Signing Up the Managers: In a Going-Private Deal: Dishing out equity to keep executives is a tricky exercise – balancing rewards with tax, legal, accounting, and securities law requirements.

A number of factors, including the lackluster performance of U.S. equity markets, the increased regulatory burden posed by the Sarbanes-Oxley Act, and the rebound in the high-yield debt market, have come together to present private equity financial sponsors with opportunities for leveraged acquisitions of publicly traded U.S. companies. But going-private transactions are not easy to do. They raise numerous corporate, tax, securities, and other legal and business issues as financial sponsors and their advisers execute a public m&a transaction at the same time they coordinate simultaneous debt and equity financings. Even the new accounting requirements for expensing stock options are in the mix. Ultimately, the equity financing provided by the sponsor and its management team is a critical component to the success of these deals, and correctly shaping the equity requires compliance with all of the issues cited. Sponsors long have recognized the key role of management in the success of leveraged acquisitions and the importance of structuring appropriate equity incentives for the executive group. From management’s perspective, the equity opportunity in these transactions is the reward that justifies the increased business and personal risk inherent in the highly leveraged organization that emerges after closing. And while the negotiation of debt financing tends to be dominated by financing sources with superior bargaining power, the structuring of equity financing is an area where creativity and resourcefulness are essential and where the experience and ability of financial sponsors, management, and their advisers can add significant value. Rollovers of equity securities by management Many going-private transactions involve a “rollover” of equity securities owned by management in the publicly traded target. A rollover occurs when the sponsor structures the transaction to allow the management team to exchange, or roll over, some or all of their shares for equity in the newly private company (or Newco) instead of exchanging the shares for cash on the same terms as the other public stockholders. There are many advantages to an equity rollover. For one, a rollover represents a source of funds for the acquisition, or more accurately, a reduction in the cash needed to effect the deal. More importantly, a rollover can provide a tax-efficient mechanism for management teams to co-invest with financial sponsors. If properly structured, rollovers permit management to avoid recognizing any taxable gain for federal income tax purposes on the securities that are rolled over while also assuring that any gains on the securities that are cashed out will be taxed at capital gains rates (recently reduced to 15%), rather than ordinary income rates, for federal income tax purposes. Rollovers are important from the sponsor’s perspective as well. Although, negotiating authority for the target in going-private transactions usually is divorced from management and assigned to independent directors, a sponsor’s reputation and track record in dealing with management in the finite world of private equity funding sources can be critical to independent directors’ assessment of the likelihood that the sponsor will actually close the transaction. Accordingly, a carefully conceived rollover strategy, coupled with a reputation for successfully “getting management to the altar,” can give sponsors a competitive edge in auctions of publicly traded companies. Stock options: management’s problem is the sponsor’s problem A fundamental selling point for an equity rollover is that it permits management to avoid recognizing gains for federal income tax purposes on rolled securities. Unfortunately, an unintended consequence of equity rollovers that meet this objective can be a basic structural difference between the sponsor’s and management’s ultimate equity returns. The problem starts with the fact that management’s “pre-closing” equity compensation often takes the form of stock options. A tax-efficient rollover of common stock options is possible – with a significant wrinkle. A manager holding options can, without recognizing gain for federal income tax purposes, exchange vested options in the target for vested Newco options. However, the holder cannot exchange vested options for vested Newco stock on a similar tax-free basis. The result is that a tax-efficient rollover of stock options often means that management and the sponsor will end up holding different types of Newco equity securities after closing – stock in the case of the sponsor, options in the case of management. Unfortunately, federal tax law treats gains from stock and options very differently. An individual investor’s gains, including the gains of an individual investor in a private equity fund managed by a deal sponsor, triggered by the sale of Newco stock will likely be taxed at long-term capital gains rates for federal income tax purposes. By contrast, an option holder’s gains – unless, as discussed below, the option constitutes an “incentive stock option” under IRS regulations – will likely be taxed at ordinary income rates. This means that, in the absence of further action and assuming a 20% difference in long-term capital gains and ordinary income tax rates, a manager holding options in Newco will likely realize equity gains that are only 75% as large as the equity gains realized by individual investors in the sponsor’s fund. A 25% differential in equity gains can be hard to ignore, but a logical response to this problem from the sponsor’s perspective is to pretend there is no elephant in the room. This is because management’s ownership of Newco options presents at least one clear advantage to the sponsor. The exercise of “non-qualified” stock options often will generate tax deductions for Newco in the form of compensation expenses that correspond to the executive’s ordinary income. If, as is not unlikely, the exercise takes place in connection with a future sale or liquidity event, the deduction can even have the beneficial effect of increasing Newco’s valuation upon exit. In theory, a sophisticated sponsor and management team should weigh the economic trade-off between a potential increase in Newco’s sale price and the tax disadvantage to management posed by its form of equity securities and strike a bargain that is acceptable to both sides. However, the reality of sponsor-management negotiations is that “negative” tax treatment is one of several ways in which managers can end up with the perception that they are getting the short end of the stick in the transaction. Accordingly, sponsors often feel some pressure to eliminate or mitigate management’s tax burden. A strategy often advocated by management is the use of incentive stock options (ISOs) instead of non-qualified options in the rollover. ISOs hold the potential of permitting the option holder to have stock option gains deferred until the option shares are sold and taxed at long-term capital gains rates rather than ordinary income rates. However, use of ISOs presents a number of problems. From a tax perspective, a rollover into ISOs is practical only if management holds ISOs in the target. A rollover into ISOs also is less advantageous to the sponsor because ISOs (assuming the holding period requirements discussed below are satisfied by the holder) will not create tax deductions for Newco on a sale or other liquidity event. Moreover, the exercise of an ISO may be a taxable event for the manager even if ISO holding period requirements are met. The “spread” on an ISO when it is exercised, i.e., the difference between the stock value and the exercise price, is a taxable preference item for purposes of the federal alternative minimum tax. More importantly, management teams accustomed to the public company environment often don’t realize that ISOs don’t offer the same advantages in privately owned companies that they do in public companies. ISO tax regulations require the holder to hold option shares for more than 12 months before a sale to receive capital gains treatment. Thus, to have ISO gains taxed at long-term capital gains rates, a manager must anticipate the liquidity event and exercise the options more than 12 months before the sale or recapitalization. Even if the manager has the resources to pay the exercise price in the absence of a liquidity event, satisfying the 12-month holding period requirement demands a level of prescience that even the best-informed managers usually don’t have. Rolling options into a “strip” An alternative solution to mitigate management’s ordinary income tax treatment can be found in the structure of Newco’s equity capitalization. While publicly traded companies tend to have basic equity capital structures consisting only of common stock, private equity sponsors often prefer more complex structures consisting of a “strip” of one or more classes of redeemable preferred and common stock. The more complex structure allows the sponsor to leverage Newco’s common stock by allocating a substantial majority of Newco’s equity value to the redeemable preferred stock, which, with a fixed liquidation preference and no common conversion feature, is the functional equivalent of debt. This structure also allows the sponsor to divorce the aggregate dollar amount of an equity holder’s investment from the projected equity returns to the investor. For example, to recognize management’s key operational responsibilities, sponsors often permit management teams to weight their equity investment in Newco with proportionately more common stock and proportionately less preferred stock than the sponsor. Because common stock returns are far larger than preferred stock returns in a successful deal, the weighting gives management a disproportionately large share of pretax profits, often referred to as a “promoted” interest. Use of a strip can help address management’s tax burden when the sponsor permits the manager to roll his or her target company common stock options into non-qualified stock options to buy redeemable preferred stock of Newco. At the same time, to “complete the strip,” the manager can invest a relatively small amount of cash in the common stock of Newco. (Generally, the cash amounts required are comparatively small because as much as 90% to 95% of Newco’s equity value is taken up by the redeemable preferred stock.) The effect is to concentrate the manager’s “stock option/ordinary income tax treatment” in the preferred stock, where aggregate returns are proportionally lower, i.e., limited to the yield on the preferred stock, and “stock/capital gain income tax treatment” in the common stock, where equity gains are proportionally much higher. Sponsors who pursue this strategy will need to keep two important details in mind. First, for management to avoid the need to recognize compensation income on the grant of the new preferred stock options, the options must have a minimum exercise price equal to 20% of the fair market value of the underlying preferred stock. Second, a significant non-tax-related problem can arise when management owns preferred stock options at the same time the sponsor owns preferred stock. The problem is rooted in the fact that this type of preferred stock usually carries a significant dividend that accrues even when the dividend is not paid. Since dividends accrue only on outstanding shares, not on options for shares, management holding preferred stock options will lose the benefit of this accruing dividend. Thus, a mechanism will be needed to assure management that it will share pro rata in preferred dividends when the managers own only options. Vesting – options and restricted stock Rollovers usually involve fully vested securities. Even when management rolls over its vested equity stake into vested Newco securities, however, it is not unusual for a sponsor to provide new equity incentives for the team that are subject to vesting. A well-designed vesting structure is critical to maximizing the effectiveness of these incentives. Sponsors and most managers tend to be familiar with basic vesting structures for stock options in which the manager’s ability to exercise the option is based on criteria such as length of service, performance, and other factors. However, vesting can be implemented in myriad ways, and flexibility in implementing vesting restrictions can enhance the prospects of successful equity financing. A vesting alternative that can help alleviate the problematic tax treatment that arises when management holds options is to permit immediate exercise of the stock options and alternatively implement vesting in the form of a right of Newco or the sponsor (typically a buyback, or call right) to cause forfeiture of unvested option shares when the manager’s employment is terminated. This “immediate exercise” provision allows the manager to use some of the liquidity he or she may have obtained on a partial cash-out of his or her shares in the target to invest in option shares up front or at any time after closing with the expectation that any gains on the shares achieved in an exit event executed more than one year after exercise will be taxed at long-term capital gains rates. One way of looking at “immediate exercise” provisions is that they effectively convert stock option plans into restricted stock plans. Restricted stock plans tend to be more advantageous, from a tax perspective, than option plans for management. When a rollover of options is not required, restricted stock may well be a preferred solution for structuring management’s investment in a going-private transaction. However, sponsors should keep in mind a fundamental difference between granting options and granting restricted stock. Unlike managers who are granted options that, through vesting restrictions, limit the right to acquire stock, managers who receive restricted stock own shares from the moment the transaction closes. The burden is on Newco or the sponsor to recover the restricted stock when it is not appropriate for the manager to keep it. In a 1996 decision, the Supreme Court of Kentucky demonstrated an extreme example of the need for careful analysis in this area. The court said that a restricted stock plan that required a manager to sell his or her shares on termination of employment at a price equal to what he or she originally paid for the shares was contrary to public policy and therefore unenforceable under Kentucky law. A related set of issues centers on the fact that enforcing vesting mechanisms with restricted stock forces Newco to come up with cash to repurchase the unvested shares. While the amounts may not be large, the company may be limited in repurchasing shares under its debt covenants or simply as a result of business exigencies. Variable accounting Accounting for stock options has been thrown into a state of flux due to the recent corporate governance and accounting scandals. The FASB recently decided that it will require companies to expense the fair value of employee stock options. Although this decision may have a significant effect on the use of stock options as incentive compensation in the future, sponsors operating under current accounting rules need also to be aware of the trap posed by “variable” accounting under current accounting rules. Under APB 25, variable accounting for stock options is required when the option exercise price or the number of option shares is not fixed at the time of grant. If variable accounting applies, an issuer is required to “mark to market” its outstanding stock options through periodic earnings charges or reductions to prior charges reflecting changes in the underlying value of the options based on the difference between the exercise price and market price. Variable accounting can be a serious problem in a going-private transaction. The continuing drag on EBITDA and net income can create problems under debt covenants while also reducing exit multiples for the sponsor and management. Further, a highly leveraged equity capitalization tends to exacerbate the problem, as incremental increases in enterprise value tend to generate disproportionately large gains in the value of common stock and common stock derivatives such as stock options. Compounding the difficulty is that the current accounting rules for stock options often produce results that are both arbitrary and far from obvious. For instance, while many sponsors find the concept of performance vesting attractive, options that vest solely on performance targets such as EBITDA or operating income are generally viewed as triggering variable accounting because the number of option shares the holder will eventually receive is not fixed at the time of grant. Similarly, option features such as “cashless exercise” purchase price provisions can also trigger variable accounting. Oddly, however, similar withholding of option shares to pay required withholding taxes is permissible under fixed plan accounting. Sponsors who are modifying employee option awards through a rollover transaction also need to keep watch on the relevant accounting rules governing recognition of compensation expense. Most issuers elect, in accordance with FASB Statement No. 123 (Accounting for Stock-Based Compensation) to apply APB Opinion No. 25 (Accounting for Stock for Stock Issued to Employees) to equity compensation issued to their employees. Under APB 25 and related FASB interpretations, vested options exchanged for “fixed” stock option awards through a business combination generally are viewed as part of the purchase price paid by Newco for the target rather than as compensation expense. This means that Newco can in most cases avoid compensation charges for book purposes in connection with a rollover of management stock options. Equity commitments Sellers in going-private transactions often demand that the sponsor, prior to signing the acquisition agreement, furnish written commitments for both the debt and equity financing required to complete the transaction. An equity commitment in this context clearly requires the sponsor to complete its due diligence and coordinate whatever internal approvals are required to obtain capital from its limited partners before signing the acquisition agreement. There is some art to structuring the commitment to minimize the potential liability of the sponsor and its limited partners in the event of a broken deal, although typically the equity commitment is conditioned on obtaining debt financing, which mitigates this risk. What can be more problematic, however, is that when the transaction includes a management rollover, the equity commitment will require, unless the sponsor is willing to underwrite 100% of the cash the rollover represents, parallel commitments, or at least backstop commitments, from each manager participating in the rollover before the acquisition agreement is signed. This in turn means that the sponsor must complete negotiation of management’s equity compensation, and most likely non-equity compensation, including employment agreements, non-competes, etc., before the deal is signed rather than in the interim between signing and closing. There are a number of ramifications to the need for up-front negotiation with management. For one, the negotiations are complicated by the presence of multiple parties. Timetables and objective milestones, as well as clear communication of core principles, are important in preventing these negotiations from interfering with the overall transaction timing. On a technical level, the sponsor must finalize Newco’s equity capital structure at this preliminary stage by determining the number and the terms of the equity securities, what classes of stock are included, what dividend, liquidation preference, and redemption rights apply, and what stockholder provisions, such as governance and board control, transfer restrictions, drag and tag-along rights, management vesting, and registration rights apply. Sponsors also should recognize the importance of proper disclosure in dealing with management at this stage. If a sponsor intends to collect a transaction fee upon closing or ongoing management fees from Newco, these fees may well be material to a manager investing in the transaction. Adding to the pressure at this point is the fact that the deal usually has not been publicly announced, and independent directors are sometimes reluctant to permit the sponsor to have significant contact with management until negotiations for the acquisition itself are more advanced. Securities laws issues in going-private deals Disclosure issues in management negotiations Whether structured as a cash merger or tender offer, going-private transactions trigger special disclosure obligations under federal securities laws. In part these obligations are mandated by SEC rules, and in part they reflect practice that has developed in response to the increased litigation risk for these transactions. Two securities laws issues particularly impact LBO sponsors. One is the disclosure requirement for a highly detailed description of contacts, meetings, and discussions between management and the sponsor going back during the two-year period prior to the transaction. When management is treated differently than the public stockholders in the transaction, which is typical, the sponsor needs to remain aware of requirements related to its discussions with management leading up to the transaction. Details of such discussions, whether focusing on the cash price to be paid to the public holders or the treatment of management, will be publicly disclosed in the proxy statement or tender offer disclosure statement. In addition, going-private transactions generally call for disclosure of financial projections prepared in connection with the deal. Difficulties can arise in this area when multiple sets of projections are prepared. It is not uncommon, for instance, for management to share with the sponsor one set of projections with fairly aggressive assumptions during the auction phase of the transaction. Not infrequently, however, management may prepare a different set of projections with less aggressive assumptions for the financial adviser providing a fairness opinion to the independent directors who must sign off on the deal. For a shareholder plaintiff, these dueling projections can create an unsettling inference that management, given the potential for conflict of interest, has engaged in a self-serving exercise of developing “low-ball” projections to convince the independent directors to approve a sale at an artificially low price. Ironically, the disparity in assumptions more likely reflects management’s aggressive efforts with bidders to obtain the best price possible for the public stockholders. All holders rule Sellers often like to structure the going-private transaction as a tender offer, which can be completed in 20 business days, rather than as a cash merger, which can take as long as 90 to 120 days to complete. Sponsors should be aware in structuring these transactions, however, that recent court decisions involving Rule 14d-10 under the Securities Exchange Act of 1934, a rule often referred to as the “all holders, best price” rule, have limited the ability to structure a going-private transaction as a tender offer. Rule 14d-10, which applies to tender offers but not to cash mergers, effectively mandates that the same price must be paid to all stockholders in a tender offer. A series of court decisions focusing on Rule 14d-10 have held that such things as non-compete agreements and other compensatory payments to management conditioned on the closing of a tender offer (presumably including a management rollover, employment agreements, option plans, and other integral elements of an equity financing for a going-private transaction) violate this rule, whether or not the payments were actually made during the tender offer period. Significantly, the effect of these decisions was to require the bidder to pay all public stockholders the same consideration that the bidder paid to management, including the non-compete payment, bonus, etc. While other courts applying Rule 14d-10 have reached different results, uncertainty and the significant exposure in the event of an adverse result have persuaded most advisers to recommend against structuring a going-private transaction as a tender offer if management stockholders are to be treated differently than the public stockholders in any respect. Delivering management equity at exit In purchasing, and paying for, control of the target, the sponsor must make sure that it protects the most fundamental of control rights – the right to trigger, and deliver 100% of Newco’s equity securities at a subsequent liquidity event. If the liquidity event is a sale or recapitalization, the sponsor needs appropriate mechanisms to ensure that management will cooperate with the exit transaction and will sell its equity securities on terms and conditions determined by the sponsor. These mechanisms must be in place up front so that holders of equity securities not affiliated with the sponsor are not in a position to extract concessions when the exit takes place. If the management equity investment in Newco involves a relatively small number of managers, these mechanisms can be put in place simply and efficiently through a stockholders or similar agreement with appropriate drag-along and equity security transfer restrictions. Management concerns with respect to “equal treatment” at a liquidity event are addressed through sponsor commitments to treat management equity securities in the same manner as identical sponsor equity securities and/or to allocate sale proceeds in accordance with the liquidation provisions of Newco’s charter. If management investment is more dispersed, however, as with a broad-based employee stock option plan, sponsors sometimes overlook the need for similar mechanisms to assure themselves of the ability to deliver the equity securities held by “rank-and-file” employees. Perhaps the most common way of accomplishing this is through a special “anti-dilution” provision in employee stock option plans ensuring the board of directors in the event of a sale or recapitalization the discretion to sell, terminate, or cancel the options on appropriate terms. The need to keep one eye on the exit event in negotiating management equity investments also exists when the exit is an initial or secondary public offering. Most sponsors correctly foresee the invariable underwriter request for “lockup” agreements from management and the sponsor in such public offerings and obtain such agreements up front. The issues associated with a public offering of a LBO company go beyond management lockups, however. For instance, the sponsor likely will need to rationalize Newco’s multi-class equity capitalization as part of a public offering. How and on what terms Newco’s outstanding preferred stock is redeemed in the offering or converted into common stock needs to be analyzed carefully to avoid last-minute glitches. David S. Denious is a Partner in the Philadelphia office of law firm Dechert. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com