Private Equity Transactions Provides a Return to the Managers on an Exit If the Across the United States, Sponsor Realizes a Minimum Return on Its Investment

Q32015 GLOBAL

PrivateUPDATE Equity

A Comparison of subscription price for the sweet equity is often set at a low amount, with some form of performance ratchet or Management Incentive hurdle, such that there is little or no value in the sweet Equity Arrangements in equity on subscription. The sweet equity then only Private Equity Transactions provides a return to the managers on an exit if the Across the United States, sponsor realizes a minimum return on its investment. Europe and Asia This often allows the managers to minimize income By Timothy Gardner, James Harvey, Michael Nissan, tax costs on acquisitions while ensuring that exit Sumit Ram and Amanda Rosenblum proceeds are taxed at the prevailing capital gain rate rather than as ordinary income. Introduction United States: In the United States the nature of the securities or interests held by managers is A key feature of private equity transactions is ensuring more varied, with managers typically holding either that management, who will be asked to deliver on options exercisable into ordinary equity, profits the company’s business plan, are appropriately interests or, occasionally, leveraged common equity incentivized and aligned with the sponsor to share (common equity subordinated to preferred equity in the future growth of the company. This is typically so as to depress entry value), with vesting of these achieved with incentive equity arrangements put in interests subject to continued service and the overall place at the time of the sponsor’s acquisition of, or performance of the business or investment. The investment in, the company. In this article we look at choice between these different interests is driven by the approaches taken to management incentive equity tax considerations and the negotiating strength of arrangements for sponsor-backed transactions in the management: options giving rise to ordinary income United States, Europe and Asia. treatment but a compensation deduction benefit in the hands of the company, and profits interests and equity Observations giving rise to capital gains treatment for the managers, Europe: The common position across the vast but no compensation deduction for the company. majority of European jurisdictions is for managers to Asia: The position across Asia is also more varied, be issued ordinary (sweet) equity, sitting alongside and in general there is no settled market standard for the sponsor’s interest held across a mix of securities, management equity incentive arrangements, although including for example ordinary and preferred equity it is more common for management in transactions in and shareholder loans (the institutional strip). The

2015 Private Equity Weil, Gotshal & Manges LLP UPDATES Global Private Equity Update

China to be given equity incentive awards that vest Transferability purely over time with no performance requirements, Ensuring that management incentive interests are held whereas in the Hong Kong market managers are only for the benefit of management is also important commonly issued with a mix of ordinary equity as well and, therefore, general prohibitions on transfers by as options exercisable into ordinary equity and which a manager of equity or other incentive interests are are linked to future business performance. In other an almost universal feature in arrangements across markets we see features similar to both Europe and the United States, Europe and Asia. Similarly, if a the United States. manager ceases to be employed by the company Pooling Vehicles (i.e., becomes a “leaver”), that manager may no longer be allowed to retain some or all of his/her The use of a pooling vehicle controlled by the incentive interests. Across Europe it is typical for the company (and ultimately the sponsor) to hold at least leaving manager to be required to transfer equity (for more junior managers’ equity interests is becoming example to a new incoming manager, or perhaps a increasingly common in European transactions. This warehouse vehicle to be recycled later). In the United allows for greater control of management’s incentive States, unvested options or equity will typically lapse, equity as well as easing the administrative burden, with any vested equity being subject to a repurchase since the company will only have one management right by the company. The price paid for equity being shareholder entity to deal with, as opposed to many transferred or repurchased is determined by the individual management shareholders. Use of such circumstances of the manager’s leaving, with a “good vehicles is not common in the United States with leaver” typically being entitled to receive a higher managers typically holding their interests directly with, amount than a “bad leaver” on vested equity. less frequently, junior managers holding phantom equity through a profits interest structure. Across Asia While each transaction is different, there are a transactions, pooling vehicles are sometimes used in number of areas where it is possible to find a larger transactions but (in some markets, like China) generally settled position and, accordingly, we set are often controlled by the company’s founders rather out below a summary of certain of the key terms and than the company itself. some of the more common positions adopted.

Right Europe United States Asia Type of Interests Held

Class of Security ■■ Rollover of existing equity: ■■ Rollover of existing equity: ■■ Rollover of existing equity: ordinary equity or into a strip of same mix of securities as typically ordinary equity or ordinary equity and preferred sponsor (pari passu save equity-linked securities equity and/or shareholder for company’s call right over ■■ loans alongside sponsor manager held equity on Incentive equity: varies, but, becoming a leaver) e.g.: (i) in Hong Kong, options ■■ Incentive equity: ordinary linked to future performance or equity, sometimes with a ■■ Incentive equity: non-qualified equity with a hurdle linked to ratchet or hurdle, or similar, stock options (exercisable a minimum sponsor return on such that the sweet equity into common stock), profits exit; or (ii) in China, shares and only provides a return once interests or, occasionally, not options a minimum return has been leveraged common stock achieved by the sponsor on (common stock subordinated exit to preferred stock to depress value)

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Right Europe United States Asia

Vesting for Incentive Equity ■■ Time vesting over e.g. a four or ■■ Combination of both time ■■ Combination of both time five year period, annually or on vesting and performance vesting and performance a straight line basis (see also vesting for both options and vesting: leaver price below) other incentive equity: ■■ Time vesting over e.g. a ■■ Time-vesting component: four or five year period four to five years ■■ Performance vesting: ■■ Performance vesting return-based and/or component: return-based operating based (e.g. (multiple of investment EBITDA) performance and/or IRR) and/or metrics operating based (e.g. EBITDA) performance metrics

Voting Rights ■■ Varies but often voting ■■ Varies but often voting ■■ Usually voting

Anti-Dilution Rights ■■ None (although see pre- ■■ None (although see pre- ■■ None (although see pre- emption rights below) emption rights below) emption rights below)

Pre-emption on New Issues of ■■ Pro rata pre-emption rights, ■■ Usually for rollover equity only ■■ Usually for rollover equity only Securities with exceptions for: ■■ Sometimes for vested incentive ■■ Acquisition issues equity

■■ Emergency issues (for example to avoid imminent default under the company’s financing arrangements) with managers having a subsequent catch-up

■■ Issues under a management incentive plan up to a certain percentage of equity

Terms of Loan Notes / ■■ Varies, but between 10% ■■ N/A ■■ N/A in most cases Preference Shares / and12% interest, PIK often Shareholder Debt seen

Management Rollover ■■ Often about 50% of post-tax ■■ Determined on a case-by-case ■■ Determined on a case-by-case Percentage proceeds basis (50% post-tax proceeds basis would not be unusual)

Use of a Pooling Vehicle to ■■ Senior managers hold directly, ■■ Use of pooling vehicles not ■■ For larger transactions Hold Management Interests with more junior managers common. Senior managers management’s equity is holding through a pooling usually hold equity interests sometimes held through a vehicle/co controlled by the directly; junior managers hold pooling vehicle controlled company either directly or, occasionally, either by the founder (if may have phantom equity applicable) or the company interest instead

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Right Europe United States Asia Leaver Provisions

Which Securities are Subject ■■ Incentive equity only ■■ Incentive equity and typically ■■ Varies, but incentive and to Leaver Repurchase rollover equity rollover equity often subject to Provisions? leaver provisions

Types of / Reasons for ■■ Good leaver – manager who ■■ “Cause” or when “cause” exists ■■ No fixed position–both United Becoming a Leaver leaves due to: States and European positions ■■ Resignation without Good seen in recent deals ■■ Death or incapacity Reason

■■ Redundancy or retirement ■■ Death

■■ Wrongful dismissal ■■ Disability

■■ Sale of that manager’s ■■ Termination without Cause part of the business ■■ Resignation with Good Reason ■■ Designated by the board ■■ as a good leaver Retirement (not as typical) ■■ Bad leaver - a manager who leaves due to any other reason such as resignation or summary dismissal

Disenfranchisement ■■ Until a leaving manager ■■ N/A ■■ Depends on whether United transfers incentive equity under States or European style the leaver provisions or if the leaver provisions are adopted leaver rights are not exercised such that a leaving manager retains incentive equity, the manager will no longer be able to attend and vote at shareholder meetings or vote on shareholder matters

Price Paid to a Leaver for ■■ If departing manager is a good ■■ Call on incentive equity: fair ■■ Deal specific, but price paid Incentive Equity leaver: market value for vested equity will distinguish between good unless departing manager has leavers and bad leavers and ■■ Fair market value for been terminated for cause or often see positions similar to vested equity; and breached restrictive covenants, Europe and the U.S. ■■ The lesser of cost and fair in which case the lesser of fair market value for unvested market value and cost equity ■■ Any unvested incentive equity ■■ If departing manager is a bad forfeited and options lapse leaver: the lesser of cost and ■■ Rollover equity: fair market fair market value value unless terminated for cause or breached restrictive covenants, in which case, the lesser of fair market value and cost

Payment for Leaver’s Shares ■■ Company usually has the ■■ Typically cash unless financing ■■ Typically cash unless financing right to pay in cash or defer restricts cash payment, in restricts cash payment, payment until an exit by issuing which case, may pay with although some deals give right a note, with interest sometimes subordinated notes due when to defer payment until exit by accruing, e.g. at LIBOR or restrictions are lifted or upon a issuing a note otherwise, company required change of control (with interest to pay in cash unless financing accruing at an agreed upon restricts cash payment, in rate) which case, a note is issued

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Right Europe United States Asia Board Rights

Constitution of the Board of ■■ Usually as is determined ■■ CEO may receive board right ■■ Usually determined by sponsor Directors by sponsor, with managers pursuant to employment together with the company’s (CEO, CFO etc.) appointed contract or if CEO owns a founders/senior management. by the sponsor, as the case significant stake, but only while If a founder retains a significant may be. No entrenched right employed interest, the founder would for managers to sit on the normally retain board seats board unless perhaps where managers have a significant rollover equity stake

Share Transfers and Exit

Permitted Transfers ■■ General prohibition on ■■ General prohibition except for ■■ General prohibition on transfers, save for estate estate planning purposes transfers, save for estate planning purposes such as planning purposes such as a portion (e.g., up to 50%) to a portion to spouse or family spouse or family trust trust

Drag-Along Rights ■■ Sponsor has right to drag ■■ Sponsor has the right to drag ■■ Sponsor typically has the management into an exit on management into an exit on right to drag management the same terms (purchaser same terms for typically the into an exit on same terms may sometimes be able same form of consideration (purchaser may sometimes to offer different forms of be able to offer different consideration (e.g., rollover forms of consideration (e.g., equity) to the dragged rollover equity) to the dragged shareholders, so long as shareholders, so long as economically equivalent) economically equivalent)

Tag-Along Rights ■■ If sponsor is selling e.g., more ■■ If sponsor is selling, then ■■ If sponsor is selling than 50% of its shares, then managers have right to tag (sometimes with a requirement managers have a right to tag along on (i) rollover equity and that a certain amount of its along, pro rata on the same (ii) sometimes vested incentive shares are being sold) then terms equity managers may (but not always) have the right to tag along

Tax Matters

Particular Tax Structuring / ■■ Will be jurisdiction specific, ■■ Non-qualified options ■■ Will be jurisdiction specific Relief but arrangements may be result in ordinary income structured so as to allow to management and tax managers to qualify for local deduction to employer reliefs or exemptions on company. Profits interests and disposal (for example, U.K.- leveraged common stock are resident managers may avail eligible for long-term capital themselves of the employee gain treatment if certain criteria shareholder scheme, allowing are met and no deduction for 0% tax rate on capital gains appreciation to the employer on compliant equity or company entrepreneur’s relief, allowing a 10% tax rate on capital gains up to a lifetime limit of £10m)

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Weil’s Global Private Equity Practice

offices worldwide, of which are Market 20 16 Recognition recognized as top tier for Private Equity by Chambers and Legal 500 Private Equity Practice Group of the Year — Law360 2012 and 2014 Ranked for Global Private Band 1 Band 1 for Private Equity Global-wide, Equity by Chambers Asia-Pacific-wide, and Across Europe — Chambers Global, Chambers Asia- The global private equity team acts for more Pacific, Chambers Europe, Chambers UK than 200 private equity clients worldwide, Tier 1 for Private Equity in the U.S., including more than 80% of the world’s U.K. and Asia top 10 funds and 70% of the top 25, as — IFLR1000 2016 ranked by PEI 300 2015 Band 1 for Private Equity – U.K. — The Legal 500 UK 2015

Ranked Top 5 for Global Private Band 1 for Private Equity – Hong Kong Equity for the last 5 years — Bloomberg; — Legal 500 Asia Pacific 2015 mergermarket Shortlisted for Business of Law Category for Developing the Global Chambers-ranked private equity lawyers Private Equity Watch 33 — Financial Times’ North America worldwide, including 10 ranked Band 1 Innovative Lawyers Report 2015

Recipient of “Private Equity Deal of the Year” Award — China Law & Practice 2015

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Recent Weil Representations

Advent International American Securities Avolon Holdings Limited/ Baring Private Equity Berkshire Partners LLC CCMP Capital Advisors/ Corporation/Bain LLC Cinven Partners/CVC Asia PQ Corporation Capital Capital Partners/Oak Hill Capital Partners

Centerbridge Partners CVC Capital Partners EQT Infrastructure Genstar Capital LLC The Gores Group JAB Holding Company L.P. Limited

The Jordan Company, Montagu Private Equity OMERS Private Equity Partners Group Holding Providence Equity THL Partners L.P. LLP Inc. AG Partners

Global Private Equity Update provides updates on current topics and trends in global private equity and is published by the Private Equity practice of Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY 10153, +1 212 310 8000, www.weil.com. If you would like more information about the contents of this issue, or about Weil’s Private Equity practice, please contact your relationship partner at Weil, or one of the authors below:

Editors: Marco Compagnoni (London) Bio Page [email protected] +44 20 7903 1547 Doug Warner (New York) Bio Page [email protected] +1 212 310 8751

Contributing Authors: Timothy Gardner (Hong Kong) Bio Page [email protected] +852 3476 9218 James Harvey (London) Bio Page [email protected] +44 20 79031070 Michael Nissan (New York) Bio Page [email protected] +1 212 310 8169 Sumit Ram (Hong Kong) Bio Page [email protected] +852 3476 9267 Amanda Rosenblum (New York) Bio Page [email protected] +1 212 310 8283

© 2015 Weil, Gotshal & Manges LLP. All rights reserved. Quotation with attribution is permitted. This publication provides general information and should not be used or taken as legal advice for specific situations that depend on the evaluation of precise factual circumstances. The views expressed in these articles reflect those of the authors and not necessarily the views of Weil, Gotshal & Manges LLP. If you would like to add a colleague to our mailing list, please click here. If you need to change or remove your name from our mailing list, send an email to [email protected].

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