Management Rollover vs. Option Pool: LBO Incentive Structures, Formulas, and IRR Impact

[@financialmodeling]

Files & Resources: breakingintowallstreet.com/kb/leveraged-buyouts-and-lbo-models/management-rollover-vs-management-option-pool/ Table of Contents: 0:00 Introduction 1:13 Part 1: The 3-Minute Summary 4:58 Part 2: Rollover vs. Option Pool IRR 6:42 Part 3: Share/Option Counts for These Structures 13:03 Part 4: Does the More Complex Method Matter? 14:10 Recap and Summary

[@yusaaxelrod8002]

Thank's Brian.

[@financialmodeling]

Thanks for watching!

[@gowthamdhanasekaran3908]

How will this change if we put a rule for a management option pool that the management would get that only if the IRR in the deal exceeds 25%?

[@financialmodeling]

Then you have to change the check for whether the options are exercisable and link it to whether the Exit Equity Value represents a 25% IRR based on the initial Equity and the # of years... if it does, exercise the options and go through the normal process. If not, the options are not exercised and nothing is paid out to management in the exit.

[@vincentnguyen6833]

Hi Brian, This was a very informative video, thank you. One question on the method of calculation in Part 1. With respect to calculating the equity to management options, would it be more accurate to use the same formula but instead of linking to 20%, calculate 20%/(1+20%) to reflect a lower management ownership following dilutions, and then multiply that by (Exit Equity Proceeds + Cash from Management Options) instead of just to Exit Equity Proceeds. I think I've seen it done like this before and this might be capturing what you're doing in part 3. Sure it won't make a material difference in most cases, but wanted to hear your thoughts on whether this is a reasonable approach In addition, could you further explain the part where you mentioned in Part 2 that management IRR is higher than sponsor IRR if there is rollover + option due to receiving "discounted equity"? I would've thought the higher IRR comes from exercise (and thus fronting the payment) of those options upon sale instead of at Year 0 like the sponsor. The valuation they're entering in at is also at the initial equity value (and not exit equity value) so not sure if that's what you were trying to reference with that comment Many thanks, Vincent

[@financialmodeling]

Yes, you could set up the formula like that in the simpler method, but then you have to change the second formula as well, and it was too complicated/redundant to cover all of this in a 15-minute video, so this was dropped and consolidated with the second approach. But you could use the second approach based on percentages as well. Exercising the options upon exit is a form of discounted equity because they're buying the shares for X and then selling them for 2X (for example). It's not really about the timing of the payment but the fact that the payment itself is tied to a lower equity value.

[@vincentnguyen6833]

@@financialmodeling Thanks for the prompt reply, Brian. All makes sense but just one follow-up to your response to my first question. When you say the second formula needs to be changed as well, do you mean factor in the diluted percentage in the exercising of options? Since it comes before, is it not still e.g. 20% * initial equity value as payment, only after which the ownership is diluted to be factored into calculation of management proceeds? Thank you

[@financialmodeling]

@@vincentnguyen6833 If you use the more complex approach, you need to add the cash proceeds from the exercise of the options to the exit equity value and then multiply that entire amount by the option pool % to get the "Equity to Management Option Holders." And to clarify, the formula for "Cash from Management Options" in this case would actually be: Initial Total Equity * Option Pool % / (1 - Option Pool %) because the Option Pool increases the equity available. If you use 1 + Option Pool % in the denominator, it does the opposite and shrinks the total equity in the deal.

[@vincentnguyen6833]

@@financialmodeling Thanks for your response Brian, your first point make sense. I'm confused however on the Initial Total Equity * Option Pool % / (1 - Option Pool %) formula. This would increase the original option % wouldn't it (i.e. granting 10% options pool would result in management receiving 11.1% of proceeds), or is that how it typically works? I thought (1 + Option Pool %) in the denominator intuitively depicts additional equity (i.e. 100% original equity + 10% management equity) with management receiving 9.1% and sponsor 90.9%?

[@financialmodeling]

@@vincentnguyen6833 If you go through the math, management gets the same amount of net proceeds from options in either case, and the remaining equity after that (to the PE firm) is the same in either case. Percentages are a bit confusing because it depends on whether you're using Exit Equity Value or Exit Equity Value + Proceeds from Options. This is why we recommend using share counts rather than percentages for this approach.