Question on management options in LBO
I have a question about management options in LBO and which method is correct - I have gone through historical posts in this form, but am still confused. Let's say we have entry equity of $100, management incentive option pool of 10% (post exit), and exit equity of $200. Let's assume this means that we have 100 shares initially at $1 per share. At exit, this would mean each share is now worth $2. An incentive option pool of 10% means that there are new 11.111... new shares created from the option pool. I thought that both option A and Option B should produce the same figure but they are slightly different and I want to understand why and which one is technically correct
OPTION A: Backdoor TSM Method - Sponsor Equity at Exit = (200 - 100) * 10% = $190
OPTION B:
- Exit Total Equity = $200
- Add back cash from exercise of the 11.111... new options at original price of $1/share: +$11.11
- Subtract dilution from 11.111... new options at new strike price of $2/share: -$22.22
- Sponsor exit at equity is $188.88... (which is different than the $190)
- Add back cash from exercise of the 11.111... new options at original price of $1/share: +$11.11
Option B produces $190 as well.
Post-exercise equity value is $211.111
Sponsor owns 90% post MIP dilution - definitionally the MIP pool is 10%
$211.111 * 90% = $190
By the way... depends on the deal but generally when we issue MIP for "10% of the equity" its 10% of the initial sponsor equity size so when you do the full math it's actually slightly less than 10%.
Thank you! What is the math if the MIP is based on the initial ownership?
Tossing out another way to think about it - flow the proceeds waterfall:
This is only assuming that the option pool is awarded as a percentage of ending equity though, most of the time it is awarded as a percentage of the beginning equity, and in that case, how would it work?
This actually does assume issuance as % of beginning equity. In my example, the sponsor owns the preferred shares (e.g., Security A) while the management team gets common shares (e.g., Security B). If we assume 1 share = $1, Security A will have 100M shares that are all owned by the sponsor. It's typically structured so Security B shares will be 100M shares (where each A gets an equivalent B share) plus shares for management where management will own 10% of Security B on a fully-diluted basis (i.e., (100M / 90%) - 100M = 11.1M shares).
That makes sense! But what does the other person who commented mean when they say that incentive plan is issued for beginning equity so that it’s slightly less than 10%? Because in our case we have management being awarded $10 out of $200 pre diluted value and out of $211.11 fully diluted basis. So it would be 5% options on a pre diluted basis and 10% on a diluted basis? Where does slightly less than 10% come in?
I actually didn’t follow their comment. Maybe they’re trying to say if check is $100M and you offer management $10M (10% of that figure), they’d own 10/110 which is like 9%?? I’ve just never seen the 10% derived that way. It’s supposed to be on fully diluted shares in some class (based on what I’ve been taught).
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