In buyout or take private transactions, the management team of the target business is a key constituency that frequently—yet often unknowingly—requires legal counsel to advocate for its interests. The management team’s interests may be implicated in such transactions in various ways, which differ from those of institutional equity sellers, given that members of management are service providers and, in many cases, equity holders of the target business, who are expected to rollover proceeds to align their interests with the purchaser.
Retaining management team counsel is intended to help management identify the attributes and the potential pitfalls and shortfalls of equity and employment documentation that management is being asked to sign in connection with such transactions. Management teams are wise to seek counsel to understand what they are being asked to sign and whether it is consistent with applicable legal requirements and counsel’s perspective on market practice in order to protect their investment and the potential return on their efforts.
Key Management Team Considerations
Counsel for the target business’s management team as a whole or for certain key executives (such as the CEO) may encounter some or all of the following in the context of a buyout or take-private transaction:
Current Equity or Transaction-Based Compensation
Members of management are frequently incentive equity holders of the seller or recipients of sale or retention bonuses awarded by the seller that are payable in connection with the closing. The equity awards may be full value (e.g., restricted stock) or appreciation (e.g., options, profits interest, or stock appreciation rights) awards that are realized upon or in connection with the transaction. Vesting terms (including potential acceleration events, change in control definitions, performance measurement, etc.) and payment timing of then current arrangements will need to be analyzed. Compensatory tax issues (e.g., Code Section 280G or 409A) may also rear their head for attention.
New Equity or Transaction-Based Compensation
In addition to then current transaction-related compensation or realization of equity proceeds on previously awarded equity incentive programs, management and purchasers will negotiate go-forward equity compensation arrangements that are tied to future upside in the business.
The structure (e.g., full value vs. appreciation awards) and terms of such awards are highly negotiable, and many private equity purchasers utilize certain programs across their portfolio that have a mix of time-based and performance-based equity. The size of such equity pool, the allocation of such pool at closing (and reservation of dry powder for future grants), the scope of eligible recipients (e.g., whether it includes independent directors and consultants), and the vesting terms of such equity are negotiated in most cases prior to closing, and in many cases in all material respects prior to signing.
In addition to vesting conditions applicable to such awards, many other terms relating to equity compensation and the arrangements applicable thereto (such as LLC, shareholders, and partnership agreements) must be fleshed out, such as liquidity (e.g., call rights, tag along rights, etc.). Additionally, the purchaser may seek to enter into retention arrangements with key executives in order to incentivize them to remain with the company following the sale, and the terms and conditions in those arrangements are also key.
Employment, Compensation, and Restrictive Covenant Terms
Members of management typically have existing employment agreements, compensation arrangements, and employment-related restrictive covenant arrangements in effect prior to the sale process. Given the presence of new purchasers, management may wish to revisit and potentially enhance employment and other compensation arrangements to reflect a purchaser structure, a larger business, or a modified role (e.g., in the context of an add-on or carveout of a business where a new leadership structure emerges) or to revise for the latest market trends.
Further, depending upon the timing of closing, executives’ bonus and long-term incentive compensation opportunities that include the year of closing may need to be addressed, especially if the transaction affects management’s ability to achieve any applicable performance criteria or such criteria are not easily mapped to a post-closing environment. Addressing compensation prior to a closing may also assist in planning for potential excise taxes and loss of deductions in connection with the transaction, which the parties are aligned to mitigate.
Even where employment related restrictive covenants already exist, purchasers frequently seek to subject selling executives who are receiving substantial proceeds to additional closing-based restrictive covenants. These covenants include noncompetition restrictions that apply for a specific period of time following closing, and, as such, they often differ from those in employment agreements or employment-based covenant arrangements, which tie to termination of employment.
Given the differences, the restricted business covered by closing-based restrictive covenants would generally be static and described as of closing as to what business is being purchased, as opposed to employment-related noncompetes that generally cover the business as in effect at the time of a future termination of employment. Management counsel should closely review the terms of all existing and newly proposed restrictive covenants (including those that may show up in purchase agreements, stand-alone covenants agreements, and employment or equity arrangements) to ensure that they are reasonable and not overly burdensome to the executive.
Rollover Equity
In many mergers and acquisitions (M&A) transactions with private purchasers, the purchaser will require (and in some cases, offer the opportunity to) individual executives or the entire management team to “roll over” (i.e., invest in the go-forward business effective as of the closing) a substantial portion of their sale proceeds in respect of their existing vested equity or equity-based compensation. The quantum of any such required rollover is often subject to negotiation and is intended to align the purchaser’s interests with those of management by causing management to have “skin in the game.” Management may desire to roll over because they believe in themselves and in the new purchaser’s/investors’ potential to grow the business and thus their investment.
Further to be negotiated is the structure of the rollover and whether the rollover is intended to be tax-deferred. Various documentation is implicated, including rollover structuring and subscription documentation, and applicable shareholders/operating/partnership agreements and/or side letters containing material economic and non-economic terms concerning the rolled equity (and incentive equity). The class and purchase price of management’s roll-over equity is often sought to be on equal footing with the purchaser.
In addition, various other rights and terms relating to rollover equity are often ripe for negotiation by management counsel, such as whether (and for whom) the rollover will be required or optional, preemptive and tag along rights, drag along provisions, liquidity rights, information and access rights, minority protections and consent rights, treatment upon a termination of employment (and related “cause” and “good reason” definitions), board membership or observer rights, and provisions for affiliate transactions, decision-making, and amendments under the company’s (or parent’s) governing documentation.
The terms of the rollover equity are generally negotiated pre-closing, especially if the rollover is intended to be tax-deferred (as opposed to rollovers effectuated on an after-tax basis), in which case the action and structure of the rollover are typically undertaken pursuant to a negotiated contribution or similar arrangements to reflect such structure.
Similarly, if derivative equity awards (vs. fully vested true equity) are being rolled, then management counsel will need to understand and consider in advance of signing the terms of the existing equity awards being rolled over, including the expiration date (if any) of the award, whether the rollover would constitute an impermissible modification, deferral or payment event under Code Section 409A, the relative value of the existing awards vs. the rollover equity, post-termination exercisability of derivative securities, and numerous other factors.
In addition, management counsel should ensure that the valuation mechanics applicable to rollover equity upon a post-closing termination of employment are equitable for the management team, including with respect to allocation of valuation costs in the event of an exercise of any appraisal right.
While the above provides a high-level description of certain key considerations for management in the transactional context, the actual considerations and approach depend heavily on the facts and circumstances of such transactions, such as transaction type (e.g., stock sale, asset sale, merger of equals, carveout, etc.), type of purchaser and target business (e.g., public company going private, private equity purchaser of private company, carved-out business, etc.) and other attributes (e.g., type and terms of existing equity awards and/or new go-forward equity awards, etc.).
How We Can Help
Our executive compensation lawyers stand ready to assist management and senior executives navigate the matters discussed above. We regularly counsel with respect to such structuring, market terms, and legal considerations and negotiate for clients to enhance employment and equity packages and mitigate risk. Please contact the authors of this blog post or your Morgan Lewis contacts with any questions.