Management Option Pool LBO Question
Assume I'm a sponsor doing an LBO, and I establish a 5% Management Option pool, with a $10 strike price. Assume upon close, the company has 100 shares outstanding.
At year 4, I IPO 50% of the company in a primary offering, meaning I issue an additional 100 shares. The company now has 200 shares outstanding. Assume the price per share is now above the strike price.
In year 5, Management is allowed to exercise their options and does so.
Is the cash inflow to the business:
1) $50 ($10 x (100 shares x 5%), with management receiving 5 shares.
OR
2) $100 ($10 x (200 shares x 5%), with management receiving 10 shares.
An option pool would typically be quoted as 5% of the fully diluted share count when it was granted, so would be 100/(0.95) - 100 = 5.26 shares. Mgmt. pays $10 per option exercised and receives a share worth the market price. They could also perform a cashless exercise which reduces the shares they receive by the aggregate strike value they'd pay, which is cleaner and I believe favorable from a tax perspective in certain circumstances, but someone else can correct me.
Okay so in your scenario, the inflow to the company would be 5.26*$10 = $52.6, not either of the two options I laid out.
Yes
Do option pools not usually include some sort of provision to protect management against this sort of dilution? Doesn't really make sense that management is "punished" by getting less ownership because of the IPO unless I'm missing something
Companies raise cash when they IPO...its not diluting management on a $ basis, other than fee leakage.
I disagree. Assuming the net proceeds from the primary offering are used to pay down all the debt (not fund the cash balance), this would mean a greatly reduced interest expense, as well as increased interest income (from the extra cash generated after the debt paydown and due to reduced interest expense). This alone can change the future share price massively, diluting management's options.
Without getting into the weeds of what paying down debt would to do a share price, what you're talking about is not diluting, it is changing equity value, different things.
every dollar of cash they used to pay down debt would be value neutral (reducing cash decreases equity value, reducing debt increases equity value). sure, to the extent the company uses IPO proceeds to do some stupid corporate action, there could be some value destruction, but generally there are governance protections in place that would prevent that, not to mention the non-management shareholders would be economically aligned in maximizing equity value
My model is calculating interest using the average of the beginning and end debt balance. Once the IPO cash is being put into the business, it lowers the interest expense I'm paying, thereby affecting the share price of that year.
Gently, no.
Of course your share price changes in your model over time! If equity models resulted in flat share prices into the future, no one would invest in the stock market.
The original question was "why does management allow sponsors to IPO companies, when its a dilutive transaction". Putting aside the fact that in control buyouts, management can't control corporate actions, an IPO transaction is not dilutive to management value (as the poster above said - cash in, debt paydown, equity value neutral).
Does an IPO impact the future value of shares post-transaction? Certainly. The post-IPO debt, and interest profile, is theoretically baked into the post-IPO per-share value. This value will certainly differ from what is available in the private markets. Does management get diluted by the IPO transaction, no.
As long as they're raising in the IPO at a pre-money valuation greater than the option strike, it'd be accretive to mgmt.'s option pool value
To be diluted in terms of value they'd have to raise at a down round (dilutive) valuation, which leads to your other question, which is a good question, regarding whether mgmt pools are structured with any anti-dilutive protections (google antidilutive protections for more detail on what's customary here) which guarantee them a certain % at time of IPO - that strikes me as unusual and I haven't seen it but maybe others have
Why do we divide by .95 instead of multiplying by 5%?
since 5% of fully diluted shares = mgmt pool, total diluted shares * 95% = non-management owned shares nonmanagement owned shares / 0.95 = total diluted nonmanagement owned = 100
Harum tempora ea aut reprehenderit. Est autem exercitationem eum iure facilis odio. Tenetur ipsam sit laboriosam quia itaque et sint dolore. Excepturi iure non quisquam earum praesentium. Ut id ipsum itaque dolor.
Quia commodi porro aut est. Similique fugiat est perferendis nemo. Sint et sunt et qui quod id. Aspernatur culpa incidunt fugit harum. Hic voluptas atque porro voluptatum molestias at aperiam.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...