One of the keys of successful private equity investing is properly aligning the economic incentives and interests of the sponsor and its portfolio companies’ management teams as they evolve over time. Unlike a public company, where management may receive higher annual compensation (typically taxed at higher rates as ordinary income) because no exit event is contemplated, much of the compensation for a portfolio company’s management team is often tied to proceeds from a future exit transaction by the sponsor (often taxed as more favorable long-term capital gains), which helps ensure the management team and the sponsor target the same value-maximizing sale outcome and timeline. These arrangements are typically put in place at the time of the sponsor’s initial investment or shortly thereafter, often via direct investment (which may be “rollover” equity) and incentive equity grants.

Flavors of Capital: Direct Investments and Incentive Equity

Direct investment by a management team in a sponsor-led buyout typically consists of (i) rollover of a portion of their existing equity (on a tax-deferred basis, where possible, and which may include the value of incentive equity previously granted by a prior sponsor) and/or (ii) investment of after-tax cash transaction proceeds (often in the form of transaction bonuses and/or option cash-out proceeds). Whether management receives the same security as the sponsor or a junior security is a negotiated point.

Incentive equity often takes the form of newly granted (i) options, (ii) restricted stock units and/or (iii) profits interests, and is typically subject to time-based and performance-based vesting. While option awards initially predominated in U.S. private equity transactions, sponsors now often grant tax-advantaged profits interests to the U.S. members of their management teams, with various other approaches for the non-management members and foreign employees. Profits interests grants may create tax complications and income events for employees in a number of non-U.S. jurisdictions and alternative approaches predominate in those situations.

Repurchases: What to do When Someone Departs

Because both direct investments and incentive equity are designed to provide a “payday” to management simultaneously with the sponsor’s exit, the future utility for retention and motivation dissipates when an employee departs and the exit remains far on the horizon. Most sponsors take the view that a departing employee should rightly participate in the value he or she helped create prior to departure, but any post-departure value creation should accrue only to the employees who remain with the portfolio company and new/replacement hires (who typically receive equity awards with a strike price or threshold value that is roughly equivalent to the value of the awards held by the departed employees as of the time of their departure). Historically, this has been accomplished via a call option on direct investments and vested incentive equity awards (in “good leaver” situations) at fair market value at the time of departure, ceasing participation in future appreciation, and payable with either cash and/or a note. Unvested incentive equity is typically forfeited, and in “bad leaver” situations all incentive equity (including vested incentive equity) is typically forfeited. These call rights usually fall away on an IPO.

The Problems With Note Repurchases

Historically, sponsors choosing to repurchase equity from departing employees have had the right to pay with cash and/or a note, with the terms of each varying from deal to deal and sponsor to sponsor. While utilizing a note alleviates the immediate cash need, it does require the payment of interest to the departed employee (which can be PIK) and moves the former employee to a preferred liquidation position (senior even to the sponsor’s equity) with a guaranteed value and return, even if the value of the portfolio company declines. Payment with a note also requires time and legal expense, which may not be justified for small equity repurchases, and typically the former employee is expected to sign the note and repurchase documentation, which they may be reluctant to do. Also, depending on the portfolio company’s structure, debt covenants may prohibit the issuance of a note.

The Problems With Cash Repurchases

Payment with cash may be somewhat simpler than payment with a note, but the portfolio company may not have sufficient cash on hand and, even if it does, that cash may be subject to legal and/or contractual restrictions (such as debt covenants) that preclude its use. Also, competing uses of cash, such as paying down debt, investing in the business, returning capital to investors, etc., may be more beneficial to the issuer (and remaining shareholders) than paying cash out to redeem equity from a former employee. If there is not sufficient cash on hand, while sponsors can potentially invest more to fund the repurchase, they may not want or be able to, and ongoing cash infusions can affect tax holding periods for the sponsor. This is particularly true if the relevant fund is “tapped out” or would prefer to use the cash for other opportunities, and/or if the issuance requires a preemptive rights process. Senior management team members (such as the CEO or CFO) may have significant holdings, which would require substantial cash for repurchase, and their departure may create questions around the portfolio company’s current valuation and future performance. Both the sponsor and the remaining employees may object to a departing employee receiving cash in exchange for their appreciated equity before anyone else, even if the upside potential of the redeemed equity is eliminated. Finally, even where cash is available, it may be “trapped” at a lower-tier entity and require complex tax structuring, or a taxable dividend, to make it available for an equity repurchase at the holding company level, and debt covenants may prohibit the use of cash, even if available.

An Elegant Solution

As sponsors have grappled with the complications of using call rights to limit equity appreciation to departed employees, in some quarters an alternative approach has emerged: the “equity freeze.” In an equity freeze, the future value of a departing employee’s equity is automatically capped at its value as of the time of departure. Through this mechanism, which is embedded in the relevant equity agreements from day one, the departed employee will not participate in future appreciation (to which the employee does not contribute) but will be subject to decreases in value alongside the other investors.

Private equity investors are increasingly concluding the equity freeze has many benefits, including: (i) no cash needed; (ii) no interest payments; (iii) future appreciation accrues only to the ongoing participants in the business, not departed employees; (iv) the former employee’s liquidation position does not become senior to the sponsor’s equity (as it would with a note); (v) the value of the former employee’s equity decreases if the value of the company decreases (which may be a direct result of the employee’s departure) and/or the share count increases; (vi) the former employee continues to be linked to the business and its long-term success; and (vii) all of the mechanics are automatic and do not require additional signatures from the former employee or complicated legal documentation. While this solution is somewhat new, it is of increasing interest to sponsors and has been proven to work in the real world.

This post comes to us from Goodwin Procter LLP. It is based on the firm’s memorandum, “Equity on Ice: A Solution for the Repurchase Conundrum,” dated May 7, 2024, and available here.