3x negotiating management terms with private equity

 Kempen supports entrepreneurs and management teams that want to sell to-, or team-up with private equity investors. We are often the one who, on behalf of our clients, address a subject of debate in those transactions: management terms. During such negotiations there are several recurring topics, three of them are described below:

1. Envy ratio

As the success of an investment depends largely on management, investors require them to participate in the equity of the company. As an incentive, management is often offered to invest at a lower valuation than the private equity investor. This advantage is captured in the Envy ratio, which is ratio of the price paid by investors to that paid by the management team for their respective shares in the equity. If for example management pays 2 million for 25% of the company and the investors pays 30 million for 75% of the company than the envy ratio is (2/25%)/(30/75%)=5.0x.
The general rule is that the higher the envy ratio, the better for management. We observe that envy ratios depend on the value and experience management teams bring to the table. In competitive auctions we sometimes see that the envy ratio is used by investors to persuade management to choose their offer. Founders, entrepreneurs and buy-out management teams are typically rewarded with 5.0x to 10.0x envy, whereas managers brought in at a later stage receive lower envy ratios.

2. Amount to invest

Private equity investors want management teams to invest their own money to create alignment, but how much is advisable? Having a meaningful amount invested in a company you believe in sounds like a great move. But be aware: assuming all else equal, the effective rate of return declines the larger the amount invested.
An additional consideration is that investors want management’s investment to be meaningful (“skin in the game”), but not so substantial that it keeps them up at night. We provide tailor made advise on amounts to be invested on a case-by-case situation.

3. Interest on shareholder loan

In our earlier envy ratio example we described how management can invest at a lower valuation than the private equity investor. Management pays 2 million for 25% of the ordinary shares, so the private equity investor should pay 6 million for 75% of the ordinary shares. However, in order to create the envy ratio, we calculated the investor has to invest 30 million in total, resulting in a difference of 24 million. This difference is usually bridged by the private equity investor in the form of a shareholder loan. However, the investor does not provide this shareholder loan for free and charges interest.
Should you care how high the interest is? If the company performs well, the impact of the interest rate on management’s ultimate return is relatively low. However, when a business goes south, the shareholder loan and its accruing interest (interest rates typically vary between 8% and 10%), wipes-out the equity value of ordinary shares rather quickly. In that case, a lower compounding interest results in a longer period in which management stays in the money on its equity investment.

...but there is more

In addition to the above items, topics like ratchet, vesting and leaver terms are items we address in negotiations. In our experience most private equity investors are well-intentioned, competent and fair. It also helps that most of the time parties at the table understand that a signed contract is not the end, but just the beginning of the partnership.

Want to know more? Email me at maarten.dezeeuw@kempen.com

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