30 April, 2018
Effective remuneration and incentive models are crucial to ensuring that management teams and key personnel are incentivised to stay with the business and contribute to its on-going success. This is a particular concern for investors following an acquisition.
There are many different ways in which incentives can be designed to achieve this. We discuss the advantages of certain incentive models and some key considerations when applying them to employees based in Asia.
Commonly used incentives
A typical package might consist of salary and benefits (set by reference to market levels), an annual bonus based on performance hurdles and, increasingly, some form of long term incentive arrangement. When designed, implemented and managed correctly, cash and share-based long term incentives can generate a range of market advantages for companies and investors, including better rates of recruitment and retention, more motivated and higher performing employees, and increased levels of engagement. Crucially, long term incentives can be used to align the economic interests of a management team with those of the company or investors, thus retaining them with the company for the long term.
How do you ensure you “lock-in” managers following the acquisition?
Often, an acquisition will trigger the vesting of any existing incentive awards held by management under pre-acquisition incentive arrangements. If a manager receives a significant pay-out as a result of such vesting, there is a danger that they will decide to walk away, thus reducing the value of the business in the hands of the purchaser.
A key question to be addressed early on in the negotiations therefore is how managers can be “locked-in” to ensure that they deliver value to the Investor. There are different ways to achieve this, primarily based around delaying the time at which managers would otherwise receive any consideration to which they are entitled on a sale of the acquired company. Common structures include “retention / escrow arrangements”, “earn-outs” and “management equity”.
When seeking to lock-in managers, it is necessary to consider what form that lock-in should take; it could for example be structured as:
- “rollover” – i.e. the exchange of existing shares held by managers for new shares in the company, which may be appropriate where managers have a substantial existing ownership interest in the company before the investor’s acquisition;
- “co-investment” – i.e. the purchase of new shares in the company, which may be appropriate where managers own little or no equity in the company (but who may have received significant cash bonuses as a result of the acquisition), or a rollover is not feasible; or
- “future incentives” – i.e. the grant of new incentive awards to managers, which can be used in addition to rollover or co-investment, providing managers with potential for upside gain for achieving growth in the business (see below).
How can managers be incentivised to drive future performance?
In addition to lock-in arrangements, new long term incentive arrangements can be put in place to drive growth post-acquisition.
The implementation of new arrangements raises an important question as to whether cash or shares will most effectively incentivise managers. Some investors are uncomfortable with giving away equity, particularly if this will result in a dilution of control, and prefer to put in place cash-based structures. There is no right or wrong answer on this point but there is commonly held view that using actual shares rather than cash has more impact on managers feeling that they have a stake in the future of the company. One method of overcoming the control issue as regards a share based programme may be to grant shares with economic rights but no voting rights. This gives the managers a sense of ownership without diluting an investor’s control.
Cash structures
On the other hand, using cash structures ensures that an investor will retain 100% control. Cash structures also have the advantage of simplicity; there being no need for multiple classes of shares or complex shareholder documents. The ability to phase pay-outs without having either to wait for an exit or needing to create an internal market also favours cash structures.
Disadvantages include the company needing to have sufficient cash available to satisfy pay-outs as and when they fall due and the fact that no tax-planning opportunities exist (as all pay-outs will be subject to income tax and social security rather than capital gains).
Common cash structures include “phantom shares” or “phantom share options”, “discretionary long term cash incentive plans” and “profit pool arrangements”.
Share structures
As discussed above, using share-based incentives can give managers a real sense of ownership of the business. Share structures also have the significant advantage of not needing to use cash resources. There is also the potential to take advantage of tax planning opportunities to achieve favourable capital gains treatment for share structures.
Share-based structures can however be more complex and expensive to implement and may require different classes of shares. Unless a simple “exit-only” structure is implemented, an “internal market” for shares will also likely need to be created to enable managers to monetise their share incentives and to create a pool of shares which can be used to provide on-going incentives for other managers.
Common share structures include “stock option plans”, “performance-based long term incentive plans”, “time-based restricted stock units (RSUs)”, “restricted shares”, “bonus deferrals” and “growth shares”.
Key takeaways
Retaining and properly incentivising the management team for the long term will be a key consideration for investors that should be thought about when planning for an acquisition. Investors should give careful consideration to the incentive arrangements they propose to implement for managers, and ensure that they properly align the managers’ interests with the Investor’s own.
Further, when rolling out incentive offerings to employees based in Asia, there will likely be localised considerations necessary to ensure compliance and the efficacy of the terms, for example:
- obligations in respect of mandatory provident fund, pension or similar contributions;
- the interaction with any statutory bonus, 13th month or end of year payment entitlements;
- local securities law requirements; and
- where vesting is tied to post employment covenants, the enforceability of such covenants in the jurisdiction.
For further information, please contact:
Fatim Jumabhoy, Of Counsel, Herbert Smith Freehills LLP
fatim.jumabhoy@hsf.com
