How are management incentive schemes typically structured?
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.
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.
They are commonly structured through employee stock options to encourage the management to stay on to carry out the business strategy for expansion of the buyer. Generally those stock options will carry only economic rights.
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.
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.
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. 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).
Most management incentive schemes are structured on an equity basis granting the managers direct equity interests in the purchaser’s acquisition group structure. If structured properly, 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.
Often management’s equity is structured to 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.
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).
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.
In portfolio companies, management incentive schemes are typically based on the earnings or structured as compensation packages. These incentives intend to align both parties’ goals.
Earn-outs are the most common earnings/contingent-based compensation and are often used in management buy-outs and other private equity transactions.
Compensation packages, on the other hand, are the combination between direct and indirect benefits that an employer provides to an employee, including salary, allowances, insurance, pension plans, vacations.
In start-up and early stage companies which have limited cash flow generation, officers’ incentive schemes typically assume the form of stock options, which can either be physical (shares are granted upon physical exercise of the option – with “physical settlement”) or virtual (where the beneficiary receives the difference between the exercise price and the value of the shares at the exercise date – with “financial settlement”).
With regards to fund manager’s incentives, in private equity funds “waterfall” remuneration schemes are often used to grant fund managers (or, more commonly, management companies) a “carried interest” on the fund’s performance (to make them benefit from the upside in said performance), provided that certain hurdle rates for investors are achieved first. This carried interest remuneration is often structured as a special right granted to participation units held in the fund only by the management company and/or its affiliates.
Most management incentive schemes are structured on an equity or equity-like basis granting the managers indirect equity interests (through a vehicle holding such equity on behalf of the management team) in the target company. Equity-based incentive schemes for Chinese national managers need to be carefully structured and implemented in light of China’s foreign exchange control issues. Non-equity incentive schemes (e.g. bonuses, phantom stock, stock appreciation rights) are more common in programs involving many Chinese national participants because equity incentive schemes in such circumstances would be too burdensome. If structured properly, equity incentive schemes result in gains that are subject to capital gains tax unlike exit bonus or phantom share schemes which attract higher rates of individual income tax.
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 annually compounding interest ranging from 5 to 10% of the subscription price. Management shares are sometimes subject to vesting schedules, typically up to six years from the investment. Options and warrants are more uncommon in financial sponsor backed companies in Finland. 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.
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, including sweet equity and ratchet instruments according to which the managers will receive a certain portion of the sale proceeds depending on the performance reached by the financial sponsor.
In addition, it is now quite common for managers to benefit from free share programs. 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.
Most management incentive schemes are structured on an equity or equity-like basis granting the managers indirect equity interests in the target company, usually pooled in a management company at a higher level of the acquisition structure above the debt financing. Such a structure provides the management an indirect equity participation in the target company which facilitates the administration of the incentive scheme as well as the participation of new managers in the incentive scheme or the retirement of former managers. Non-equity incentive schemes are less common but seen in smaller deals or in programs with many participants in which the equity structure is too burdensome. Non-equity schemes have a broad range from bonuses, phantom stocks to cash settled options programs.
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.
It is common for employees in Ireland to participate in share incentive schemes as a means of attracting and rewarding employees.
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 following recent changes to the main Luxembourg company law in 2016, Luxembourg public limited liability companies (SAs) have been given the ability to issue free shares to employees and management, both of the SA itself and certain group companies. This amendment offers more flexibility in the implementation of management incentive schemes in such entities – previously, 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.
Most management incentive programs are structured on an equity basis granting the managers direct equity interests or the value of the equity interest in the purchaser’s acquisition group structure. If structured properly, equity results in gains being subject to capital gains tax rather than share option, exit bonus or phantom equity which attract higher rates of tax for the individuals and social security contributions for the portfolio company which employs them. Profits interest structures are the most popular choice, which results in capital gains if structured properly. 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 which employs them.
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 with a portion of management’s equity also 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.
Typically, management will invest directly into a “TopCo” (as an individual or via a wholly owned company) in which the lead investor and all other managers invest. 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.
The structuring of the management incentive schemes will very much depend on the financial sponsor and its preferred approach to such schemes. Maltese company law and employment law allow a significant degree of flexibility for the correct structuring of such schemes. In our experience over the years we have rarely encountered any material difficulties in implementing management incentive schemes and structures in the context of a Maltese target company.
It is usual to structure such incentives through employee stock options or phantom units. Employee stock options usually result in equity shares being issued to the management based on a pre-agreed vesting schedule whereas phantom units carry only economic right in case of a pre-agreed exit event.