Management Option Pools in LBO Models
Hi everyone,
I am currently working through some practice LBO cases and had a question about management options. I am noticing that in different posts on WSO, the way that management options are treated seem to be different. I'm noticing a couple of techniques, but I'll use a sponsor equity of 100, equity at exit of 500 and management equity of 10% for demonstrative purposes.
The first way I'm seeing is that some people are treating the strike price of the option as the equity at entry. In that case, it looks like this:
Value of management option = (500 - 100) * 10% = 40 Value of sponsor equity after mgmt option = 500 - 40 = 460
The second way I am seeing (commensurate with how WSO does it) is calculate the fully diluted impact of the management option and assume a cash inflow from the management option exercise. It also seems the option is calculated on the beginning equity here:
Cash received from management option exercise: 100 * 10% = 10 Adjusted equity at exit = 500 + 10 = 510 Portion owned by management = 10% / (1 + 10%) = 9.1% Equity owned by sponsor = 510 * (1 - 9.1%) = 464
These strike me as two completely different methodologies. How will we know which one to apply if we are only given a simple instruction like "assume a management option pool of 10%"? Appreciate any guidance in this area about how to differentiate these models and if they are in fact completely different types of options.
A is correct.
I always find it easier do these using shares. Let's use 100 in your example. Sponsor gets 100 shares at $1 / share. A 10% pool means management gets 10% of the company, excluding the impact of strike, but including the option dilution. Therefore, your option pool is x / (100 + x) = 10%, x = 11.1111
Post option issuance, sponsor holds 100 shares, options are 11.111 / 111.111 shares (10%!), with a strike price of $1 / option.
At exit: Equity value pre-options of 500, post option payment for strike of 511.1111. Sponsor gets 90%, which equals $460. Management gets 10%, or $51.1111, less the payment for strike of 11.1111 = $40.
Aren't proceeds here $44.4444? ($5-$1)*11.1111 shares? I know my logic is flawed, but can't figure out why this isn't true.
The problem is fully diluted value / share is not $5. Let's gross your math back up - $5 x 111.1111 total shares = $555.55, vs. equity value + cash from options of $511.1111.
Never knew about this before, but management has to pay in for those options correct? Then they get their proportion in equity proceeds.
I'm not in buyout, but part of the issue is how these questions are framed. Almost testing candidate on ability to know they way you want to think about option structure without giving them the details. 2) How typical is the $1/option? 3) Management also gets pro rate benefit of the cash to the company from the exercise of their option, so the net cost (for exercise) is lower?
Bump. Can we get some more (second) opinions on which is correct? A or B?
It's always A homie. Your B math is wrong. It should be 11.1111 as dude above said that's 10% fully diluted not 10% primary shares.
so 111.111 shares. Mgmt pays in 11.111 so 511.111 total adj equity value / 111.111 = 4.6/share mgmt gets 11.111 shares = 51.111 (remember they paid 11.11 so 40 gain). Sponsor gets 511.11-51.11 or 460.
same ans always
Sorry to revisit this topic again - but I'm wondering how things would change if we have both management rollover and options?
I'm thinking options are payout first, then the rest of equity proceeds are split between mgmt and sponsor pro rata to the ownership percentage at entry. Would this be correct?
It depends on the structure of the waterfall but few options:
Crazy to get a reply from SaaSChimp himself - thanks a lot!
If I'm understanding correctly, with vanilla assumptions (pari passu, options fully vested, no PIK), sponsor/mgmt gets their initial investment back, then everything is paid out at the same time. Mgmt options would basically be extra ownership % for mgmt at exit (based on fully-diluted ownership). When mgmt rollover is junior then you create a payout waterfall accordingly. Either way, mgmt options would be in the same tier as mgmt rollover in the cap structure
You can treat them separately, the fact that rollover and options are both owned by management doesn’t matter.
Typical option structures noted above, with payments above strike price. Strike price is often set for initial grants at sponsor entry valuation, so mathematically common equity gets paid back first, then the options participate in their pro rata ownership.
For rollover, lots of different structures are typical, from fully pari passu to sponsor having a preferred return.
Very well put! Thank you sir
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