1107144_1 1 Private Equity and MBOs How to Sell Your Business or Attract Equity to Grow Through a Private Equity Buy-Out Date : March 2014 Author/s : Jeff Mansfield / Kieren Parker Article 6 of 9 For private business owners or managers looking to sell their business or a stake in it, or to fund its next stage of growth, this is the sixth in a series of nine articles which provide a guide to understanding private equity and the private equity buy-out process. On-going Involvement as Managers or Owners Management, sweat equity and sweet equity A feature of PE investments is the opportunity for management to share in the risk and reward of the business as equity owners. PE firms reserve a significant minority stake in the portfolio company to incentivise management and to align managers' interests with the PE owner. There is no set formula for the dollar amount that managers are expected to invest, other than it needs to be meaningful in the context of their personal situation, so that the loss of the investment would not be a painless experience. (In smaller companies which may not be sizeable enough to attract PE investment but may attract VC investment, managers are commonly founders who already own an equity stake, so the dynamics are probably different.) The structure of management incentive schemes is driven to a large extent by tax planning. For example, schemes may comprise 'sweat equity', meaning ordinary shares in respect of which management pays fair value, alongside 'sweet equity', meaning instruments or rights that increase the value of management equity relative to other shareholders, depending on the success of the investment. Putting aside their complexity, management incentive schemes can be lucrative, but come with the risk of managers losing some or all of their 'sweat equity'. They are discussed further in the summary of common terms in shareholders agreement in Article 8 – Things to Expect in a Share Purchase Agreement when Selling Your Company. The new owners might put in place a second tier incentive scheme for the level of managers below the CEO, CFO and other senior executives. Indeed, certain tax rules encourage broad based employee schemes which are open to 75% of the employees. Although the alignment of management with the PE firm through common ownership is real, it will not escape managers that the PE firm's investments are diversified across all portfolio companies owned by the fund, and probably across more than one fund. By contrast, managers are exposed solely to their own portfolio company, meaning the opportunity to earn significant wealth comes with a concentrated risk of loss. Owners retaining a minority stake For owners remaining partially invested, the terms of their equity ownership will likely be simpler than management, reflecting their less active role in the day to day business. Moreover, depending on the size of their stake and their ongoing involvement, the equity held by an owner accustomed to control could feel more like a passive investment. Regardless, a PE firm will see the owner's participation as an important partnership, which together with management is key to a successful investment. Financing Structure Even after the global credit crunch, PE firms are likely to want to introduce debt to fund the acquisition of the target company and leverage their own investment. The appropriate amount of debt will depend upon the nature of the target company's business and its balance sheet. It will be important to review financial covenants in any financing documentation to ensure they do not create any undue stress on the target company's operations. In addition to debt, PE firms may structure their own investment as convertible notes or preference shares in the target company, rather than ordinary shares. It will be important for managers investing in the target company, and owners remaining as shareholders to understand the terms attaching to any convertible notes or preference shares.