Probably the most common form of vesting criteria for performance-based incentive equity in private equity transactions is based on the sponsor’s achievement of a multiple of invested capital and/or internal rate of return. Typically, the sponsor seeks a multiple taking into account both cash proceeds received from the portfolio company, such as through receipt of cash dividends, and cash proceeds from the disposition of its equity securities. If, prior to a change of control, the sponsor receives non-cash proceeds, such proceeds usually are not taken into account until they are reduced to cash. Although these mechanics generally are straightforward, complications arise when addressing the consequences of a change of control or an IPO. The following addresses some of the issues that arise in connection with determining whether performance-based vesting criteria have been achieved in the context of a change of control.
If a sponsor were to sell all of the equity securities of a portfolio company for a fixed amount of cash, all paid at the closing of a change of control, the determination of whether or to what extent management’s performance-based incentive equity vests would be simple. The problem is that virtually no transaction is structured without some sort of contingent or non-cash consideration, whether in the form of a purchase price adjustment, escrow, holdback or earn-out or perhaps a seller note. In addition, even though a transaction may result in a change of control, the sponsor may retain or roll over some of its equity securities in the portfolio company. In these situations the objectives of the sponsor and management may diverge. Typically, although not always, management wants the final determination of whether or not its performance-based incentive equity has vested to be made at the time of the change of control. If the sponsor receives any non-cash or contingent consideration or retains or rolls over equity, management would like such consideration or retained or rolled over equity to be valued and taken into account as cash in determining whether the performance vesting criteria have been achieved. For the sponsor, there are potential problems with this approach.
The problem with valuing all non-cash, contingent consideration (including even marketable securities) and retained or rolled over securities is that the sponsor may never receive cash in the amount that such consideration is valued, through failure of conditions to receipt being satisfied or failure to realize on the non-cash portion. There are also a number of problems with valuation depending upon the nature of the consideration. For example, how does one value the right to receive cash held in an escrow that will be paid out if certain litigation is resolved favorably? What about a purchase price adjustment based on whether actual working capital is different from targeted working capital? What about an earn-out? Applying traditional valuation principles to these types of assets or rights is difficult at best. Even if the documents provide that the board will make the determination in good faith, taking into account all applicable discounts, including discounts based on the time value of money and the risk that conditions to payment may not be satisfied, the board may be put in a difficult position.
If non-cash or contingent consideration does not turn into cash at the value ascribed to it at the time of the change of control, the return to the sponsor is illusory since it does not have the cash to deliver to its investors. Even valuing marketable securities may not achieve the sponsor’s objective because the sponsor may not be able to sell the securities for cash at the price at which they were valued in the change of control.
There is an alternative to valuing contingent consideration and non-cash proceeds (including retained securities) at the change of control, but it is not without its own complications. Instead of valuing such consideration and securities, the sponsor and management may take a “wait and see” approach. In this case, management’s incentive equity would be canceled, but management would retain the right to receive cash if the performance vesting criteria are satisfied after the various contingencies are resolved. The complications with this approach include the source of the cash if the performance conditions are achieved. With this approach, the sponsor may need to set some cash aside. This issue may be eliminated or at least mitigated if additional cash proceeds will be paid by the buyer which can serve as a source of funds to pay out the additional incentive equity if it vests. If the performance conditions are not achieved, the portion of the consideration attributable to the performance equity should inure to the benefit of the sponsor, not the portfolio company. Management may be resistant to a wait and see approach if it is required to be employed on the date the performance conditions are satisfied, as is typically the case.
Neither of the two approaches is ideal. When designing equity incentives at the outset of a particular transaction, there is no way to know what contingencies will apply to the purchase price on exit or whether any securities will be retained or rolled over. For this reason, perhaps the best approach is to provide the sponsor with optionality by giving it the right, at the time of the change of control, to either take a wait and see approach and hold the transaction open or close it out by valuing everything, including retained or rolled over securities. Which approach makes more sense may depend upon the nature of the contingencies and the sponsor’s determination as to the likelihood of whether they will be satisfied once everything has been reduced to cash.