Sweat Equity LBO
Hi, I am trying to understand how sweat equity works in an LBO. Could someone please walk me through how to take it into account in an LBO?
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Dilute the shareholdings of the sponsor and management by (say) 10/15% at exit to get the % shareholding at exit.
In reality, there are likely to be ratchets / some sort of performance hurdle which needs to be met, but can keep simple by doing the above and assume it gets allocated.
Thanks, would you be able to walk me through the steps of how to build this in the model?
my understanding is, say there is an IRRhurdle of 20%, once that is hit, in your ev to equity bridge calc, you first remove x % attributable to the sweet equity, and then the rest gets divided between management/ sponsor equity? Appreciate if you can provide any further color
In a nutshell, yes. If you are backsolving for a target IRR you'd need to know if the sponsor targets this IRR pre or post MIP. I've seen both but think pre MIP might make more sense. If target is post MIP then this will affect sponsor's equity check. Need to be careful on which investor you dilute though. If management already holds a stake and sweat equity belongs to them as well then you only dilute the remaining shareholders.
I see, thank you. Just to clarify, in the case that sponsor targets the IRR post MIP, why would you not dillute management In addition to sponsor? Would it not be possible for the MIP to be negotiated as a kind of add-on on top of their rolled over stake?
And if the IRR is targeted pre-MIP, you would not dillute anyone, correct? Essentially just remove the MIP number from the EV to equity bridge?
Who you dilute is unrelated to whether you target pre or post MIP returns. Exactly because this is an "add on" to existing mgmt stake (if any), you only dilute the other party (or parties). If sponsor and mgmt hold say 50% each, MIP kicks in for 10% and you dilute both pro rata then mgmt basically dilutes their stake only to give that dilution back to themselves so they end up with less than what their post MIP stake should be.
Not sure I understand they second part of your comment. If you solve for pre MIP target returns then nothing changes on your LBO from the buyers pov. They will get diluted at exit if rachets are met but no changes in their equity check at entry (ceteris paribus)
Understood, thanks so much!
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