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Things Managers Should Think About When Investing in a Private Equity-Backed Transaction
Like any relationship, there are pushes and pulls built into the dynamic of private equity and company management. Asking management to own equity in a business is a way for private equity to create aligned interests and get everyone pulling in the same direction. These proposals from private equity buyers to management can create a huge range of emotions from pure terror to total elation. While the very ends of that spectrum are rarely warranted, it is important to understand the financial relationships you will have with your new partner.
First, let’s explain the situation a bit. If you are a manager or an owner that is remaining post sale of a business, and you are selling to private equity, chances are they will ask you to invest along with them.
Investing Back Into the Company
If you are an owner and you are receiving proceeds from the sale transaction, you may be asked to invest a percentage of those proceeds back into the business – which, theoretically, keeps everyone aligned. The average range that PE groups like to see is about 20% of the equity coming from the management team, but most will settle for “a meaningful amount.”
If you are a manager, you may be asked to invest alongside the private equity group as well. If you don’t have the personal capital to do so, many groups will offer you low or no-interest loans with which to make the purchase. In some cases, managers receive a transaction bonus, which they then turn around and invest alongside the private equity partner.
Many times, this investment can be structured as a tax deferred event, meaning you will not have to pay taxes on the proceeds you are reinvesting until the company is sold again.
For a lot of people this is an amazing opportunity to create real wealth. Your new private equity partner will be focused on growing the business and will want to exit in 3-7 years.
The Management Option Pool
In addition to actual invested capital, some private equity groups will set aside some equity available as options for management. Usually, this incentive equity pool is 10%-12%, but can vary quite a bit depending on the transaction and type of company (technology company options can be much higher).
These options vest based on some target deliverables, such as profitability or sales growth, and most are also based on time at the company. There can be quite a few restrictions around these shares, and if an employee leaves, they will generally forfeit any unvested options and may be required to sell equity back to the company (usually at fair market value).
Where Things Can Go Wonky
All this seems perfectly reasonable as a partnership in the beginning. When stressors are added to the business or the relationship, things can get a bit sticky.
1) Sometimes, private equity groups pull an Orwellian move and make their equity better than management’s equity. If the company is sold and after debt is paid off and advisors are paid, they pay themselves first, management may not get the return they were expecting. Look out for unexpected preferences in the private equity stock versus yours.
2) If the company is sold to another private equity group, you may be asked to roll as much as 50% of your proceeds back into the business. Again. The sale event creates a nice window for shareholders to get a payday, but the new private equity owner is going to want the same thing as the last private equity owner and you might not be able to pull all your cash out.
3) If you want to leave before the company is sold, you probably won’t get top dollar for your equity. There are generally no put rights or exit opportunities available outside of when the company is ultimately sold. If you leave the company (willingly or unwillingly) many groups require you to sell your equity back at fair market value.
4) If the company doesn’t do well, you have the double whammy of equity that isn’t worth much, and you might be out of a job. My asset manager friends would tell us that this is a terribly undiversified position.
5) Yes, you are an owner, but there will be days when you will not feel like one. Many (most?) private equity companies will tell you that they have no interest in managing the business, but in reality, they will participate in all large decisions – including when and to whom, the company is ultimately sold.
6) There are these things called Management Fees – which are a bit of a misnomer because they don’t go to management, but to your private equity partner. Not all of them use Management Fees, but you should be aware of the practice. It’s not really a “bad” thing (although it rubs some people the wrong way), it’s just important that you understand that your fellow equity holders have a mechanism to take cash out of the business and you do not.
The Bottom Line
I am not trying to scare you here. I have seen management equity turn into life-changing dollars for people. They can be unbelievably good investments. But that’s just the thing. These are investments and you should treat them that way. Make sure you understand the financial structure of the company you are buying into – how much debt, are there preferences, etc. Make sure you are comfortable with your new partner and their plans for growth. Asking the right questions upfront will make this go forward partnership more comfortable for everyone.