, it doesn't matter what the term is, a participation threshold distribution, threshold hurdle amount, something along. You only participate in the profits in excess of uh, the value of the company on the date of grant. And what we've seen increasingly is that many sponsors will build in that, that threshold amount. So let's say in our hypothetical deal it's $50 million, the threshold amount. They're only going to participate above $50 million, that that amount is subject to an 8% rate of return. So it increases every single year. So while it's not expressly sort of a performance vesting criteria, you can build in uh, performance criteria by virtue of adding an automatic increase to the participation threshold.

Speaker B: Yeah, yeah, no, I've seen that and used that and I think that for listeners reference. The important thing here for profits interest is that you can always make that distribution threshold above zero or harder to achieve. As long as that profits interest is worth zero or not in the money the day it's granted you can't make that distribution threshold less than $50 million. In our example you can't make it 30, but you could make it 75 million enterprise value or something of that nature. So Andrew, what's the um. Are there any other benefits to that structure as opposed to or sorry. In addition to the idea that just mathematically it's different. Whereas in a performance vesting profits interest, once you hit the metrics, then that unit vests and sort of you share immediately above 50 million in value. Assuming that there were no distributions along the way as opposed to in Andrew's example, if you set the distribution at 75 million, then those profits interests don't share in the upside until 75 million is hit. So it's a, it's a different math example. But are there any other kind of upsides or why are you seeing people take that approach?

Speaker C: I'm, um, seeing people take that approach because one it is, you know, from a layperson's perspective it's objectively more difficult for sort of the recipient to realize that they're being subject to a performance, to a different sort of performance criteria. And I think that's one of the main way, that's the primary sort of advantage. Similarly, I think there's. If you're not going to expressly use performance criteria and just use sort of a rate of return auto increase on the distribution threshold. Uh, it's a way of saying, look, we know everyone in the market. The value of the company should be increasing by x ray percent every year. We're only going to incentivize you if you're doing better than market.

Speaker B: Got it. So before we leave the negotiation of the terms of the profits interests, any other key issues you're seeing with respect to the terms of those profits interests?

Speaker C: Sure. Even before we get to that, there's one item about profits interest that raises its head all the time and that's by virtue of giving a profits interest to an individual, they become a real equity holder in the company. They are a partner, which means that for purposes of tax filings they can no longer be a W2 employee. They are now a K1 partner. And as you know, many of our listeners probably know, K1 partners have to file estimated quarterly taxes. K1 partners cannot participate in employee benefit plans on a pre tax basis. They have to pay their full trade of health care. And you know, for a lot of individuals that comes as a huge shock and not something that they're used to in any way. And in some cases I've seen executives say no, that's like a deal breaker. I can't be a K1 employee or K1 partner rather. So there are ways though to get around that. One thing we often see is oftentimes it's just kind of if you're doing profits interests, you don't go that deep into sort of the management team or the pool. You know, you limit it to just the C suite executives who can, who are capable sort of the being K1 partners and then do some sort of synthetic equity for the more, uh, rank and file individuals. The other solution is you can create what's known as sort of a management aggregator or management hold code whereby essentially the recipient of the profits interest immediately contributes their profits interest to this separate entity we'll call Management Holdco, which then issues a tandem profits interest to the individual such that the individual no longer holds the equity directly from sort of the operating company or holdings. In that way they can be a W2 employee for purposes of where they work, but their profits interest sits at an entity that's not going to get any distributions or any money until likely an exit event. So there'll be a K1 partner of that Management Holdco, but that's not generating a profit. So there won't be any quarterly estimated taxes to file.

Speaker B: Yeah, that's a great point. We do that on a fair number of our platforms. I mean, I think that one takeaway is that that issue can be structured around. But the other I think kind of threshold question which I'm interested in is. Yeah, in the, in the context of a $50 million manufacturing company, you know, Andrew, you alluded to the idea that these profits interest plans don't go all the way down to the rank and file. What's a typical setup as far as how many people are getting these profits interest and what are their roles at the company?

Speaker C: Yeah, uh, no, I think it's, you know, generally in this context there would be maybe three to five individuals and it's pretty much anyone with a C in their title. So you have the chief executive officer, the cfo, some Chief operating officer. Those are the types of individuals who would receive the awards. After the top four or five people, it makes more sense to move to sort of a synthetic equity program for everyone because it's just easier to handle and they're not going to be real equity holders.

Speaker B: Right. Or even just a cash bonus program, which might be easier for people to understand.

Speaker C: Right, yeah. So when I say synthetic equity, oftentimes you'll get something like a phantom profits interest, which are in a lot of ways essentially a disguised transaction bonus. It's a fancy way of saying transaction bonus.

Speaker B: I hear you. Let's see. Okay, so before we, before we wrap, I do want to hit some other hot button issues that I get a lot of questions about. Let's talk about severance and for again, back to our example, our star chief executive that we're excited about. What are you seeing around terms of severance and related terms of non competes and things of that nature?

Speaker C: Yeah, absolutely. So severance is always one of those hot button issues. And generally the trend has always been is that an executive will try to negotiate that whatever severance amount they receive, which is often paid in installments over a period of time, the non compete period should be commensurate with that. So if you tell executive, okay, if we terminate you without cause or for, you know, there's a termination for good reason, we're going to pay you a year's worth of salary over 12 months and 12 equal installments. So a lot of the clients, or PE sponsors rather, would have non competes of, you know, a 24 month period. So executives will often push for those two periods to match. Because the rationale is if you're asking me executive to quote, sit on the beach, you have to pay me to sit on the beach for the same period of time.

Speaker B: Yeah, makes sense. And does that flow down? What are you seeing as far as severance and, um, people below the CEO. So CFO and others, anything.

Speaker C: CEOs we tend to see a year is very common. CFOs, the sort of the next rung of executives, we tend to see six months. An emerging trend that we've also noticed is that severance scales up with the amount of time that you stayed at the company, such that if you are, uh, terminated without cause in the year following the acquisition, you'll get, this is a hypothetical, of course, six months of severance. But if you make it past that first year, then you'll get 12 months of severance if you're ever terminated without cause.

Speaker B: Makes sense. That's interesting, but certainly lines up. So Andrew, this has been really fun chatting with you through all these topics. It's interesting they come up on every deal. The fun part is that I think each deal has a little bit of a different nuance to it where I'm picking up the phone and calling you or one of our other partners here at McGuire Woods. So I think while we covered a lot of ground, I think there's a ton of nuance to all these discussions that we didn't cover. So, you know, I think welcome anyone listening to Give Andrew a phone call me a phone call as you're kind of thinking through these issues on your deals. Andrew, really appreciate your time. Thank you very much.

Speaker C: Thanks Craig.

Speaker A: Thank you for joining us on this episode of Deal by deal, a, um, McGuire woods podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website@meguiarwoods.com we look forward to hearing from you. This podcast was recorded and is being made available by McGuire woods for informational purposes only. By accessing this podcast, you acknowledge that M. McGuire woods makes no warning, guarantee or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuire Woods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any any investment or course of action.