Do you use the Treasury Stock Method when calculating Ownership in an LBO test with Mgmt Option Pool?

I've noticed it seems that sometimes it's used, and sometimes it's not. On a model test, should it be used?

Taking an example...assume:
-Initial Sponsor Equity **= $100 (no mgmt rollover)
-
Exit Equity Value = $200
-
Mgmt Option Pool = 10%, strike at initial sponsor equity
-
Shares Outstanding (arbitrary) **= 100

Implying:
-# of Mgmt Options = 100 x 10% = 10
-Initial Equity per share = $100 / 100 = $1.00
-Exit Equity per share = $200 / 100 = $2.00

So to calculate % sponsor ownership after exercise:

Exit Equity Value = $200
(+) Proceeds from Mgmt Option Exercise = # of Mgmt Options x Initial Equity per Share = 10 x $1.00 = $10
= New Equity Value after Proceeds = $200 + $10 = $210
(/) Shares Outstanding after Option Exercise = 100 + 10 = 110
= New Share Price = $1.91
(x) Sponsor Shares Outstanding = 100
= Equity to Sponsor = $191 and % Ownership = 100/110 = 91% (9% mgmt ownership)

However if you then use the TSM method of assuming the proceeds are used to repurchase shares, you get:
Proceeds from Mgmt Option Exercise = $10
(/) New Share Price = $1.91
= # Shares Repurchased form Mgmt = 5.24

Equity Value after Proceeds = $210
(-) Proceeds Used = ($10)
= New Equity Value = $200
(/) New Shares Outstanding = 110 - 5.24 = 104.76
= New Share Price = $1.91 (doesn't change)
(x) Sponsor Shares Outstanding = 100
= Equity to Sponsor = $191, but now % Ownership = 100/104.76 = 95% (5% mgmt ownership)

 

Your math above is fine, but its not necessary for a modeling test to get to the correct answer. The only reason to do TSM is to make sure there is a single per-share price for all owners, and this really only comes into play for funds flow / deal closing and post-closing true up mechanics (ie, lots of purchase agreements include TSM mechanics). In a model, you can use management proceeds as a plug to get sponsor equity - pay them the net of Per Share x # options less payment for strike price, then give the rest of the equity to the sponsor.

On your math, make sure to not understate the size of a 10% option pool. For 100 basic S/O, a 10% option pool would be 11.111 options, so that fully diluted the sharecount is 111.11 and management holds 10%.

 

Thanks for the response! I figured it's not normally relevant since TSM theoretically shouldn't affect the IRR calc since the equity to sponsor at exit is still the same per the math above (I think?)

On the math though, how are you getting 11.111 options? The calculations in my post (before TSM) is what was used in the WSO prep pack, except it doesn't actually use share counts. They calculate as Equity to Sponsor as Exit Equity + Proceeds from Mgmt. Option Exercise (10%Initial Sponsor Equity) - Equity issued to Mgmt. ((10%/110%)(Exit Equity + Proceeds from Exercise) which gets to the same result. Is this solution wrong?

run-rate pro-forma illustrative adjusted normalized management EBITDA
 

The issue is not really a corporate finance point, just math. 10/110 does not equal 10%, it equals 9.1%. When you tell a management team they are getting a 10% option pool, that should be 10% on a fully diluted basis, not 10% before giving effect to the issued shares. The math is 100/0.9 = 111.111, so that management gets 11.11/111.11 or 10% full diluted.

 

Hypothetically / for simplicity - if someone assumed a strike price of $0 in a paper LBO, would that be dinged / considered wrong? Understand the mgmt option proceeds will be available to mgmt and sponsor on pro rata basis once exercised, but just wondering if that would get you dinged in an interview for assuming $0 exercise price in the context of a paper LBO

For example, say sponsor puts in $100mm equity at entry, 10% option pool, then sells for value implying $200mm equity at exit. Would it be fine to say MOIC is 1.8x (200*(1-.1))/100)? Or would you need to say 1.91x as calculated here?

 

I've never heard of a paper LBO that includes a management option pool...but if you encounter it, I would show you understand the impact of strike prices by saying something like "I know my MOIC is ~2x, which implies my 10% gross option pool = 5% fully diluted, which gets a net 1.9x MOIC". Dilution goes up if your calc'ed MOIC is higher (impact of strike price is less), 3x you can assume 7.5% dilution, any higher I'd just assume 10%.

 

Do you mind explaining this a little more? Confused on the calculation to get from 10% gross option pool to 5% fully diluted. What does the 5% fully diluted mean (doesn't the 10% have to be the % of fully diluted shares management gets?)

"I know my MOIC is ~2x, which implies my 10% gross option pool = 5% fully diluted, which gets a net 1.9x MOIC". Dilution goes up if your calc'ed MOIC is higher (impact of strike price is less), 3x you can assume 7.5% dilution, any higher I'd just assume 10%."

 
Most Helpful

The difference between the 10% and 5% is the difference between option count and proceeds received.

Private equity sponsors create option pools to align incentives with management - the size of that pool is based on sharecounts, so if the fund authorizes a 10% option pool, that means 10% of the fully diluted shares of the company.

Like public company options, private equity management options have strike prices. While there are a variety of strike price structures PE firms employ, the most common would strike management options at the PE firm's cost. What this means is at exit, the value for a management option is not the same as the value of a PE firm-owned share, since management has strike price netted out.

The value math is easy at a 2x MOIC. Assume the options have a strike of 1x MOIC, so if the company has generated 2x, the net-of-strike proceeds to management is 2-1, or 1. Therefore, if they own 10% of the full diluted shares, divide it by 2 and they own 5% on value.

I see you are an analyst 1 - assume you know about treasury stock method for public companies? TSM is also done on PE firm exits for management options, which will get you to the same math as above.

 

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