As buyout firms navigate current pressures on portfolio company financial performance, we have seen a growing number of sponsors consider resetting management incentive plans (MIPs) to reincentivise management, either as a standalone measure or as part of a broader business restructuring. MIPs may be diluted and/or management equity “underwater” due to shareholder debt interest outstripping the company’s rate of growth, or additional funding increasing financial hurdles, in each case resulting in the equity held by management being out of the money. While the optimal solution will depend on existing structure, jurisdiction, financial performance, commercial objectives, and exit strategy, we discuss four recently observed methods and the related key issues for sponsors to consider.
Historically, cash bonuses and other “phantom” equity plans linked to performance hurdles being achieved at exit have been less attractive due to tax inefficiencies; the payment of a bonus is treated as employment income and taxed accordingly. Nevertheless, such plans have become a popular choice in recent deals because they are straightforward to implement and do not typically require (a) capital structure amendments; (b) management funding their own participation; or (c) a third-party valuation of equity.
Employee benefit trusts (EBTs) can also work well alongside a cash bonus or phantom share plan. With the right planning in place, shares in an EBT can be liquidated at exit to fund phantom equity or cash plan awards. However, to the extent not funded by an EBT, a potential buyer may assert that bonus costs should be deducted from the purchase price payable to a sponsor at exit. Further, “rollover relief” enabling a manager to defer capital gains tax by reinvesting a portion of exit proceeds into a buyer’s structure will be unavailable.
When existing growth or return hurdles attaching to management’s equity are based on a business plan which did not contemplate financial underperformance, we have seen sponsors reset hurdles in line with a revised business plan to keep management incentivised.
This will require amendments to the company’s constitutional documents and a third-party valuation, which can add time and expense. Further, if resetting existing hurdles increases the value of the management equity, the employee and the company will pay employment taxes on the increase (at the point of implementation). While an increase in value (and therefore tax payable) should normally be minimal if the MIP is underwater, managers may be unable or unwilling to fund these liabilities and a sponsor may need to consider the provision of a loan or “grossed-up” bonus. Loans need to be carefully structured to mitigate tax charges and address complex regulatory issues. However, any further upside at exit should benefit from capital gains tax treatment and managers will not need to pay any further subscription monies for their equity.
As an alternative to resetting existing hurdles, a new class of growth equity with more achievable hurdles, or preferred equity ranking ahead of existing equity could be issued to incentivise managers. This method has become increasingly popular, alongside the increased use of cash bonuses and phantom equity plans. This will also require amendments to the company’s existing constitutional documents and a third-party valuation.
Managers will need to pay fair market value for their new equity, or employment taxes will be due on the difference between the market value of the shares and the price that the managers pay (if any). Any upside at exit, however, should benefit from capital gains tax treatment. If managers are unable to fund the subscription price for the equity using personal funds, a sponsor may wish to consider providing loans. As above, there are complex regulatory and tax considerations to navigate when providing loans to managers.
When the coupon accruing on the sponsor’s shareholder debt exceeds the growth in value of the company’s ordinary equity, we have seen sponsors consider temporarily reducing the coupon on all or a portion of the shareholder debt to enable management’s equity to “catch-up”. When the ordinary equity is heavily underwater, and simply reducing the coupon will not sufficiently reincentivise management, a portion of the shareholder debt could also be waived.
A third-party valuation is required to determine the impact of the amendment or waiver on the value of the equity held by management. If the amendment or waiver will result in an increase in value of such equity, then the abovementioned employment tax consequences may apply, and management and the company may face tax charges. In addition, corporation tax may be payable by the issuer if the amendment or waiver results in a credit arising in the accounts of the issuing entity, unless an exemption under applicable tax legislation applies. We have seen this option being used less frequently than resetting hurdles or creating a new class of equity, as sponsors have found that resetting the MIP or creating a new class of equity is easier to communicate to management and incentivise them going forward.
In our view, sponsors will continue to need to be creative when thinking about how best to incentivise management. The most appropriate course of action will depend heavily on the facts applying to a particular sponsor’s situation, and may even result in a combination of approaches being pursued.