Private Equity groups believe that the selection of the right CEO to lead their portfolio companies is critical to their success. They will seek an individual with a strong track record of P&L achievement in the same or a related industry. Once they’ve found this person, they will want to agree on a compensation package which aligns the executive’s interest with their own.
The most important way in which interests are aligned is through equity ownership. The PE group will want the executive to invest in the acquisition as a tangible demonstration of his/her commitment to the venture. They will also create a plan whereby the CEO and other senior executives can earn additional equity by achieving defined operational results. This earned equity allows the executive to create real wealth during his/her tenure with the company. It’s therefore important for the CEO to understand how to maximize this very important component of compensation.
Strengthen Your Negotiating Position
Bring the deal – Presenting an acquisition target gets the attention of PE groups immediately. It also shifts the power dynamic from one in which the PE is choosing a CEO to one where the CEO is choosing among PE groups.
Have a plan -Be prepared to present a plan for growing the business. Some key elements of the plan are:
Organic revenue growth
Likely exit options.
PE’s understand that things will change once you are actually running the business, but a well thought out plan will serve to demonstrate your strategic thinking as well as make them more enthusiastic about the target.
Have an agent – Negotiating hard with your soon-to-be boss can be very awkward. Having someone whose role is to negotiate on your behalf allows you to maintain a collegial relationship with the PE throughout the process. Whether you use an attorney or investment banker in this capacity, it’s important to choose someone who is well versed in the range of terms which are achievable in this type of situation. The value of this negotiation can translate into millions of dollars a few years later when the PE is exiting the investment.
What are the key parameters?
The amount of equity – The range of equity allocated to management can range from 8-20%. Where a given situation falls within the range depends on several factors including the industry, your strength as an executive and how badly the PE wants to get in on the deal. If the PE believes the deal is theirs if they want it, they won’t be as generous as when they believe they’re competing to get in on it.
The percentage allocated to the CEO – The range for the CEO is typically 33-50% of the management incentive pool. If you’re perceived as a strong leader and if you’re bringing the deal, you should be able to get to the top of the range.
The terms by which the equity is earned – When it comes to this type of negotiation, the devil is definitely in the details. It’s very unusual that any of management’s shares are granted unconditionally. Some of the common bases for granting shares are tenure, achieving operational objectives and achieving the ultimate exit value for the company. Some combination of these is typical.
There are several factors that can make the management equity pool less valuable than it appears on the surface. It’s important to understand these clearly:
Strike Price – This means the price that management pays for its shares. The price may be set at or below the initial price paid by the PE or it may increase if the PE has to make additional equity investments for add-on acquisitions. The effect is to reduce the value of management’s shares at exit. For example, if the price of each share is $1 at the time of the initial acquisition and at exit it is $3, then management’s 15% will effectively be the same as 10% with no strike price.
Dilution – Do management’s shares dilute as the PE makes additional investments. If so, their ultimate value is very uncertain.
Preference – The PE may argue that they should receive their invested capital before the value of management’s shares is calculated. This may be acceptable if there is a catch up provision so that as long as a certain minimum return is achieved, management will get the full value for its shares.
While each situation is different, we believe that the best deal can generally be struck using a structure wherein management’s equity is undiluted and has no strike price as long as the PE’s return is above a specific level.
The CEO can maximize the long term financial value of the venture for management by focusing on the equity component of compensation. The keys are planning to maximize your negotiating leverage, understanding the various parameters and working with a capable advisor/agent.
Michael B. Ribet is a partner at Capital Results (http://www.capitalresults.net), a Chicago investment bank which assists “bankable” entrepreneurs in acquiring large companies in conjunction with Private Equity groups. He can be reached at (312) 541-6232 or firstname.lastname@example.org.