Show Me The Money! Trends in Executive Compensation
As the calendar inches closer to 2024, a pivotal concern looms large in the minds of most employees: cash bonuses.
However, for executives, especially those who work for private companies that may be involved in a potential sale or merger, their calculus is different. Rather than fixating solely on traditional year-end bonuses, executives are focused on creative and tax-efficient ways to maximize compensation, both now and at other inflection points throughout the year.
In this post, we dissect the executive compensation trends we expect to continue in 2024, including considerations such as rollovers, catch-up allocations, and the emergence of the “extra thankful” shareholder.
Rollovers
In private equity transactions, executives of the target portfolio company are often required (or strongly urged) to contribute (colloquially, “roll over”) a portion of their existing equity position into the acquiring entity in the same security as the private equity investor.
Increasingly, we have seen rollovers with larger (although still minority) shares of ownership. In addition, there has been a discernable trend to waive customary repurchase rights on a termination of employment (at least for senior management), with exceptions for “cause” terminations or breaches of restrictive covenants. Where repurchase rights do remain, such rights are often at fair market value, as opposed to the more punitive repurchase price of the lesser of cost or fair market value.
For the private equity investor, a roll over serves as a convenient alternative source of financing, especially during times when borrowing is expensive. For the executives, the rollover allows them to share in the future growth of the company, often on a tax-deferred basis.
In short, higher rollovers provide a key alternative financing route for the private equity purchaser, while also more closely aligning executives’ interests with those of the private equity investor.
Catch Me (Up) if You Can
A catch-up allocation, while by no means required, is a commercially advantageous benefit that gives the executive a more meaningful stake in appreciation at an earlier time.
For further background, in a typical limited liability company or limited partnership structure (each a “partnership” for tax purposes), members/partners receive distributions according to a waterfall – in its most basic form, investors first receive a return of their invested capital, then a preferred yield, and the employee incentive equity would begin to participate only after such return to the investors. This waterfall ensures that employee incentive equity can be treated as “profits interests,” which are not taxable at grant and may provide the opportunity for capital gains on exit.
The primary requirement for this special tax treatment is that the “profits interests” must sit behind the invested capital (or equity value at grant if higher) such that on the date of grant, if the partnership’s assets were sold in a hypothetical sale followed by a liquidation, the money would flow only to the investors and not to the holders of profits interests.
Recently, we have seen an uptick in the use of an added, executive-friendly wrinkle: the catch-up allocation. In between the return of capital and preference and the subsequent pro-rata distributions, the executive is allowed to “catch-up” – in essence, the executive gets a priority distribution after the return of grant date equity value that allows the executive to be on an even playing field as if the executive had participated from day one.
The “Extra-Thankful” Shareholder
This is a type of structuring bonus where an “extra-thankful” shareholder will solely fund the payment from shareholder’s share of the deal proceeds.
To zoom out, service and/or deal documents often include a so-called transaction bonus – usually a one-time bonus that is paid upon a successful completion of a transaction. Generally, this bonus will be paid to a select group of employees, usually chosen by the target’s founders, upper management, board, or some combination of the above. However, it is not always the case that all selling shareholders want to bear the cost of such bonuses – in other words, shareholders might not want their proceeds diminished. As a result, a single majority shareholder may propose to bear that cost alone; namely that shareholder will pay the bonus out of his/her/its portion of the deal proceeds without diluting the return to the other selling shareholders. This “extra thankful” structure presents complicated deal mechanics (the extra-thankful shareholder is deemed to contribute cash to the company, increasing its tax basis, with such cash then run through company payroll). Since the deal documents need to properly allocate the cost of the payment (and the related payroll taxes borne by the company) and, potentially, the tax deduction benefits to the sponsoring extra-thankful shareholder, careful drafting is required.
Conclusion
Executive compensation is constantly evolving and demands creative thinking that combines economic reality and adherence to complex tax laws.
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