Private equity – Navigating manager exits and management incentives in challenging times

A common feature of private equity backed companies is that members of the management team hold shares alongside the private equity house – the economic interests of management and the private equity house are aligned.

When a portfolio company is experiencing financial stress, the alignment of interests between management and the private equity house can break down. The financial stress brings the performance of the management team into sharper focus. One or more key members of the management team may need to be replaced to take the company forward. In addition, a fall in the portfolio company’s value can leave management’s equity “underwater”, impacting the incentives of the continuing management team.

Manager exits

In dealing with the removal of a senior executive from a portfolio company the private equity house will need to consider the departing manager’s employment rights and rights as a shareholder, including rights regarding the treatment of the leaver’s equity shareholding.

Employment rights

The leaver’s rights as an employee will be governed by the leaver’s employment contract with the company as supplemented by applicable employment law.

Termination of employment

If a decision is taken that a senior manager should be replaced, should the leaver be removed immediately, or retained in position while a replacement is identified? In most circumstances, immediate removal will be desirable. If a permanent replacement has not been identified, the leaver can be replaced by another member of the existing management team or an interim hire.

Assuming a well-drafted executive employment contract, the private equity house will need to decide whether to terminate the leaver’s employment without notice under a PILON (payment in lieu of notice) clause, or to give the leaver notice and at the same time put the leaver on garden leave.

During garden leave, a manager cannot attend the workplace, work elsewhere, or contact clients, suppliers or staff and therefore acts as a guaranteed period of non-competition.

Review of restrictive covenants

It will be necessary to consider the restrictive covenants in the employment contract and their relationship with the garden leave clause. Are the restrictive covenants in the employment agreement reduced by the length of any garden leave for example? Also, what are the terms of the leaver’s restrictive covenants in the shareholders’ agreement (which typically run from the date the shareholder ceases to hold shares)?

Restrictive covenants restricting an employee’s activities after termination of employment are void under English law for being in restraint of trade, unless it can be shown that they are reasonable in the circumstances of the parties and the public interest to protect a legitimate business interest of the employing company.

Restrictive covenants in employment contracts are generally considered more critically by the courts than equivalent covenants in a commercial contract such as a shareholders’ agreement. Generally speaking, an employment covenant that exceeds 12 months will not be upheld by the courts.

Restrictive covenants will not be invalidated by virtue of the leaver’s employment being terminated, provided that the termination occurs in accordance with the leaver’s employment contract and the employer is not otherwise in repudiatory breach of the employment contract. Immediate termination with payment in lieu of notice in accordance with the leaver’s employment contract will not be a breach of contract.

Managing reputational risk: confidentiality and announcements

Managing the message to the market of the leaver’s departure and reputational risk will be of concern to the private equity house. The settlement agreement should therefore set out the agreed position (including confirmations that the parties will not “bad mouth” each other on social media). Post #MeToo, there are strict rules around how far an employer can go in gagging a departing manager under an “NDA” and blanket prohibitions are now unenforceable as managers will always have the right to blow the whistle and/or speak to the authorities around issues of material concern.

Settlement agreement

The private equity house will want the leaver to enter into a settlement agreement providing for full and final settlement of certain matters on which the leaver has to take independent legal advice.

The settlement agreement will include waivers of any contractual claims against the company and waivers of statutory employment claims including claims for unfair dismissal. Save in cases of serious misconduct, generally speaking, the majority of senior executive exits will trigger unfair dismissal rights as they are usually presented as a fait accomplis with no right of appeal. In contested terminations, it is also common to see allegations of discrimination and/or whistleblowing being made where the damages are uncapped to increase the quantum on any settlement package. It is also common for managers in dispute with their employer to issue a Subject Access Request for their personal data. Such requests are time consuming and expensive to deal with and are a further incentive for an employer to reach an amicable agreement with a departing manager.

In addition to the above waiver of claims, the settlement agreement should cover confidentiality and announcements, as discussed above, and deal with the leaver’s entitlements as regards to management equity (discussed below). The settlement agreement may also reproduce in full, or at least draw the attention of the leaver, to the leaver’s obligations under restrictive covenants and other post-termination of employment obligations regarding intellectual and company property.

A review should be undertaken to identify whether the leaver is a key person under any of the portfolio company’s financing documents or other key contracts, or whether the leaver holds a key function under any regulatory regime to which the portfolio company is subject. The settlement agreement should provide for cooperation from the leaver in relation to all such matters, as well as dealing with resignations from directorships and company-nominated positions on industry bodies.

The leaver may need to be persuaded to enter into a settlement agreement, most obviously by being treated more generously regarding termination payment than the contractual position justifies. Other important issues for the leaver will be the value of the shares subject to compulsory transfer (although this will not have the same importance where the value of the shares clearly have no value, as discussed below) and the terms of any employee reference to be given by the employing company.

Management equity – leaver provisions

The “leaver provisions,” which stipulate what happens to a manager’s shares upon ceasing to be an employee of the portfolio company’s group, can be among the most keenly negotiated provisions of the “equity documents” in a buyout transaction.

The key concerns of the private equity house in relation to the leaver provisions are to prevent valuable “sweet equity” being retained by managers who are no longer working in the business, and ensuring that leavers are not over rewarded for selling their equity.

The key concerns the managers will have in relation to the leaver provisions are the extent to which they are required to sell their equity and the possibility that they will not receive full market value (or, if greater, cost) for their shares, as a result of ceasing to be employed prior to an exit.

The following principal matters will be addressed by leaver provisions:

• Good Leaver/Bad Leaver – these provisions treat managers differently depending on how or why they have become a leaver. Often “Bad Leaver” includes managers who have been summarily dismissed for “cause” and “Good Leaver” includes managers who have ceased to be employed because they die or have become seriously ill. An “Intermediate Leaver” definition can catch leavers who do not fall within the “Good Leaver” or “Bad Leaver” category. Understanding and drafting these leaver definitions is critical as they will establish the procedure, timelines, and prices for the transfer of shares.
• Vesting – vesting provisions whereby over time fewer of the manager’s “sweet equity” shares are required to be sold at the lower of cost and market value rather than at the greater of cost and market value.
• Price – Bad Leavers will only receive the lower of what they have paid for their “sweet equity" shares and market value, whereas Good Leavers will generally receive the greater of market value and cost. If the leaver provisions provide for an Intermediate Leaver category, with vesting, the leaver will receive greater of market value and cost for their vested sweet equity shares. If “rollover equity” (issued as consideration for a sale of shares on an earlier buyout) is subject to compulsory transfer, it is likely to be provided that those shares are sold at market value.
• Timing – there will be pressure to deal with the manager’s exit as quickly as possible to minimize disruption. The procedure in the constitutional documents for the compulsory transfer of the manager’s shares may take more time than it will take to deal with the exiting manager’s departure. The main negotiation on exit of a manager happens around the settlement agreement and so the private equity house will want to ensure that the settlement agreement grants flexibility for the company to deal with the compulsory share transfers without needing any further agreement from a potentially recalcitrant former employee.

In addition to leaver provisions, there may also be malus and clawback provisions in the investment documentation which may, particularly in the case of Bad Leavers, either reduce the consideration payable to or the number of shares retained by the leavers and/or enable the company to require the leaver to repay all or part of such consideration in certain circumstances (for example, where a restrictive covenant is subsequently breached, a hole in the accounts is subsequently discovered, or where misconduct is later identified).

Operation of leaver provisions in a distressed situation

As outlined above, a private equity house in a buyout transaction will typically expect that the investment documentation will provide that leavers have to sell all of their sweet equity shares, with the price determined by the leaver being “Good,” “Bad” or (if applicable) “Intermediate”.

Managers will argue that a leaver should be entitled to retain all of any rollover equity, but this will be a matter for negotiation. If it is accepted that the leaver’s rollover equity should be sold, the managers will argue that the leaver should receive market value, whatever the applicable category of leaver.

In a situation where the portfolio company is in a situation of financial stress, it is likely that there is no value in the equity. If this is the case, then reaching an agreement on valuation should be less of a challenge than it otherwise might be, but the leaver may not recognize the stark reality of the situation, and may not be in a cooperative frame of mind.

The provisions of a well-drafted set of articles of association dealing with shares subject to a leaver’s compulsory transfer notice will include a suspension of voting rights and waiver of pre-emptive rights in respect of any new issue of shares (and on transfer of shares if applicable). Equivalent provisions should apply to any shares the leaver is entitled to retain, for example because the shares are rollover equity from an earlier buyout. Such provisions mean that passing shareholder resolutions will not be delayed or made more difficult by a delay in transferring a leaver’s shares.

If the articles do not contain a suspension of voting rights provision, there is a risk that the leaver’s negotiating position is enhanced by delaying the compulsory transfer of shares process, particularly where a capital restructuring is imminent, and the leaver holds a significant proportion of the management equity.

If a settlement agreement can be agreed while any share valuation issue is outstanding, it should, wherever possible, include a power of attorney in respect of the shares which the leaver is required to transfer, and an obligation to deliver signed blank stock transfer forms and share certificates (or indemnities), prior to payment of any sums payable under the settlement agreement.

Even in a distressed context, there may be circumstances in which a leaver sells their equity for more than market value for UK tax purposes, for example, where leavers are entitled to receive the greater of cost and market value for their shares. If this is the case, they will be subject to employment taxes on the excess over market value. It is the responsibility of the relevant employer to account for employment taxes via payroll, although employee taxes may usually be recovered from leavers pursuant to the tax indemnity in the investment documentation.

Resetting management equity

If the difficulties the portfolio company is facing are such that there is no meaningful prospect of the management equity accruing value in the reasonably near future (the relevant exit horizon) then the private equity house will need to consider how to ensure the continuing management team (including any new hires) are incentivized to work through a turnaround and towards a successful exit.

Cash bonus

Although a cash exit bonus scheme may be considered, this is inefficient for tax purposes and doesn’t align incentives in the same way as share ownership by the management team.

Capital restructuring

In practice, a portfolio company’s financial difficulties may dictate that there is a debt for equity swap, or other form of debt restructuring. Any management incentive plan must be integrated into any wider capital restructuring.

The potential value of management’s equity can be increased by reducing the overall debt burden (third-party debt and shareholder debt) which must be satisfied before value accrues to equity and by increasing the share of the sweet equity to the overall equity proceeds. The latter can be achieved either by amending the terms of any existing ratchet shares, or issuing new shares providing a ratchet with a realistically achievable exit value hurdle. The latter will be more appropriate where new key managers have been added to the team and not all existing (and continuing) managers are intended to benefit from the new scheme.

Taxation

The tax consequences of any capital restructuring will have to be considered, including the consequences of any debt restructuring/debt for equity swap.

As regards an amendment to the terms of any existing ratchet shares, or the creation of a new class of ratchet shares, the parties will want to ensure that no immediate “dry” tax charge arises under employment tax rules. In order to avoid this in relation to the amendment of existing ratchet shares, no value should arise in the relevant shares as a result of the change to the ratchet provisions. For new ratchet shares, the shares must not be issued for less than their relevant tax market value. A balance will have to be found between ensuring that no value immediately accrues from any revised or new ratchet shares creating a dry tax charge, and creating an incentive which is attractive to the continuing management team.

Next steps

Dealing with manager exits can be disruptive and emotive. Getting a new management incentive scheme in place to reset the management team after a company has faced financial stress is essential. Dealing with the complexity involved, in conjunction with any wider capital restructuring, requires a multi-disciplinary team of lawyers to identify and mitigate the various potential pitfalls.

At Hogan Lovells we take a "joined-up" approach across our various teams who regularly work together on these matters. Please contact any of the co-authors of this article for more information.

Authored by Simon Grimshaw, John Livesey, Cees Brouwer, Ed Bowyer and Fiona Bantock.