Kramer Levin has prepared the 2013 Private Equity (“PE”) Portfolio Company Incentive Equity Compensation Survey (the “KL Survey”). The KL Survey analyzes key terms in incentive equity compensation programs offered by private equity firm portfolio companies. In particular, the KL Survey:
- analyzes key variables in the incentive equity compensation programs of 31 PE-sponsored companies represented by Kramer Levin, where the compensation program was implemented in 2008 or thereafter;
- compares our findings to those set forth in a similar study conducted by PricewaterhouseCoopers (the “PwC Survey”); the PwC Survey analyzed the incentive compensation programs of 32 PE-sponsored companies, where the compensation program was implemented between January 1, 2006 through April 30, 2008; and
- illustrates trends and market developments since 2008 in structuring incentive equity compensation programs in the privately held PE-sponsored portfolio company.
The findings in the KL Survey highlight the following developments and trends:
The Rise Of Profits Interests
Profits interests have become more prevalent and are now widely used to effect incentive equity grants. In the PwC Survey, 81 percent of the grants were stock options, while in the KL Survey, 75 percent of the grants were profits interests. The growth in popularity of profits interests since 2008 is directly correlated with the increased use of (and familiarity with) limited liability companies. Limited liability companies are very flexible vehicles that are designed to give effect to the parties’ contractual goals, including the manner in which the members participate in current distributions and distributions upon sale or liquidation. Profits interests are more tax efficient than stock options from the grantee’s perspective; profits interests enable a holder to participate in future appreciation in the issuer’s equity value after the grant date without contributing capital and without recognizing tax upon receipt or vesting of the interests. Profits interests also allow the holder to potentially receive capital gains treatment upon disposition and to be eligible to participate in current distributions. The ability to participate in current distributions has become more important to management teams as leveraged dividends have increased in popularity recently.
Increased Pool Allocation
In the PwC Survey, a majority of the compensation programs had an allocation between 6-10 percent of outstanding capital, while the KL Survey shows that a majority of compensation programs fell in the 11-20 percent range.
In the KL Survey, 69 percent of the compensation programs provide for only time-based vesting and 31 percent provide for a combination of time- and performance-based vesting. The PwC Survey had a higher frequency of time- and performance-based vesting at 75 percent of the compensation plans in that survey.
The KL Survey shows that vesting periods are usually four or five years (52 percent and 34 percent of the programs in the KL Survey, respectively), typically with annual vesting (66 percent); most of the incentive equity programs provide for automatic and full acceleration of vesting upon a change of control of the issuer.
Participation In Distributions For Unvested Incentive Equity
In the KL Survey, we found that over a majority of the compensation programs permitted holders of unvested incentive equity interests to participate in current distributions by the issuer. The distributions are typically placed in a set-aside or escrow account for the benefit of the holder and amounts are released to the holder when the corresponding incentive equity interests vest. In 67 percent of the cases where there is a set-aside or escrow account, interest accrues on the amounts that were subject to hold-back.
Repurchase Rights; Put Rights
In both surveys, a company call right with respect to vested equity upon termination of service applies in almost all incentive equity compensation plans. A put right in favor of the employee is much less prevalent — appearing in roughly 20 percent of the compensation plans and often limited to “good” leavers. The repurchase price paid by the issuer is usually a function of the reason for termination, with a bad leaver (for-cause termination; resignation without good reason) often receiving less than fair market value (100 percent in the case of for-cause termination, but only 32 percent in the case of resignation without good reason) and a good leaver (termination without cause; resignation with good reason) often receiving fair market value for the vested equity interests. The employee put is usually at fair market value (71 percent in the KL Survey). In most cases, unvested equity interests are forfeited upon termination of service regardless of the reason for termination. If the equity interests are not repurchased by the issuer upon termination of service, in a majority of the compensation programs, the equity interests convert into passive economic interests resulting in a forfeiture of non-economic rights, such as voting rights, preemptive rights and tag-along rights.
Published December 17, 2013.