How to calculate management option pool size for various model test formats
I’ve been trying to figure out how to handle management options in an LBO, and am getting pretty confused because there seem to be different “shortcut” approaches taken by various models available online. Specifically I’m only asking about how to calculate the shares / size of the option pool, not the subsequent returns calculations.
In the BIWS private-private model, you’re given an option % but no balance sheet and no info about shares / strike price. So they take the post dilution option % and multiply it with the equity value from sources and uses to get the value of the options pool at strike.
In the advanced WSPrep model (which is a take-private LBO), they multiply the post dilution option % by the purchase equity to get the value of the management option pool, and then divide by the post-close share price to get the number of management option shares.
In another model, (level 5 PF, also take-private model) you’re just given the management option share count outright, along with pricing information.
In one you’re multiplying the post-dilution option pool % by the Sources Equity, in the other you’re multiplying it by the Purchase Equity and then backing into share count by dividing by via the post-close share price, and elsewhere you’re just given the option count outright.
To the people who’ve gone through these test in actual interviews / work in PE, can you please share advice on how to best derive option pool sizes for these tests? Do interviewers normally tell you which method to follow? And generally, should options be based off sources equity / purchase equity?
Sorry for the long write up, and many thanks in advance!
When calculating the management option pool size in LBO models, the approach can vary depending on the specific assumptions and details provided in the test or model. Based on the most helpful WSO content, here’s a breakdown of the key methods and considerations:
1. Understanding the Different Approaches
BIWS Private-Private Model:
Advanced WSPrep Model (Take-Private LBO):
Level 5 PF Model (Take-Private LBO):
2. Key Considerations for Interviews and Tests
Sources Equity vs. Purchase Equity:
Post-Dilution Option Percentage:
Strike Price and Share Price:
3. General Advice for Deriving Option Pool Sizes
4. Common Pitfalls to Avoid
In summary, the best approach depends on the specific details and instructions provided in the test or model. If no method is specified, clearly state your assumptions and proceed logically. Practicing various scenarios will help you handle these calculations confidently in interviews or on the job.
Sources: Management Option Pools in LBO Models, Management Option Pool LBO Question, Option Pool Question, Creating own LBO assumptions, Private Equity Interview Questions - 13 Topics to Know
Bump
The most correct way to do is to grant the option % based on the post-closing capital structure as that's the equity value that you'll carry forward and which serves as a reference for any sort of metric or calculation that would be related to the post-closing capital structure, including options.
In practice, though, I could grant options to management based on any metric I choose, even global warming (who is going to stop me?). It is a contractual right, so we can negotiate and set the calculation however we want. See for example the option clause to management below.
In this clause, you can see it is tied to post-closing, since the moment management signs to enter the management pool should coincide with the date the transaction is consummated and the capital structure is altered. Also, the strike is set based on the fair market value at the date of the agreement.
Usually, if I grant options on the purchase equity value, management ends up with a higher share. The strike price is also straightforward to understand. For example, if it says the options can be exercised when the shares reach X value or (increase by a certain % from the initial value), then you just check that the strike price > initial equity, calculate management's share and the number of options, minus the proceeds the company receives, and then grant the shares.
I never touched a public-to-private in case there are some more "special" aspects to consider and which might justify granting options from the purchase equity value (however, I suspect might be the case if management had existing options so you would be granting something above those or consider those as the floor i.e. the minimum they should also be able to get in the post-equity closing, so it's highly improbably in an LBO test to get so detailed/focused on this), so if anyone wants to correc this, feel free. However, if you justs want to grant a nominal amount of shares, then you can derive it either from the entry equity or the sources equity and just tweak the percentage, but the sources equity is the more accurate imo (can ask guidance also, might appreciate you exercising critical thinking).
p.s. have lots of free time today as you see
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