How do private equity firms factor in dilution or option redemption costs in their models? If you do a typical dcf and then you buy a company and bring in a new management team who you give a ton of options to, and the value of the company appreciates greatly, they will own a big share of the company, or you will have to buy back their options at a great cost, either way reducing your claim to profits, so how do PE firms factor this in?
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Its very easy to model - you give the managers options worth X% of the common equity (with some vesting based on time or overall deal return) and you just build this into your exit waterfall. Typically x is not >10% so it is not a massive driver of returns, but you need to think about all the same
Good response from PZ87.. something else to consider: you don't always bring in a new management team. Its very common to incest alongside management, which creates rolled equity in the deal.
This is a good point, but often times PE firms can the management team and put in their own. In this case, it would seem like they are paying a huge premium for their own management team given that they need to offer way more incentives to lure someone there than to keep on managers who already have a stake in the business. Buy their stake and essentially give it to new managers, versus let existing management stay and keep their stake. An expensive propisition.
I guess then that you would work a lot with lawyers on coming up with an option plan/vesting schedule and this would be modeled in. I have just never seen options modeled in on the basis of ones that aren't on the table already, and for the most part people model in dilution based on options that are in the money. I.e. if you do a dcf and model out that the market cap should be $1b, which at 100M shares outstanding would be $10 a share, and it's currently trading at $2, well there might be 5M old options exercisable at $8, so how do you factor that in. Sorry if im being incoherent, it's been a while since I did modeling this detailed.
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