Equity-based compensation in portfolio companies of private equity funds is used to provide an incentive and reward for growth, increases in equity value, and other business objectives. Equity compensation is commonly provided to management teams and key employees, but it may also be granted to directors, contractors, fund managers, and consultants.
This article provides a summary of the various types of equity compensation and a discussion of valuation requirements and methods for portfolio companies of private equity funds.
A primary advantage of this method is it establishes a value for equity compensation based on the support of the latest round of financing or transaction.
Types of equity compensation
The most common types of equity compensation used in portfolio companies of private equity funds include restricted shares, profits interests, and appreciation rights. Stock options or phantom shares may also be used. Equity compensation grants in portfolio companies of private equity funds often include performance and service vesting requirements. Performance vesting targets are usually tied to growth (i.e., EBITDA) or achieving a target price or return in an exit transaction. Service vesting is based on continued employment. In portfolio companies of private equity funds, equity compensation awards are usually designed to pay out upon on a sale, IPO, or other liquidity transaction.
In addition to equity-based compensation, capital structures in portfolio companies of private equity funds can include a variety of other interests, including subordinated debt, preferred shares, warrants, options, and convertible securities. Preferred shares are a common form of investment for private equity funds, and preferred interests can include liquidation preferences, dividends, conversion, or other economic rights. Portfolio companies of private equity funds are usually organized as C corporations or limited liability companies. In particular, limited liability companies provide a structure that offers broad flexibility in the design of an equity compensation plan.
The valuation of equity compensation in portfolio companies of private equity funds is required for taxes, financial statement reporting, and transactions. A value for the unit of equity compensation is determined at the grant, financial statement reporting, exercise, and redemption dates. Tax valuations are commonly associated with compliance for Internal Revenue Code Section 409A and special requirements for profits interests. A tax valuation is also required upon exercise or redemption. Valuation for financial statement reporting is required to determine the income statement expense and balance sheet liability recorded for equity compensation according to GAAP.
All valuations used for equity compensation must be current. It is generally considered current for tax and financial reporting when it is not more than one year old and there has been no change that would have a material effect on value since the last valuation.
Valuations are required for modifications to the plan, M&A, or disputes. A valuation is also used for fairness opinions, to benchmark or establish the reasonableness of the equity compensation plan, and for related purposes, such as gifting and financial or estate planning.
For most situations involving equity compensation, an independent valuation is strongly recommended (or required) to comply with financial statement reporting and tax requirements.
Equity compensation in portfolio companies of private equity funds can be valued using several methods. These include income methods (such as a discounted cash flow analysis) and market methods (such as using public company multiples). Frequently, option-based methods (such as Black Scholes) are used. In the valuation process, a value of the company and total equity is established, and that equity value is then allocated to the various equity interests. The allocation of value takes into consideration the preferences, economic features, conversion options, and rights of various securities in the entire capital structure.
In 2013, the AIPCA issued new valuation guidelines that apply to equity compensation issued by any privately owned company. The guidelines identify appropriate valuation methods and include changes in key items such as basis and discounts. The IRS is also expected to consider these new guidelines for tax purposes.
For portfolio companies of private equity funds, equity compensation is usually granted at or close to the time of an acquisition or capital transaction. That transaction can provide a basis for establishing an initial value for a unit of equity compensation. The OPM backsolve method is commonly used to value equity compensation based on a recent transaction. For subsequent valuations, income-, market-, or option-based valuation methods are used.
Portfolio companies in private equity funds sometimes consider valuing equity compensation on an intrinsic basis “as if the company was sold today” and then running that result through a waterfall. Unfortunately, this method is usually not appropriate for equity compensation and does not comply with the new valuation guidelines because an intrinsic method does not capture the expected future appreciation in value associated with many forms of equity compensation. This is particularly true for profits interests, stock options, appreciation rights, and capital structures with preferred or convertible securities.
Finally, equity compensation is potentially dilutive to common equity interests. This occurs on a percent and value basis. The impact of value dilution from equity compensation must be factored in to the total equity value.
Equity compensation is a key component in most investment strategies of private equity funds. The objective is to achieve higher returns for investors and provide wealth enhancement for plan participants. There are a wide variety of forms of equity compensation that can be used, individually or in combination, to accomplish these objectives. Valuation is an important component in any plan because it establishes and measures results.