IVCA Feature: Educational Luncheon Highlights, ‘Strategies for Incentive Compensation at Private Companies,’ Sponsored by Neal, Gerber & Eisenberg LLP

January 22, 2014

On January 21st, In the midst of another blast of cold in Chicago, the IVCA kicked off 2014 with the first Educational Luncheon of the year. “Strategies for Incentive Compensation at Private Companies” was the topic, sponsored by Neal, Gerber & Eisenberg LLP. The moderator for the event was Michael Gray, Partner at the firm. Mr. Gray felt that the topic was timely because, “So much of the key value driving a company’s success is by its CEO and Senior Management Team. Making sure they are incentivized in a fair manner is a critical element of every deal – and their incentives should be aligned with investor interests in the success of the company.”

The panelists at the luncheon included...

  • Avi Epstein, Principal & General Counsel, Sterling Partners – Middle Market Private Equity firm.
  • Chris Morgan, Partner and Founder of Lantern Partners – Recruiters of Senior Executives in the software and software enabled services industries.
  • Gian Fulgoni, Executive Chairman and Co-founder of comScore, Inc. – a leader in measuring the digital world and preferred source of digital business analytics. 



After opening remarks from IVCA Executive Director Maura O’Hara, “Strategies for Incentive Compensation at Private Companies” got under way, as Moderator Michael Gray offered a series of questions and issues for the panelists to consider.

Michael Gray: Let’s start with structures of management compensation plans, as in how you align the executive compensation with the private equity firm. 

Avi Epstein: At Sterling, we think about compensation in three buckets – salary, annual bonuses and equity incentive fund plans. On the equity side, you want to make sure as closely as possible, that you align their interests with yours. It sounds obvious, but what I observed a lot of folks doing is overly complicating the equity side of the equation. When you create too much complexity, the management team loses sight of exactly how they’re going to make money for you. One of the lessons that we’ve learned is to keep things simple, and make sure your management equity plan aligns nicely with what your goals are. 

If you have internal metrics that you are seeking, don’t establish a plan that has the management team making a lot of money and you don’t. Similarly, you shouldn’t construct your plans where you make all the money during the waterfall, and they don’t see any of it. Try to keep the management equity plans as clean as possible.

Gray: Chris, as you represent the executive, the CEO or management in trying to understand their stake in the structure. What are some of the front line processes, in the way the subject of this alignment comes up?

Chris Morgan: We are seeing instances in which the preferences are actually lower, to get the executives on the exact same page with the investors, to get everybody pulling on the same oar with the same amount of fervor. Those types of deals are preferred by the executives, and often they are willing to take a lower percentage of shares, when packages are kept simple. 

We’re seeing a lot of variance regarding the kinds of equity that is being put out there –more performance-based shares versus regular time vested shares. As long as we keep these goals reasonable within what we’re asking the executives to accomplish, the vast majority are willing to be kept ‘on the hook’ for their performance. 

It’s also important to show the senior executives and the CEO in compensation talks how the ‘waterfall’ exit will work for everyone involved. No one will resent the fact that the investors or limited partners will make more money than the executive, as long as everyone knows where they stand in the equation.

Gray: Gian, since you are a board member, but have been on the other side of it, what are some of the interesting metrics you’ve seen as incentives for executives for getting particular outcomes?

Gian Fulgoni: Of course, the way a plan is structured is based on what you want the individual to do. There will be different plans for different positions, but I prefer to leave it up to the CEO to figure out the structures for his management team. I think also when these plans are being put together, it’s important to look back and look forward. If the CEO was involved in the founding of the company, and then is diluted down at some point, you have to take that into consideration.

You have to look at the inception, but you also have to look forward. You have to figure out what you want as an investor out of the company, and what is the exit strategy. Whether you use options or restricted stock, you have to tie it back to what you want that CEO to do. In the last ten years, there has been a shift from options to restricted stock – especially for public companies. That diminishes the downside, and it’s more of a tangible value. For both types of plans, you want to tie it back to what you expect from that CEO.

Epstein: Sterling Partners is in growth stage, so our motto is make sure you have the right CEO in the right space who is excited about the business. Gian’s point can’t be emphasized enough. It’s not sufficient to make sure you’ve identified the right CEO, it’s the program that you established to incentivize them will get you to your goals.

In plan negotiations, the CEO now has the counselors and advisers in place, so as an investor you can’t just send them a piece of paper with vague figures and think that it will work. You have to sit down with a financial model, and ask them if it’s realistic. If the CEO is not signing into it, you might lose their attention and you might lose them.

Morgan: The key add to that is that no one ever comes to me and says, ‘can you find me a CEO that has never done this before?’  So 99% of these candidates have been there before, they know the spreadsheets and they may have been burned in the past. These are people who have a critical eye as to how you build these models. So the simpler the better, and the more open the better.

Gray: Chris, how often do companies come to you with their plans and goals – and you analyze it with them – versus a company that just wants you to find a suitable candidate based on what it does?

Morgan: It’s almost always done on the front end; we sit down with the investor team and understand what the expectations are in the first 12 or 24 months, and how those expectations tie back with the equity compensation. And we do give them a good perspective on if those expectations are reasonable based on the company’s current status. We do our best on the front end, so we’re not waiting until the executive gets to sign-up day, we want to make sure the expectations from both ends are in alignment.

Epstein: The analogy I thought about is when my wife and I were hiring a nanny. We couldn’t trust any of the candidates who didn’t hold the baby, and didn’t ask how much they would get paid. So you don’t want CEOs who don’t know the company – won’t hold the ‘baby’ – and aren’t focused on how they will make money at the end of the day.

Fulgoni: Well, there is the technology sector, in which you might be bringing in someone younger, and they are less educated about the incentive programs – and may not be as motivated by the money? 

Morgan: For positions outside the CEO role, you are absolutely correct. For VP levels, Chief of Marketing, fine. But 99% of the time, for the CEO role I’m being asked to find someone who has been a CEO of a similarly sized company with similar channels.

Fulgoni: I realize that is whom you’re asked to find, I’m just raising the possibility that it might not be the right person for a tech company. In digital and internet based companies, one of the issues we deal with is that if you’re not hands-on with what is happening in the digital world, you don’t have a prayer for running a fast-paced, ever changing technology company.

Gray: Gian, are you telling Chris to not call you for a CEO job? [laughter]

Fulgoni: After running a public company now for 20 plus years, I count my aging in fiscal quarters. One fiscal quarter is equivalent to about four years of human life. [laughter] Been there and done that. No need to call me.

Gray: Gian, can you talk how the compensation of the CEO drives the rest of the management team, and the compensation of that team, and how it does or sometimes does not get equally distributed?

Fulgoni: The CEO will always expect that his/her incentive compensation will be significantly higher than the management. But it’s ideal to get the CEO to understand that there will be a significant upside for the management team that he assembles. The KPIs [Key Performance Indicator] will be different. The metrics for KPI compensation may be similar at the board level, but when you go below those levels the basic structure of the numbers in the plan might be the same, but what you do to earn it is very different.

The more you can tie the vesting of the incentive components to variable that an individual directly controls, the better. The more you get away from that, and the more complicated it gets, you can lose the executive motivation that you need for the plan.

Morgan: Recently, we looked for a Chief Revenue Officer [CRO] for a 50 million dollar Private Equity-backed company. They had very specific goals for growth, revenue and we’re looking toward an exit. They mapped out very precisely what they wanted to see in a CRO, so the compensation package for that position included an incentive based equity program that was retroactive.

For example, if the net goal was $10 million a year and you didn’t achieve it in the first year, but made $20 million the next year, the vesting goes back into the first year. You need to be simple and flexible, but you also need to be cognizant regarding how you’re using compensation to drive very specific outcomes for the company, and for the investors in the business.

Gray: Avi and Chris, I want to discuss management pool structures, and how those are split up within those teams, and at what point do we say no matter how simple we make it, the lawyers are incapable of making these documents less than 40 pages long? And how do we deal with levels of equity compensation within the teams?

Morgan: What I’ve been seeing is a gradual decline in the percentage size of the management pools. The averages were up to 18% ten years ago, and now we’re below 15% now in average pool size. 15% set aside, and a ‘non-founding’ CEO will walk away with five percent of that. You recruit for these businesses from the top down, because obviously they can bring their friends in. You need to make sure there is enough left in that pool for the rest of the executive staff, or you’ll be putting the CEO in a very difficult position.

Epstein: For us, the bigger issue is patience. The Private Equity industry tends to be less patient with their management teams then they were five to ten years ago, which means more turnover. I think this is an area in which the Venture Capital community is different from the Private Equity buyout community. For PE concerns, when an executive leaves, we have to get that equity back – the executive has to capture the value that they also deliver while they are there.

What I hear from executives in the Venture community is ‘I earned it, it’s mine.” The problem with that is in long-term ownership situations; they might have several executive teams in that time. They all collect the equity, and then the collective pool size can grow to 20 or 30%. The investment community can’t tolerate that. You learn a lot about each other in that negotiation point. On the investor side, it’s the economic interest. Even if the pool size is 20-30%, it’s about multiple layers of people sharing in the waterfall, what portion goes to management?

Gray: I got a call from somebody regarding an LLC, in which a new person got a big chunk of equity. Within that, the company was talking about split units, and that made no sense to the caller. In that sense, talking about split units, who care. It’s about what happens at the waterfall point. What are the economics? Who is getting diluted? Is it the management team, or are they diluting everyone pro rata? You can get caught up in the mechanics, but you have to focus on the economics.

Audience Member: Can the panel give an example of the type of complexities we can take out of deals?

Epstein: The easiest one to discuss is the utilization of KPIs as incentive on the equity side. I love using KPIs in regard to annual bonuses, because the individual CEO can control that. Different events will impact vesting, somebody has to keep track of all that, and there is no natural mechanism for the CFO or somebody else to figure out what has vested. We’ve moved away from vesting incentives, because of the complexity.

Our vesting comes in two flavors; almost all of it is time vest. Our usual deal is four years, with a one-year cliff. Meaning they earn their first quarter on their one year anniversary, and then monthly or quarterly after that.

Gray: Gian, let’s talk about the dissolution of a management team, Can you talk about that in the context of that in a business sense – there can be dips, management teams can be wiped out – how do you deal with these issues?

Fulgoni: I think it’s important to address it, to put something new in place that makes the senior executives feel whole, with an incentive to stick around. If you think they’re the right team, that’s what you want.

And I’ve always been surprised, in my time in public companies, that anytime you try a ‘re-price option,’ big funds that invest in public companies go nuclear over it. The argument is ‘I’m not getting my investment re-priced, so why should the senior management team get it?’ I always felt that statement is shortsighted. If the management team isn’t motivated, they’re not going to work hard or they’re going to leave. The investment then is worth even less.

 Avi, does the same thing happen in Private Equity investments?

Epstein: It’s an awful position to be in as an investor. On one hand, you clearly want to feel that you and the management team are perfectly aligned. But if the performance plan fails, and there is no accountability on the value side, then you’ve created misalignment between investors and the management team. We have reset our management pools in cases in which we just felt like we couldn’t generate enough momentum with a current management team, and then had to attract new management.

Fulgoni: It all comes back to the rate of change, what is affecting a company’s success or lack of success. I have a feeling that we’re in a time that you can plan as much as you want, but there is no way you can guarantee that plan is going to work, because there are so many other things that you have no control over, that can affect the performance of the company. I suspect that locking in one strategic plan is not the way to go in this current environment. If you don’t adjust to that reality, you don’t have a prayer of being successful.

My advice to investors – evaluate objectively whether the company’s inability to hit their objectives, was execution, or was it something completely out of their control that negated the performance of the company. If it’s the latter, than you’ve got to adjust the management plan.

Morgan: We’ve seen performance shares that vest based upon the development and establishment of alternate market plans.

Gray: Chris, how sophisticated is a CEO candidate that comes to you in evaluating their gains, in the short term, long term and dealing with tax issues in structuring compensation?

Morgan: They are thinking about it upfront, very much so, in terms of how any event or any vesting could result in some taxation. It’s a great concern for sure, something that a CEO thinks about before they even sign a deal.

Epstein: I guess the theme for me is don’t set your management team up so that they will have an issue regarding having to pay tax, but having no money to pay it. It ripples in a number of different areas, and there are some senior executives who know how to deal with it, and if the management pool goes deep into the organization, there are individuals at other levels who don’t know how to deal with it.

The way I think about it - profits, interest, stocks and the compensation form it takes – generally that subjects the equity holder to pay tax on an annual basis. Normally, if it has the cash, the company makes the tax distribution, but what happens if they can’t? So even if you have tax friction when formulating options, that’s a better format for those kind of executive negotiations. On the other hand, there are CEOs who are sophisticated enough to handle it themselves, but I really want them to know what that means, and what it could mean, depending on circumstances.

Morgan: It becomes a question on how deep you push out equity? VP level and above? 

Epstein: This usually becomes a conversation we have with the CEO. Usually a CEO comes in with a philosophy, there are some who want to go very deep – there was one CEO we dealt with that had 45 people in mind. But we usually deal with 8-10 people or fewer but we try to be deferential to what the CEO wants for their team. We want to support them.

Gray: Another thing we want to talk about is acceleration investing in a change of control – what are you seeing philosophically in regard to partial acceleration, no acceleration or full acceleration? Do you pay in full at closing or do you hand it out six months later based on a transitioning management team?

Morgan: if it’s a purchasing transaction, obviously the buyer has a lot to say about how things are handled moving forward, because often they want to maintain as much talent as they can. That’s part of the negotiation process. I think executives would like to see more acceleration than less for sure. We’re still all over the board in terms of what we see regarding technology companies. We’ll see no acceleration at all, we’ll see six months or a year out in acceleration, or we’ll see full vest. It depends on the investor, the cap table, the deal who’s involved; it’s all over the place. It would certainly make my conversation with the executive a lot easier if they felt on the same playing field as the investors 

Epstein: That also resonates with me. The CEO’s job is to perform at or better than planned, and to deliver an exit. It’s hard for me to say after they’ve done that, they won’t get paid out what they were promised according to the transitional equity plan – especially in deference to a buyer. That can create another misalignment with the investors. In general, they should see significant acceleration. What we’ve done is make sure that a CEO can provide at least some transition time.

The one plan we’ve gravitated towards is that we take half of the unvested equity, and accelerate that in the change of control. With the second half, we hold it back for a period up to six months, so they’ll get their payout and they will be there for transition. If the company decides they don’t want the CEO after three months, then they get the payout in three months. 

Fulgoni: If I were the CEO, I would expect my non-vested equity to occur when the buyout occurs, but I think the six-month idea is interesting, because it does allow for a transition. If the buyer doesn’t want the CEO around, then it’s only fair that the non-vested portion vest immediately or pretty soon thereafter. But also, if the buyer wants the CEO, I would expect that they would get another slug of equity. 

One of the situations we see today, that we haven’t seen in the past, is one Private Equity firm buying a company from another Private Equity firm. That’s very different from one corporation buying another – in that situation; the CEO should get everything vested immediately, because lord knows if they’ll have a job going forward. Maybe the CEO would set up in the plan that distinguishes between those two types of exit strategies. With a Public Equity buyout, it would be set up another way, which would be different than a corporation buyout.

I think that Private Equity has had success in the last ten years because they have the right view why a certain acquisition makes sense fundamentally, whereas a corporate acquisition of another company often has pitfalls in regards to hopes and dreams that don’t work out.

Morgan: Avi, have you ever structured a CEO’s compensation in which the acceleration of vesting was based upon specific financial metrics of return?

Epstein: We’ve toyed with that, but as I said earlier the vast majority of our structures is in the time vest. But when there is a gap in negotiations, we can add a certain amount when, for example, there is a 3 times return. That can make a lot of sense, and goes back to having the investor and management aligned. 

Gray: What about the repurchase of the equity of an executive when they leave? 

Epstein: First, giving a put to a senior executive is a nightmare. The big reason is that if the executive gets out before we do, then there is a misalignment created in incentives. But also you have the issue of what if the company appreciates substantially, and their equity is worth a ton, the CEO leaves or is maybe terminated, you might have a humungous check that doesn’t go to build the business, but paid to a now former executive. We won’t do that unless it’s a truly extraordinary situation.

I want to say to the executive that they should capture every bit of the value that they created while they were there. So we generally have a repurchase right. We do have a principle in mind when we’re generating executive compensation – don’t ask anything of the management team that you will be embarrassed to say to their face.

Fulgoni: It’s an interesting issue, especially if a company is smaller and in the tech sector. There are a fair number of people who will jump from company to company, in demand for their tech skills, but as soon as their option is vested, they’re gone to the next place. In those situations – and to avoid not hiring a person like that – you might be better off to have a repurchase right.

Gray: Chris, you’ve been dealing with common stock comp structures rather than preferred – with it complications – how has that been working out?

Morgan: A new CEO takes a position not knowing exactly what awaits them. When it feels like there are fewer surprises in the company, once they know what they’re in for, on the front end they are willing to take a little less of the fully diluted shares as a percentage. They negotiate much less aggressively with us if they feel like everyone in the organization is working off the same piece of paper. They also stay longer if they have that feeling that the investors are behind them.

Epstein: One of the problems I see with those structures, for example, if I have a company that’s worth $100 on day one, and if day two I give the management team ten percent on a common/common structure. Then if I sell the company on day three for that same $100, and no value was created? Then I invested $100, got nothing back, but the management team gets an automatic $10.


Q: Back to acceleration, and termination without cause. What’s the norm for that?

Epstein: At Sterling Partners, termination without cause means no acceleration. Vesting keeps them there, and I’ve had some folks ask, but we’ve never given in.

Q: How do you structure, during a Private Equity deal, a CEO rollover in equity?

Epstein: Never 100%. You want the CEO to taste victory, but you still want him to work through the transition. What I love to see, is when we do a buyout, and ask for a 25% rollover of equity, and they’d love to do more for a smaller check, then we have tremendous confidence in that CEO – because that tells me that they know the business better that we do. They’re willing to sign into it, and that adds confidence in both backing that CEO and in buying the company.

Q: What if the CEO holds up a deal?

Epstein: On the buy side, if I hear that from a CEO, I’m going to question whether we want that person. Two, I’m questioning whether I’m paying the right price. On the sell side, it’s very uncomfortable. What we try to do is put our CEO and the potential purchaser as close together as possible, very early in the selling process. The process is never as smooth as you hope it can be, you just have to be cognizant it’s a reality in the deal world.

Q: What is the philosophy of creating a win-win scenario?

Epstein: It’s called a partnership, and if it doesn’t feel like one, then we’re the wrong financial sponsor and they’re the wrong CEO. You’ve got to be joined at the hip, and if you are, you’ll be able to ride through a lot more turbulence along the way.

Gray: What I work on is mostly the sell side, and the plans, employment agreements, and more can be very messed up. I always say you can brush those teeth and you can pay lawyers to clean them up, or you can come to us now and get an entire mouth of implants. It can be miserable.

Gray: At the end of the day, there are really good companies being sold to really smart sponsors, and there are CEOs and management team honoring the spirit of the deal, even though the documentation may be screwed up. The economics are there, and if there is little internal squabbling, that harmony is pretty good in those situations.