Michael Sirkin, US Chairman & Managing Director
Michael Sirkin, US Chairman & Managing Director
Employment Agreements in Private Equity owned Companies verses in Public Companies
Employment Agreements in Private Equity owned Companies verse in Public Companies
Recognizing the difference in the ownership and goals, we are often asked by executives joining a private equity portfolio company for the first time about the differences in compensation, severance, benefits and other core compensation issues between public companies and private equity owned companies. Executives coming from public companies and having felt constrained by the oversight of proxy advisory firms, such as Institutional Shareholder Services (commonly known as ISS) and Glass Lewis, as well as the governance views of institutional investors, often are hopeful of more “creativity” in arrangements. Many are surprised when it turns out that the differences, other than with regard to long term equity, are generally limited, although still important to recognize when discussing employment arrangements with private equity owned companies.
We have in previous articles discussed how equity incentives in private equity owned companies differ from those in public companies. Private and public companies both utilize equity incentives to try and align the interests of investors and management. However, the equity arrangements by necessity differ due to ownership structure and anticipated time frame of the investment. Private equity firms use front-loaded grants intended to cover multiple years, compared to public companies’ annual grant approach. Discussions of the differences in long term equity incentives between public and private equity owned companies can be found at www.jamiesoncf.com/perspectives.
This article discusses compensation items other than long term equity.
A. EMPLOYMENT CONTRACTS
Employment contracts are probably equally common at top levels in public and private equity owned companies, but public companies more often use severance plans instead below the chief executive officer level (and, sometimes, even at the chief executive officer level). When employment agreements exist in private equity owned companies, they are usually evergreen or indefinite in length so they cover from acquisition to exit. In public companies, the evergreen or indefinite employment term contract is also heavily used; but, because of governance pressures, some companies use fixed term contracts with no severance on non-renewal.
A private equity buyer will often want to replace existing employment agreements with new ones in its standard form to have consistency across its portfolio companies and, thereby, make them easier for the private equity firm to administer. However, if the private equity firm believes the existing form favors the employer, it may well leave the employment agreements in place with only minor changes. The public company will generally have its own standard form for executives joining the company if it does not use the severance plan approach. The severance plan usually would give the public company the ability to amend the terms on notice without employee approval and avoid the need to negotiate severance with every new hire through his or her lawyer.
B. BASE SALARY
Base salaries in private equity owned portfolio companies are generally in the same range as in public companies for the same size company, although, at the top of the market place, they are often slightly lower. The one area where an executive’s base salary generally increases when moving to a private equity owned portfolio company from a public company is when a Division is sold and the executive is promoted from Division head to chief executive officer of the portfolio company. In this case, there is usually an increase in base salary to recognize the added responsibilities.
C. ANNUAL BONUS
Target annual bonus levels as a percentage of base salary are generally similar in public and private equity owned companies. There is often less of a specified maximum built into the private equity owned company plan and usually more discretion. This is expected since, rather than public shareholders, the portfolio company board is composed of employees of the financial sponsor who report only to the financial sponsor. The recent promulgated SEC regulations under Dodd Frank with regard to clawbacks, emphasize that public company employment agreements usually provide for clawbacks of annual bonuses and incentive equity based on financial restatements or cross reference the company policy on clawbacks. The private equity owned company employment agreement does not usually provide for clawbacks based on financial restatements. Of course, at least half of the incentive equity will be at risk until exit on any termination and all equity is forfeited on a cause termination in the private equity owned company.
D. BENEFITS
The private equity owned company will have the same basic benefits of healthcare, life insurance, 401(k) and disability benefits as the public company, but often will not have all of the ancillary benefit programs. The larger the private equity owned company, the more likely they will have public company type benefits.
E. PERKS
The private equity owned company will likely have less perks and fringe benefits than a public company because of the desire to limit expenses. Use of aircraft will occur where necessary for business use, but not often for private use.
F. SEVERANCE
Severance levels are generally similar pre change in control in public and private equity owned companies. However, the common increase in severance multiples found in public companies in connection with a change in control is generally not found in private equity owned companies. It is increased in public companies because executives may well be terminated in such situations through no fault of their own, but, instead, because there is no role for them. Therefore, arguably, they need and deserve a bigger cushion. In private equity owned companies there is not usually a step up in severance on a change in control. The reason is that the expectation when management joins the company is that it is going to be sold within a couple of years and that management will be adequately compensated at that time by the vesting and sale of their equity.
G. 280G COVERAGE
280g is a section of the tax code that imposes an excise tax on executives in the case of a change in control where management receives significant payments. At one point this excise tax was commonly grossed up by the company so that the executive would have no cost for it. The gross up has not existed for a number of years because ISS, Glass Lewis and governance advocates treat it as a very bad pay practice and penalize the board for authorizing it. Instead the employment contracts provide a “better of” provision where the executive retains the greater of the amount he can receive without being subject to the excise tax and the amount he would retain if he received the full amount and paid the excise tax. You often see the same “better of” provisions in private equity owned company employment agreements for the top people, but it does not often come into play because there is an exemption from 280g for privately owned companies if the executive waives the excess parachute payments unless reapproved at the time of the deal by 75% of the ownership interests. So there is commonly a provision that provides the Company will seek the approval in good faith if the executive waives.
H. INDEMNIFICATION AND DIRECTOR AND OFFICERS LIABILITY INSURANCE
While the basic provisions on indemnification and insurance are generally the same in employment contracts in both types of companies, there are differences that need to be considered. The level of insurance coverage in a private equity owned company is usually less than in a public company because there are no public shareholders and, unless public debt is utilized, no securities law filings. Therefore, both the probability of a lawsuit and the amounts involved will be less. In the private equity owned company, there usually is a very broad indemnity in the organizational documents to cover the directors and sponsor employees. Depending on wording, it may or may not cover the executives of the operating company. If it does not, this protection needs to be provided through the employment agreement. In a public company, the certificate of incorporation or bylaws usually includes protection for the officers and directors. In both cases, the employment agreement usually has provisions assuring post-employment continued coverage for actions while employed. In all cases this coverage is usually just for officers and directors, and any coverage of non-officer employees is not covered by the bylaws beyond being discretionary.
I. RESTRICTIVE COVENANTS
The private equity owned company often has restrictive covenants in three agreements—the employment agreement, the equity grant agreement and the purchase agreement. The first two usually continue for one to two years after termination of employment, while the one in the purchase agreement, if provided, usually runs 3 to 5 years from the purchase. They all should generally be coordinated as to the restrictions and limitations. The public company will generally have one in an employment agreement or a separate restrictive covenant agreement. Some public companies, but not all, will include them in their equity grants. While the private equity owned company equity grant will almost always provide for clawbacks for violations, the public company remedy provisions vary greatly.
CONCLUSION
Employment arrangements, in addition to equity, are important in the private equity setting and must be carefully reviewed and negotiated. This is especially true, as is most often the case, when the definition of cause and good reason are being carried over from the employment agreement to the equity plan. But, in all cases, the executive is signing on for a package and the employment agreement is an important part of it.
Jamieson Corporate Finance US, LLC is a member of FINRA/SIPC
Recognizing the difference in the ownership and goals, we are often asked by executives joining a private equity portfolio company for the first time about the differences in compensation, severance, benefits and other core compensation issues between public companies and private equity owned companies. Executives coming from public companies and having felt constrained by the oversight of proxy advisory firms, such as Institutional Shareholder Services (commonly known as ISS) and Glass Lewis, as well as the governance views of institutional investors, often are hopeful of more “creativity” in arrangements. Many are surprised when it turns out that the differences, other than with regard to long term equity, are generally limited, although still important to recognize when discussing employment arrangements with private equity owned companies.
We have in previous articles discussed how equity incentives in private equity owned companies differ from those in public companies. Private and public companies both utilize equity incentives to try and align the interests of investors and management. However, the equity arrangements by necessity differ due to ownership structure and anticipated time frame of the investment. Private equity firms use front-loaded grants intended to cover multiple years, compared to public companies’ annual grant approach. Discussions of the differences in long term equity incentives between public and private equity owned companies can be found at www.jamiesoncf.com/perspectives.
This article discusses compensation items other than long term equity.
A. EMPLOYMENT CONTRACTS
Employment contracts are probably equally common at top levels in public and private equity owned companies, but public companies more often use severance plans instead below the chief executive officer level (and, sometimes, even at the chief executive officer level). When employment agreements exist in private equity owned companies, they are usually evergreen or indefinite in length so they cover from acquisition to exit. In public companies, the evergreen or indefinite employment term contract is also heavily used; but, because of governance pressures, some companies use fixed term contracts with no severance on non-renewal.
A private equity buyer will often want to replace existing employment agreements with new ones in its standard form to have consistency across its portfolio companies and, thereby, make them easier for the private equity firm to administer. However, if the private equity firm believes the existing form favors the employer, it may well leave the employment agreements in place with only minor changes. The public company will generally have its own standard form for executives joining the company if it does not use the severance plan approach. The severance plan usually would give the public company the ability to amend the terms on notice without employee approval and avoid the need to negotiate severance with every new hire through his or her lawyer.
B. BASE SALARY
Base salaries in private equity owned portfolio companies are generally in the same range as in public companies for the same size company, although, at the top of the market place, they are often slightly lower. The one area where an executive’s base salary generally increases when moving to a private equity owned portfolio company from a public company is when a Division is sold and the executive is promoted from Division head to chief executive officer of the portfolio company. In this case, there is usually an increase in base salary to recognize the added responsibilities.
C. ANNUAL BONUS
Target annual bonus levels as a percentage of base salary are generally similar in public and private equity owned companies. There is often less of a specified maximum built into the private equity owned company plan and usually more discretion. This is expected since, rather than public shareholders, the portfolio company board is composed of employees of the financial sponsor who report only to the financial sponsor. The recent promulgated SEC regulations under Dodd Frank with regard to clawbacks, emphasize that public company employment agreements usually provide for clawbacks of annual bonuses and incentive equity based on financial restatements or cross reference the company policy on clawbacks. The private equity owned company employment agreement does not usually provide for clawbacks based on financial restatements. Of course, at least half of the incentive equity will be at risk until exit on any termination and all equity is forfeited on a cause termination in the private equity owned company.
D. BENEFITS
The private equity owned company will have the same basic benefits of healthcare, life insurance, 401(k) and disability benefits as the public company, but often will not have all of the ancillary benefit programs. The larger the private equity owned company, the more likely they will have public company type benefits.
E. PERKS
The private equity owned company will likely have less perks and fringe benefits than a public company because of the desire to limit expenses. Use of aircraft will occur where necessary for business use, but not often for private use.
F. SEVERANCE
Severance levels are generally similar pre change in control in public and private equity owned companies. However, the common increase in severance multiples found in public companies in connection with a change in control is generally not found in private equity owned companies. It is increased in public companies because executives may well be terminated in such situations through no fault of their own, but, instead, because there is no role for them. Therefore, arguably, they need and deserve a bigger cushion. In private equity owned companies there is not usually a step up in severance on a change in control. The reason is that the expectation when management joins the company is that it is going to be sold within a couple of years and that management will be adequately compensated at that time by the vesting and sale of their equity.
G. 280G COVERAGE
280g is a section of the tax code that imposes an excise tax on executives in the case of a change in control where management receives significant payments. At one point this excise tax was commonly grossed up by the company so that the executive would have no cost for it. The gross up has not existed for a number of years because ISS, Glass Lewis and governance advocates treat it as a very bad pay practice and penalize the board for authorizing it. Instead the employment contracts provide a “better of” provision where the executive retains the greater of the amount he can receive without being subject to the excise tax and the amount he would retain if he received the full amount and paid the excise tax. You often see the same “better of” provisions in private equity owned company employment agreements for the top people, but it does not often come into play because there is an exemption from 280g for privately owned companies if the executive waives the excess parachute payments unless reapproved at the time of the deal by 75% of the ownership interests. So there is commonly a provision that provides the Company will seek the approval in good faith if the executive waives.
H. INDEMNIFICATION AND DIRECTOR AND OFFICERS LIABILITY INSURANCE
While the basic provisions on indemnification and insurance are generally the same in employment contracts in both types of companies, there are differences that need to be considered. The level of insurance coverage in a private equity owned company is usually less than in a public company because there are no public shareholders and, unless public debt is utilized, no securities law filings. Therefore, both the probability of a lawsuit and the amounts involved will be less. In the private equity owned company, there usually is a very broad indemnity in the organizational documents to cover the directors and sponsor employees. Depending on wording, it may or may not cover the executives of the operating company. If it does not, this protection needs to be provided through the employment agreement. In a public company, the certificate of incorporation or bylaws usually includes protection for the officers and directors. In both cases, the employment agreement usually has provisions assuring post-employment continued coverage for actions while employed. In all cases this coverage is usually just for officers and directors, and any coverage of non-officer employees is not covered by the bylaws beyond being discretionary.
I. RESTRICTIVE COVENANTS
The private equity owned company often has restrictive covenants in three agreements—the employment agreement, the equity grant agreement and the purchase agreement. The first two usually continue for one to two years after termination of employment, while the one in the purchase agreement, if provided, usually runs 3 to 5 years from the purchase. They all should generally be coordinated as to the restrictions and limitations. The public company will generally have one in an employment agreement or a separate restrictive covenant agreement. Some public companies, but not all, will include them in their equity grants. While the private equity owned company equity grant will almost always provide for clawbacks for violations, the public company remedy provisions vary greatly.
CONCLUSION
Employment arrangements, in addition to equity, are important in the private equity setting and must be carefully reviewed and negotiated. This is especially true, as is most often the case, when the definition of cause and good reason are being carried over from the employment agreement to the equity plan. But, in all cases, the executive is signing on for a package and the employment agreement is an important part of it.
Jamieson Corporate Finance US, LLC is a member of FINRA/SIPC
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