By Garrett Galvin

A company may find itself in a position to sell for a variety of reasons: a sale may be necessary to continue its growth, a potential buyer made an offer too good to pass up, or the owners are simply looking towards their next venture. Regardless of the reason for the sale, the prospect of selling the company can be a difficult but exciting time for all involved and it is important for the sellers to have management support of the transaction to bring it across the finish line. 

Getting management buy-in can be no small task in a venture-backed company, as multiple rounds of preferred stock financings may have significantly diluted the equity holdings of the management team. Depending on the purchase price offered in the sale and the extent of prior financings, it could mean that after all the preferred stockholders are paid their portion of the proceeds, according to their liquidation preference, there is little or nothing left for management who are usually common stockholders or optionholders. If management suspects that it will not be paid a share of the sale proceeds, the company may struggle to attract, retain, or motivate skilled managers to bring the sale to fruition. To counter this, many companies adopt a management carve-out plan.

Management carve-out plans, as the name implies, carve out a portion of the sale proceeds to pay certain key individuals, thereby motivating them to stay with the company through the transaction. These plans are contractual obligations to pay cash, and therefore debts which guarantee that the plan payments will be made before any payout to the preferred or common shareholders. If the deal is structured such that there is a potential for earn-out payments upon reaching certain milestones post-closing, the plan can likewise be structured to grant additional payments upon the occurrence of those same milestones to continue motivating the management and key employees to reach those milestones following the sale. 

Size of the Plan

The size of the plan will vary depending on the value of the transaction triggering the plan. The board must balance ensuring the plan is large enough to incentivize the employees throughout the transaction while still fulfilling its fiduciary duties to maximize value to stockholders, who would ordinarily be entitled to the portion of the sales proceeds that are being earmarked for the plan participants. 

The board has a lot of flexibility in terms of how to structure the awards under the plan, but most follow a few basic structures. The awards can be structured on an individual basis, either by dollar amount (i.e. Participant A will get $X and Participant B will get $Y upon a change in control) or by allocating funds to a pool which may be specified as (i) a fixed dollar amount to be split amongst the participating employees (e.g., $5MM); (ii) a straight percentage of the consideration (e.g., 10% of net proceeds); or (iii) a sliding percentage based on the size of the consideration to reward a larger sale size (e.g., 10% if the purchase price is between $X and $Y, 15% if the purchase price is greater than $Y). Further complicating the decision, the plan must also contemplate what amounts should be included or excluded from the calculation of the consideration used to determine the size of the pool; for example it is common to exclude transactions expenses while it is uncommon to exclude other liabilities and many pools also include earn-out payments or escrow amounts in the consideration calculation. It is important to be clear what amounts will be included or excluded when creating the plan to manage participants’ expectations. The plan should be structured such that payouts associated with these escrows or earn-outs should not be paid until the earn-out or escrow is actually earned and becomes payable to the shareholders. 

Where Do The Funds Come From

As discussed above, the board of directors owes a fiduciary duty to all shareholders, preferred and common equally, and therefore it is the board’s duty to ensure the maximization of value for all the shareholders in the event of a sale. However, a management carve-out plan by its definition will carve out value from shareholders to reward management. If the plan is not carefully structured to fairly allocate where those funds are coming from, it may result in shareholder litigation. For example, if a plan is structured such that the plan is to be paid at the top of a distribution waterfall, it will be the common shareholders footing the bill to pay out the plan. Consider a $10 million transaction with a 10% management incentive plan, where the company has $5 million in preferred stock, and $5 million in common stock outstanding. Under a simple waterfall distribution approach, the plan would receive 10% ($1 million) to pay participants, the preferred stock would be paid its $5 million out of the remaining $9 million, leaving the common shareholders with only $4 million to split ratably.  In this simple example, the entirety of the plan has been paid for using funds that would otherwise have been distributed to common stockholders while the preferred stockholders were paid their full value. The plan size here could increase (or the purchase price decrease) by $4 million before the preferred stockholders take any hit, while the common shareholders’ payout decreases dollar for dollar with the plan increase. 

The board must carefully consider how to structure carve-out plans to ensure fairness amongst all shareholders. If one class of shareholders is treated unfairly when the plan is paid out, that group may sue the company under a breach of fiduciary duty claim. Structuring the plan to ensure that the cost is fairly allocated amongst the preferred and common shareholders, obtaining stockholder approval of any plan which might be viewed as unfair when implemented, and using independent committees and directors to ensure the common stockholders are treated fairly under the plan can help reduce the risk of costly shareholder litigation.

Who Participates

The board of directors will typically approve a plan detailing a broad class of employees who are eligible to participate (i.e., full-time employees) and following adoption of the plan, the board or its delegate, such as the CEO, designates which individuals within that broad class will participate in the plan.  The CEO is often given this responsibility because the CEO is in the best position to know which employees are most important to a successful sale and it prevents the board from having to be involved in the minutia of the company operations. Obviously, the more employees who participate and get a cut of the pool the less each individual will receive, or the larger the plan pool has to be. So while each employee plays a role in the sale and incentivizing everyone to work to push the sale along is admirable it is generally not realistic unless the company is very small with only a few employees. Generally, plan participants are limited to management and certain high level employees who are pivotal to retain through the sale. 

Once participants are identified, each one should sign a short agreement detailing the application of the plan to that particular individual, such as their percentage interest or fixed dollar amount, and application of any forfeiture provisions in the plan. Most plans provide that a participant  must remain with the company until closing the transaction in order to be eligible to receive their allocation under the plan and if that person leaves the company prior to closing, either voluntarily or being terminated for cause, the plan should hold that the participant forfeits his or her allocation thereby only rewarding employees who help to close the transaction. The forfeited allocation can either be automatically reallocated pro-rata amongst the remaining participants or it can return to the board or its delegate to be reallocated at their discretion. Note that some plans provide for a pre-closing protected termination window such that the participant may leave or be terminated within that time period without sacrificing their allocation. This allows the company to reward participants who greatly contributed to the value of the transaction but nonetheless left the company before the deal closed. 

Tax Implications

Payments from a management incentive plan, whether in the form of cash or stock of the acquirer, will be taxed as ordinary income to the participant and subject to payroll taxes and withholdings. Note that even if the stock received as consideration are of a privately held company, and therefore illiquid, the value is still taxable upon receipt and if the shares received are subject to vesting they will be taxable as they vest unless an 83(b) election is filed. 

Section 409A of the Internal Revenue Code (the “Code”) imposes additional taxes and penalties on nonqualified deferred compensation if that compensation fails to meet the requirements set out in that section. To avoid these penalties, the plan must be structured to either comply with the requirements of, or be exempt from 409A. The short-term deferral exemption is the most widely used exemption to avoid the implications of 409A. Under this exemption, 409A will not apply if the deferred payment is made no more than two months and fifteen days following the end of the calendar year in which the right to the deferred compensation vests. If no exemption is available, then to comply with 409A, (1) the plan must be in writing; (2) it must establish the amount, time and form of payment of the deferred compensation; and (3) the payment event must be one of six permissible payment events as detailed in the Code. If a carve-out plan is not compliant with 409A, or exempt from the section, then in addition to additional excise taxes and penalties, payments anticipated under that plan will be recognized as income for tax purposes as soon as the right to that compensation vests even if it has not yet been paid. 

Payments under the carve-out plan may also be subject to the “golden parachute” tax rules pursuant to Section 280G of the Code upon the sale.  The golden parachute rules levy an additional 20% tax on certain “disqualified individuals”: officers, the highest compensated employees, shareholders who owned more than 1% of the outstanding shares of the company or anyone who would have been included in any of these categories within the previous twelve months. If the total compensatory payments received by the disqualified individuals in connection with the sale (including severance, bonuses, option/share acceleration and similar payments in addition to payments under the management carve-out plan) exceed three times the disqualified individual’s average compensation for the past five years then that individual will be subject to the additional 20% tax on all amounts that exceed his or her average historical compensation and the company will lose the corresponding tax deduction for compensation. If payments to disqualified individuals upon the sale will exceed the threshold discussed above, the shareholders of a private company undergoing the change in control may approve the payment subject to the golden parachute rules such that the tax will not apply and the deduction will be preserved. For the approval to be effective, three conditions must be satisfied: (i) there must be approval of the disinterested shareholders (i.e., shareholders who are not disqualified individuals (or affiliated/related to a disqualified individual) entitled to payments above the three times threshold) who hold more than 75% of the voting power of the company entitled to vote and the vote must be separate from the vote to approve the sale, though all parachute payments can be approved in a single vote; (ii) there must be full disclosure to all shareholders of all payments to be made to disqualified individuals; and (iii) the disqualified individuals must execute advance parachute payment waivers where the individual agrees to waive the amount in excess of the threshold amount if the shareholder approval is not obtained.

Conclusion

Management carve-out plans are commonly used by companies undergoing a sale; these plans help ensure that management and other key employees remain motivated throughout the transaction by reserving some of the sale proceeds for them. How to structure the plan will vary depending on the company’s facts and circumstances. It is therefore important to seek advice from experienced legal and tax experts to ensure that the plan best meets the company’s needs and does not expose it to unnecessary litigation or unwanted tax consequences.