Many companies’ strategic plans change significantly post acquisition. There are numerous reasons, including the new owners’ goals and objectives, potential changes in executive management, changes in the composition of the Board of Directors, strategic fit with a Private Equity buyer’s other portfolio companies, and other.
Building for future growth
The acquisition (or change of control transaction) often results in additional capital available to the acquired company. As part of the growth plan, many organizations will also add new members to their senior management team, or to their board of directors. To attract and incentivize these individuals, many organizations will issue some form of equity compensation, ensuring that these individuals will share in the future growth in value of the organization.
Types of equity incentives
Equity incentives can come in many different shapes and forms. One relatively simple example, used by both private and public companies, would be a time-vested option to purchase stock in the organization at a predetermined price (the strike price). This type option rewards both loyalty of the employee (due to the time vesting requirements) and appreciation in equity value (as the option payout depends on the difference between the strike price of the option and the stock price). Stock options lend themselves to organizations that have a liquid market for their stock, like public companies. In the private equity space, equity incentives are often structured to reward the incentive holder for specific company performance metrics and the eventual sale price of the organization. For example, one may encounter a management incentive unit that vests only if the organization exceeds certain cash flow targets (typically based on earnings before interest, taxes, depreciation, and amortization or “EBITDA “) in each of the following three to five years. Another example, based on an exit sale price, would be a management incentive unit that only pays out if the company is sold within a certain time frame, at a multiple of, for example, three times the original investment of the private equity buyer.
Regardless of the type of equity compensation instrument an organization chooses to employ, it is important to estimate the fair value of the equity grant for multiple reasons: One, it protects the issuer from erroneous compensation expense charges. Second, it protects the grantee from potential tax obligations and penalties. And third, it allows the compensation committee to properly assess the value of incentives awarded to executives and employees. For these reasons, appraisals for compliance with Accounting Standards Codification (ASC) Topic 718 and with Section 409(A) of the Internal Revenue Code are an important tool for governance and financial compliance purposes.