21 October 2019 - Article
1. What conflicts may arise in the course of negotiations between my interests, as an incoming manager, and those of incumbent management?
You will be negotiating many of the same points with a Private Equity House (‘PE House’) as the incumbent managers (who will often be rolling 25-50% of their sale proceeds into the acquisition structure). Typical negotiation points include leaver and vesting provisions, service agreements, restrictive covenants and other covenants and veto rights under the investment agreement. Your interests will not, however, be totally aligned with the incumbent managers as they may side with the PE House on certain issues such as the coupon on the institutional strip, the allocation of unvested management incentive shares and any rights you may seek to protect your position/shareholding.
2. What is a typical acquisition structure and would you clarify what you mean by sweet equity and institutional strip?
A percentage of the ordinary shares will be allocated to managers by way of share incentive-these shares are referred to as ‘Sweet Equity’.
The management team will want as much Sweet Equity as possible for minimal cost (10% of the equity for a subscription price of £1m is quite common but management pools frequently range from 10-20%). The management team should seek to negotiate down the coupon on the shareholder debt (given this amounts to a preferred return for the PE House.
Depending upon the nature of the business, part of the purchase price may be funded by bank debt. The balance of funds, apart from the Sweet Equity, is known as the ‘Institutional Strip’. This will comprise shareholder loan notes or preference shares (up to 95) at 8%-12% interest/coupon. Existing managers will roll over into the Institutional Strip on the same terms and ratio (equity to debt) as the PE House.
You should ideally take investment advice as to the value of your sweet equity. If you are able to negotiate down the hurdle rate on the loan notes or preference shares, this will materially increase the value of your sweet equity. PE Houses are usually looking for a combination of an internal rate of return of 20 per cent or higher and a multiple of invested capital of at least two times (2X). You may be able to argue for a ratchet to award you an increased share of the equity where performance is significantly above target eg where the PE House is obtaining in excess of three times (3X).
3. How much of the sweet equity should I expect to receive?
The split of the sweet equity will vary from industry to industry but with the CEO taking the largest share of the sweet equity, possibly as much as 8-10% but more usually 3-5%. A Non-Executive Chairman will not always be offered equity but if they obtain equity, much will depend on what is expected from their role and anything from 1-5% may be offered. In a brands business, the creative director may demand a greater share of equity than the CEO but it depends on the business. An example of a sweet equity split for a luxury brands business is set out below but the final outcome will vary from business to business.
Management Incentivisation Pool/Sweet Equity
Role – Shares
CEO – 4.00%
Chairman (Non-Exec) – 1.00%
CFO – 1.00%
Creative Director – 2.00%
Total C Level – 8.00%
Other Executive team members – 2.00%
Unallocated – 4.00%
TOTAL – 14.00%
In practice, sweet equity pools typically range from 8-20%.
A PE House will tend to restrict equity to the C Suite and a small number of other key executives. The spread of equity does vary between industries. For example, the spread of equity is likely to be greater in a technology business than in a retail business.
4. Other executives
If you are to be appointed as CEO, you will want to have input in the selection of the Chairman as he will have a significant impact on your delivery of the business plan and your relationship with the PE House and Fund limited partners.
5. Will I have to pay for my sweet equity up front?
The PE House may be willing to lend managers funds to pay the subscription amount on their sweet equity. The PE House may be willing to loan subscription monies at a favourable interest rate of perhaps 2.5/3 per cent over base rate. Any such loan would be repayable if the manager is a leaver or if there is an Exit and may otherwise have a long stop date of perhaps 10 years. Waiving the loan or interest below 2.5% will have adverse tax consequences.
6. Will I have to pay tax on my sweet equity when I acquire it?
Valuation advice will be required to ensure that the unrestricted open market value is being paid for the sweet equity. Otherwise, income tax will be charged on a disposal on the proportion of the proceeds representing the level of undervalue at the time of subscription.
7. The PE House has offered me a consultancy for pre-deal assistance – should I accept it?
If you are between roles you may be tempted to enter into a consultancy or other arrangement with a PE House in order to receive some compensation for your time spent helping put together a deal. This, however, should be carefully considered as the PE House may seek to impose exclusivity on you. This exclusivity would be designed to prevent you working with a different PE House to effect a deal for the proposed target company for perhaps 12 months. Whilst a consultancy arrangement with a PE House puts some money in your pocket, it weakens your and the sellers’ negotiating position once any exclusivity for the PE House’s acquisition of the target company has expired (given your exclusivity will run from the expiry of your consultancy). If the PE House’s approach on the acquisition is unacceptable to the sellers, the sellers might be minded to look elsewhere for an investor. However, if they are wedded to bringing you in, any exclusivity provision you have signed up will prevent the sellers from convincingly arguing that they will switch to another PE House for investment.
8. What length of restrictive covenants should I expect?
The management sellers will realise significant goodwill from the sale of the business. Typically they would roll over 20-50% of their sale consideration into shares in the acquisition vehicle. You, on the other hand, will not be realising any value on joining the business and arguably should therefore be subject to shorter restrictive covenants. Many PE Houses look for restrictive covenants of 24 months for an incoming CEO and 18 months for other C Suite executives. These restrictive covenants will be contained in the investment agreement as restrictive covenants of this length would not be enforceable in your employment agreement. The risk for you is that you join and in the early years before your sweet equity has accrued significant value, you are replaced by a new CEO. PE Houses tend to act quickly if they have doubts about a CEO; removing a CEO within the first 12 months of an investment would not be unusual. You are therefore more likely to want to achieve some financial protection against being forced out of the business in the early stages given the length of the restrictive covenants you will have imposed on you. Alternatively, you may look to argue that the length of the restrictive covenants be reduced if you are removed without cause or constructively dismissed.
9. What should I expect regarding my service agreement?
Although it is the sweet equity which has the potential to provide you with a significant return for your efforts in growing the company, it is important to ensure that your service agreement is closely scrutinised and negotiated. If you are dismissed summarily under your service agreement, this is likely to mean you are a bad leaver with the result that you obtain the lower of cost and market value for your sweet equity, and still have the liability to repay any loan you took out when subscribing for the equity. For that reason, the circumstances in which you may be removed summarily should be restricted. You should also look to obtain a range of benefits appropriate to your status eg pension, life assurance, income protection, car allowance, D&O insurance, private health insurance. A PE House will normally insist on a payment in lieu of notice (PILON) provision (and you should try to argue that this is paid in a lump sum rather than in instalments and takes into account the value of contractual benefits).
As with the restrictive covenants in the investment agreement, you should argue that any period of garden leave is deducted from your restricted period. The restrictive covenants in your service agreement will be shorter than in the investment agreement (eg for a CEO they might be 24 months in the investment agreement and 12 months in the service agreement). To the extent you have existing business interests, these would need to be expressly carved out from the covenants in the service agreement and investment agreement.
Depending on your circumstances, you will want to review a number of different issues in your service agreement such as place of work, the ability for the employing company to change your role and the basis on which your salary will be reviewed going forwards. As regards termination for ill-health, you would want to be retained as an employee if you would be entitled to claim under the employer’s group income protection or life insurance policies and this should be carved out of the employer’s right to terminate your employment.
As mentioned above, your return from your efforts is primarily obtained through your sweet equity. Nonetheless, you should look to obtain a bonus, perhaps of 50-75% of salary linked to EBITDA, or another suitable industry metric. PE Houses are reluctant to reward underperformance and so are often reluctant to award bonuses on a sliding scale and are more likely to insist on cliff entitlement at or above the target level, or possibly at 90-95% and above of the target. You would want the bonus paid shortly after the end of the relevant financial year end.
You would ideally want to benchmark your salary. By way of example, 2019 C suite remuneration in a PE backed retail business with sales of £100-£150m might be in the range of £150,000-£250,000 base salary plus a 75% bonus and sweet equity allocations in line with those set out in paragraph 3 above.
You will need to take advice on the termination of your existing employment agreement including restrictive covenants and confidentiality.
10. Corporate governance
You would ideally argue for a smaller board (and therefore a limited number of PE House appointees) to keep board level discussions manageable. In addition, you should restrict the fees the PE House is entitled to charge for is appointed directors. It may be appropriate to give the PE House Directors weighted voting rights so that they control the board without having to swamp the board by appointing a majority in number of the directors.
11. Can you explain how my sweet equity will be treated if I leave the business?
A PE House will usually insist that resignation is a bad leaver event and restrict good leaver to the PE House’s discretion and ill-health, retirement and death. You might be a bad leaver if you are summarily dismissed or resign. In other circumstances you may be an intermediate leaver (including if a PE House exercises its discretion to treat a bad leaver as an intermediate leaver). A PE House may argue that a leaver who breaches restrictive covenants should be treated as a bad leaver.
The typical valuation matrix for leavers might be:
Good leaver: market value
Intermediate leaver: 25% per annum vesting at market value up to 75%; the balance at lower of cost and market value
Bad leaver: the lower of cost and market value
You should ideally argue for daily or monthly vesting to avoid ‘cliff’ vesting and for 100% intermediate vesting.
12. What warranties will I need to give?
You will not be required to give warranties about the target business but would be expected to warrant your own personal information and the business plan and forecasts and any reports obtained by the PE House (eg commercial report and legal, finance and tax reports). You should only warrant reports subject to your awareness and on a qualified basis. A cap on liability for breach of warranty of 1-2 times salary is common for an incoming manager.
13. In what circumstances will I be forced to sell my sweet equity?
If the PE House finds a third party purchaser for a controlling stake in the business, it will be able to force the sale of shares by all shareholders (a drag-along).
14. What happens to my equity if the PE House sells out?
An incoming manager will want to have a tag along (i.e. a right to sell out) if a third party acquires a controlling stake in the business.
15. Will I be able to claim entrepreneurs’ relief regarding my sweet equity?
As regards your sweet equity, you need to ensure that, if you expect to retain 5% or more of the equity (voting rights, capital and sale proceeds or economic interest), you are able to claim entrepreneurs’ relief on any exit. There are traps for the unwary. For instance, if preference shares carry no coupon, they would be treated as ordinary share capital which might then mean that the 5% threshold was not satisfied by a Founder/CEO with more than 5% of the ordinary share capital unless the preference shares had a very low nominal value. Preference shares may also be treated as ordinary shares if they have a fixed coupon which varies if a holder is a bad leaver. Preferential rights of other classes of shares may also deny you entrepreneurs’ relief in some circumstances. You also need to take care with the leaver provisions in that you may cease to be an employee and director prior to any sale of your sweet equity being triggered which would mean you would not be entitled to entrepreneurs’ relief.
Other tax issues will also need to be considered. For instance, if loan notes are issued instead of preference shares, you would want to have a veto over the issue of additional notes to satisfy outstanding interest as that may create a tax charge.
16. Do I need veto rights and how else do I protect myself?
To some extent you can take comfort from what the management sellers negotiate. At the very least, the management sellers will require a veto over any change to the target company’s articles and/or the rights attaching to any shares which has a materially adverse effect on them which is disproportionate to the impact it has on the PE House. The management sellers will also want to have protection against dilution in the company’s articles of association. You would ideally look to obtain a similar veto. What you can obtain will depend on your bargaining position but you should certainly obtain pre-emption or catch up rights to protect you from dilution (ideally as regards both equity and debt securities).
The level of veto rights that may be obtained will be heavily influenced by the negotiating power of the parties. For example, if the target company is an eponymous brand, the Founder (if remaining in the business) would expect to retain vetoes over matters such as the disposal of the brand, creative decisions and any material change in the business. In other situations, it may be harder for the management team to justify these kinds of protections as the PE House will insist on flexibility to maximise its investment return. Ideally the management sellers would have firmed up the position on vetoes and other key provisions in heads of terms signed up with the PE House (at the time when the management sellers are able to play one PE House off against another and thereby extract some concessions).
There will be numerous points in the legal documents where negotiation will be warranted. For instance, you would want to ensure that the management incentive pool is ring-fenced for management (and ideally fully allocated on any exit). This means that the sweet equity held by a leaver should be allocated to other management or the company’s employee benefit trust and should not be allocated to the PE House. You should negotiate the definition of fair value which dictates what price leavers obtain for their shares. The terms on which any valuer is to be appointed and how they are selected may also have a material impact on the valuation of your sweet equity.
17. Who will pay my legal fees?
The PE House will agree to a capped amount being paid for managers’ legal fees. The payment of these fees by newco will create an income tax charge on the amount of the fees.