Apr 29, 2020

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.

Region

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?

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