How are management incentive schemes typically structured?
Private Equity (2nd edition)
Typically, management incentive schemes in Greece include the following elements:
(a) Bonus plans; and
(b) Stock option plans.
The most common bonuses are productivity bonuses or performance base bonuses, usually consisting of a base rate coupled with a variable rate that is specifically tied to the individual's performance. Under Greek law if bonuses are regularly paid, they constitute part of the employee's regular remuneration and shall be taken into consideration for severance calculations. If bonuses are paid at the employer's discretion and without prejudice, they constitute discretionary benefits.
The concept of employee share participation schemes is introduced in the Greek Company Law (Law 2190/20) only for companies that have the form of a société anonyme. The maximum number of shares to be issued under a stock option plan may not exceed 1/10 of the existing shares of the company. The terms of the stock option plan, including the price of shares on the grant of the option, conditions of vesting, the percentage of shares to be granted and the categories of employees that may participate in the plan are determined by the General Assembly of the shareholders. Stock option plans may apply to employees of a company as well as independent contractors (Board members or consultants), that do not have an employment relationship with the company. Unless an employee’s remuneration package is negotiated individually, the company must comply with the principle of equal treatment. This means that single employees or groups of employees cannot be treated unequally, unless this is justified by an objective reason. Therefore, the company may select specific employees as beneficiaries and, for example, use seniority or performance achievement as selection criteria, provided that these are clearly defined and justified by the employer’s legitimate interests. Participation in a stock option is normally treated as a discretionary and revocable grant and is not computed for calculating severance. Employee stock option plans are more commonly used in listed companies, particularly in those with an international footprint, and are much less widespread in small and medium-sized enterprises.
Management incentive schemes can be implemented in various ways, depending on a number of different factors including the type of corporate entity involved and the residence of the management who are to participate.
Most commonly they take the form of the issuance of a separate class of shares with specific economic rights attached. These can be held directly or through a pooling vehicle depending on the desired control structure and the number of participants.
It is worth noting in the context of management incentive schemes and, more generally, management participation in Luxembourg entities, that Luxembourg public limited liability companies (SAs) have the ability to issue free shares to employees and management, both of the SA itself and certain group companies. This offers significant flexibility in the implementation of management incentive schemes in such entities – before the free shares concept was introduced in 2016, the Luxembourg legal requirement to pay up a minimum of one-fourth of the nominal value of a share in an SA prior to issuance had complicated the process.
It is also possible to issue to management share like securities known as parts bénéficiaires whose features are as set out in the articles. Such flexibility with respect to voting rights, economic entitlement, make them an attractive option for use in certain situations.
Management incentive schemes are typically structured by means of a leveraged equity participation, i.e. a direct or indirect participation in the ordinary share capital of the portfolio company while most of the equity investment is financed with fixed yield instruments such as preferred shares and/or shareholder loans Is this relevant here?. Usually management solely invests in ordinary shares (sweet equity) (generally a stake between 10% and 20% in total) and the financial sponsor invests in a combination of fixed yield instruments and the remainder of the ordinary shares (strip). The participation of management in sweet equity is usually subject to good- and bad leaver provisions. Depending on the situation, certain managers may be invited (or urged) to invest a certain amount in the strip too.
It is common for management not to own ordinary shares in the company directly. but rather indirectly through a Dutch foundation. The Dutch foundation typically holds the ordinary shares in the portfolio company through a separate management vehicle and management are issued with depositary receipts for such shares by the Dutch foundation. The foundation and the separate management vehicle are usually controlled by the financial sponsor. By using this structure, economic rights on the one hand (i.e. the entitlement to dividends and other distributions on the shares) and voting rights (which remain with the foundation) on the other hand can be split. As depositary receipts, contrary to shares, can be transferred by means of a private deed (i.e. without the involvement of a Dutch civil law notary), this structure makes it also more flexible to deal with leaver situations. A simple, but less common, alternative for a leveraged equity participation by management is a cash bonus (or stock appreciation right).
Financial sponsors usually expect management to make a meaningful investment in the acquired portfolio company. In transactions where management holds substantial ownership in the target company, they may also be required to rollover a part of their investment alongside the financial sponsors.
Management incentives in the Norwegian market come in many forms, but are customarily equity-based. The choice of model and structure would usually depend on the financial sponsor. International financial sponsors typically prefer to deploy their standard model with as few changes as possible, while Norwegian and Nordic financial sponsors more regularly build a model tailored to the specific circumstances.
The MIP models range from structures such as a straight forward co-investment alongside the financial sponsor in the equity of the portfolio company, to more complex structures providing substantial gearing to managements investment and a different return profile.
An example of the latter, would be the typical "International styled" MIP structure where the new holding company of the portfolio company is capitalized with ordinary shares, preference shares and shareholder PIK loan held by the financial sponsors, and the management invests in a portion of the ordinary shares. The management's investment in ordinary shares may be bundled in a separate joint holding company, a pooling vehicle, and the management would be bound by a management shareholders agreement. In some instances, where it is desirable that certain members of management shall have the same return profile on their investment as the sponsor, they will also invest alongside the sponsor in the same instruments and same proportions as the sponsor.
Share options are rare in the Norwegian private equity market as they are less tax efficient than other forms of equity-based incentivation and will normally be most relevant for management incentives in publically listed companies and early phase VCs.
There is always a degree of tax optimisation inherent in these schemes, but there is no uniform solution. Equity, options, hybrid debt and contractual profit participation mechanisms are available. In some deals, all of these mechanisms are employed, depending on the seniority of the management.
Management incentive schemes are typically structured as cash compensation (typically by way of M&A bonus or severance pay). Stock options or phantom stock are also frequently used.
Typically, management will invest into a “TopCo” (as individuals or via a wholly owned company or via a jointly owned ManCo with the rest of management) in which the lead investor also invests. The TopCo usually owns a MidCo and the MidCo owns a BidCo. It is the BidCo which takes up the external financing so most sponsors want the management incentive scheme to be in a company outside the banking group. Most commonly, management invest via a mix between preference shares and ordinary shares with a mix which is substantially heavier on the ordinary shares compared to the mix of the lead investor.
Management incentive schemes are an important part of transactions involving a financial sponsor.
Broadly speaking, management inventive schemes can be structured either as "strip investments" or as "sweet equity". In case of a strip investment, managers invest at the same terms and conditions as the financial sponsor. In case of sweet equity, managers normally receive a certain discount and/or other different share classes (e.g. managers receive all ordinary shares while the financial sponsor receives a mix of ordinary shares and preferred shares with a fixed interest which results in a certain envy ratio in favor of the managers). However, Swiss tax law sets rather narrow limits with respect to tax exempt capital gains on sweet equity.
Managers are usually asked to finance a substantial part of their investment with equity (roughly 50% or more) in order to have "skin in the game" and to fully align the managers' with the financial sponsor's interest. Sometimes financial sponsors are willing to grant loans to managers in a certain amount; however, due to tax reasons, such loans need to be granted at arm's length terms and full recourse.
Management usually invests directly in the acquiring entity (AquiCo) but managers can also be pooled in a management pooling vehicle (due to tax reasons, such pooling vehicle should generally be "look through", see question no. 13 below).
Often, one single shareholders' agreement between the financial investor and management or pooling vehicle is concluded, which governs all aspects of the investment (governance, exit procedures, shares transfers, vesting conditions, good/bad leaver provisions etc.). Usually, managers have very limited governance rights but are obliged to vote as instructed by the financial sponsor or the financial sponsor is the controlling partner of the pooling vehicle. New managers will have to accede to the shareholders' agreement if entering the scheme at a later point.
Most management incentive schemes are conceptually structured as either stock option plans or free share plans, the latter being less beneficial for Belgian tax residents from a tax and social security point of view.
In practice, Belgian employees are often offered options on the basis of a stock option plan issued by a foreign parent company. In such cases, these plans usually require some alteration to enable the application of the tax beneficial treatment of the Belgian tax law on stock options. Recently, we have seen a rise in tax litigation with respect to plans set up by parent companies in the past, whereby Belgian tax authorities claim that tax and social security should have been withheld (contrary to the clear provisions of the law).
In co-investment schemes, the shares are usually acquired directly by the managers as capital gains on shares are, in principle, exempt from personal income tax. Where future exits do not take the form of capital gains but rather give rise to dividend upstreaming, additional structuring may be required in order to try to lower or defer the tax pressure (dividends are taxed at 30% in the personal income tax).
The most common management incentive regime used in Canada is the employee stock option plan. An employee stock option is generally a right granted by a company to its employees that allows the employees to purchase stock of the company at a predetermined fixed price. Typically, the stock option will vest (become exercisable) over a certain period of time (frequently 4-5 years) and will survive and be exercisable for a finite period of time before it expires. Stock options may also include a performance vesting criteria. The options, once vested, may be exercisable into voting or non-voting shares. Stock options present advantageous tax treatment to Canadian resident employees, as described below.
For a target company incorporated in China, the management team is usually incentivized indirectly through granting thereto of options to purchase the “shares” of a limited liability partnership, which will hold the equity interest or shares of the target company. The founder(s) of the target company will usually act as the general partner of the limited liability partnership, while the incentivized management team members, upon exercising the vested options, will become the limited partners of the limited liability partnership.
For a target company not incorporated in China (usually in an offshore jurisdiction, e.g., Cayman Islands and British Virgin Islands), the management incentive plan is usually similar to that in most other developed common law countries in terms of reservation, granting, vesting, and exercising of options/ordinary shares. We do note that since China still maintains a foreign exchange control regime, the Chinese participants so incentivized will face PRC foreign exchange control barrier to exercise their vested options unless they complete relevant PRC exchange control registrations.
The management incentive schemes aim at aligning the managers and the financial sponsor’s interests. To do so, the financial sponsor will request the key managers to make a significant investment in the target company. In practice, the amount to be invested by top managers could represent 6 to 12 months of the manager’s gross salary. For less senior managers, the investment will generally represent between 3 to 6 months of their salary. In a secondary LBO, the financial sponsor will request the top managers to reinvest around 50% of their net proceeds or 30% to 40% of their gross proceeds. The incentive plan is specific from one transaction to another and managers may subscribe a large variety of instruments.
It is now quite common for managers to benefit from free share programs that benefit from a specific tax and social regime (under certain conditions). The vesting of these shares will generally be subject to certain conditions including an obligation for the beneficiary to remain a manager/employee of the company during the vesting period that must be at least equal to one year.
In Germany, management incentive schemes are common and are typically structured on an equity basis, granting management direct or indirect equity interests. Indirect equity interests in the target company are generally pooled in a management company above the debt financing entities and acquisition entity which facilitates the administration of the incentive scheme including involvement of new managers or the departure of former managers. This structure enables management to hold an indirect equity share in the target entity.
Non-equity incentive schemes are used infrequently, however are more common in smaller deals or schemes with a large number of participants with an onerous equity structure. These types of schemes cover a broad spectrum of incentives including option programs, bonuses or phantom stocks.
There is no general rule and it varies depending on the deal itself. That said, management schemes in PE-related transactions, usually involve the granting of stock options (or alternatively, and most recommend, phantom stock due to corporate governance or employment law concerns) to key members of management, earn-out payments, and other forms of performance-based compensation.
Typically senior management are incentivised with direct equity interests in the investment holding structure (in the form of ‘sweet’ equity) at the same level as the sponsor’s investment and any rollover investment. This ‘sweet’ equity takes the form of ordinary shares and sits behind the investor and rollover investments and offers the equity upside for management if the business performs well.
The size of the sweet equity pot for allocation and the terms relating to sweet equity are deal specific. It is quite common to see ratchet provisions and sweet equity typically vests over a 4-5 year period, sometimes 100% vesting only being achieved at the point of exit for the sponsor.
Bonus schemes are often seen as a drain on cash and management typically prefer the capital gains tax treatment in respect of equity rather than income tax levied on a cash bonus.
Most management incentive programs are structured on an equity basis granting the managers direct equity interests (such as shares or share options) in the portfolio company. An employee stock option plan (ESOP) is usually employed to incentivize the managers in a variety of ways. The financial sponsor will generally work with the managers to structure the ESOP in a tax-efficient manner in which the managers can buy shares directly, be allocated shares as bonus or receive shares options. ESOPs commonly account for between 3% and 10% of the fully diluted equity, depending on the size of the transaction.
It is easiest to structure management incentive schemes by issuing employee stock options (ESOPs). Companies which are not start-ups are prohibited from issuing ESOPs to their promoters/founders. Therefore, in such cases, other schemes are usually opted for, in the form of management options, warrants, stock appreciation rights and phantom stocks. However, in our experience, it is common to have management incentive schemes in private unlisted companies in India, but it is rare to come across such a concept in listed companies due to the statutory restrictions mentioned above. In any event, the most ideal option is usually chosen based on the tax analysis for the relevant promoter/founder.
A common management incentive scheme in Ireland is granting the managers of the selling entity direct equity interests in the purchaser’s acquisition group structure. The positive aspects of this structure are that the equity results in gains being subject to capital gains tax rather than share option, exit bonus or phantom share schemes which attract higher rates of tax for the individuals and social security contributions for the portfolio company which employs them.
Hannes Snellman: Management incentives are usually structured through share ownership, either by issuing new equity or through rollover arrangements. Both common and preferred shares classes are usually used. Preferred shares are typically paid a fixed interest ranging from 5 to 10% of the subscription price. Management shares are sometimes subject to vesting schedules, typically up to 4-6 years from the investment. Options and warrants are more uncommon in financial sponsor backed companies in Finland, save for startups backed by VC sponsors. At the other end of the spectrum, managements’ investment agreements typically include leaver clauses. In case a leaver event occurs, the management member in question is customarily obliged to sell their unvested shares to the private equity investor at a price, which depends on the leaver event at hand.
In Brazil, management incentive schemes are typically based on productivity and usually represented by cash bonuses and stock option programs, which can be part of broader compensation packages providing for other benefits such as allowances, insurances and special pension plans.
In M&A transactions in which senior management is also on the sell side, especially in private equity deals, earn-out arrangements are extremely common and can be structured under an equity or a cash compensation.
Management equity is typically subject to vesting over a period of three to five years. Compulsory transfer provisions apply upon termination of the management function, with the consideration varying depending on the reason for termination (a “good” or a “bad” leaver), although structures have become less aggressive in that regard due to recent developments in Austrian labour law. In addition, the private equity fund will require a right to drag-along the management upon an exit and typically will insist on the pooling of the management equity in a pooling vehicle (often a partnership).
In buyout transactions, a private equity firm often involves future management in the due diligence process and the financial modelling. Typically, management is offered the opportunity (and is sometimes even required) to acquire an interest in the target to ensure their commitment. Senior management is sometimes also given the opportunity to invest in the same instruments (‘institutional strip’) acquired by the private equity firm to ensure that their interests are fully aligned. In the latter case, structuring options are by definition limited. Where management is asked (or given the opportunity) to participate on a target level, share options (in the case of stock corporations), restricted shares (for a description of the typical restrictions, see below), profit participation rights (a contractual arrangement that can be structured as equity or debt and, by contrast to shares, never confers voting rights), virtual shares (that is, a contractual arrangement giving the member a stock like return) and phantom stock (that is, a contractual arrangement giving the member a bonus depending on operational performance) are the most common structures.
The detailed structuring of incentive packages is usually driven by the tax treatment of the benefits in the jurisdictions of residence. For example, management will have a strong interest in ensuring that any gains in relation to interests acquired are taxed as capital gains (and not as employment income unless a preferred tax rate applies). Management will typically also have an interest in limiting taxation at the time of the grant. It should be noted that where the investor provides financing to the management, tax authorities may be more inclined to question whether economic ownership has passed for arm’s-length consideration. Since the tax treatment of incentive programmes is often somewhat unclear, it is advisable to seek a tax ruling on the related tax issues before deciding on a particular incentive structure.
Management incentive programs tend to be structured to grant the managers direct equity interests or the value of the equity interest in the buyer’s group structure. Equity grants result in gains being subject to the lower tax rate for capital gains rather than ordinary income tax rates. Profits interest structures are the most popular choice, which generally results in capital gains tax. In addition, stock options, phantom equity and restricted stock units are often used, which results in ordinary income to management and a compensation deduction for the portfolio company that employs them. These are therefore less tax efficient, but sometimes easier to administer.
Often a portion of management’s equity is structured to vest and deliver a return on any exit after a certain IRR and cash exit multiple is achieved by the financial sponsor to align the management team’s returns with those of the fund management team. Another portion of management’s equity is often structured to vest and deliver value over a 4-5 year period, subject to continued employment through each vesting date and the value of management’s equity appreciating above the buyer’s acquisition cost.
Cash compensation awards are still common in sponsor-backed buyout deals; in some cases sponsors arrange for the management team to hold an equity stake in the company. The structure of these equity-based incentive schemes vary, but are typically structured as a rollover of existing equity into new equity or a granting of stock options either in the post-buyout portfolio company or its parent company.
Transaction bonuses and golden parachute payments are not common in Japan. However, in transactions in which the management members are also the sellers, buyers sometimes compensate the management members by providing severance payments to them.