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)

Comments (9)

Most Helpful
  • VP in PE - LBOs
Feb 24, 2020

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%.

    • 2
Feb 24, 2020

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?

    • 1
  • VP in PE - LBOs
Feb 24, 2020

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.

    • 1
Feb 24, 2020

Ahhh I see thank you. Are there ways a prompt could be phrased to imply that it is 10% prior to dilution? Or should we always assume its post dilution?

  • VP in PE - LBOs
Feb 24, 2020

I haven't seen it pre-dilution in practice. Not sure how folks do it on modeling tests; if you are concerned I would just put an in-cell reference on how you are treating it.

    • 1
Feb 24, 2020

Great, got it. Appreciate the thorough responses!

Mar 22, 2020

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?

  • VP in PE - LBOs
Mar 23, 2020

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%.

Mar 23, 2020
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