Option Pool Question
Hi guys, I'm trying to get some clarity on how management option pools work. Take the following example:
Assumptions:
Equity Value at close of $100
Year 5 Equity Value of $200
A $20 dividend recap in year 3.
A 5% Management Option Pool.
My Method
Upon exit, the company's cash inflow from management would be $4.21, calculated as 5.26% ((5%/(1-5%)) x $80 ($100 - $20))
This would leave the company with a a post-exercise Equity Value of $204.21 ($200 + $4.21).
This $204.21 would be distributed 95% to the sponsor, giving him exit equity proceeds of $194. After adding in the $20 dividend, the sponsor has total proceeds of $214.
5% would go to management, giving them exit equity proceeds of $10.21. Subtracting the $4.21, this leaves management with net proceeds of $6.
Alternate Method
The WSO model seems to contradict my methodology, instead calculating proceeds from management of $4.0 ($80 * 5%), giving a post-exercise equity value of $204.0. Then, to calculate management's ownership %, they take $204 multiplied by 4.76% (5% / (1+5%), giving management gross proceeds of $9.71, and net proceeds of $5.71.
My method seems like it's correct, but I'd appreciate any input anyone can provide.
Both methods are correct. Just depends on the specific terms of the option pool agreement.
Always worrisome when WSO has bad math and then posters confirm their bad math.
Always do these including share counts. Let's assume 100 shares, so equity value / share at close is $1. We issue 5.263 options (100 / (1-5%) total shares) to management, struck at $1 / option.
Now here's the critical part - option pools are made to align sponsors and management. That means most sponsors are not in the business of providing an option pool, then screwing management. So when options are struck at the sponsor's entry price, then a div recap happens that takes value out of the business (without any benefit to the option holders), the option pool is most of the time made whole by reducing strike by the amount of the dividend. OR more options are issued, but this is less common.
Our dividend is $20, or $0.2 per share. Therefore, options are now struck at $0.8.
At exit, equity value of $200, add cash from options exercise of $4.21 (5.263 x $0.8), distributed equity value of $204.21. Per share value for all of $1.94 ($204.21 / 105.26). Sponsors 100 shares = $194, option pool gets $10.21, less $4.21 cash paid to exercise, option pool gets $6.
Sorry for the probably dumb question, but I sometimes see management options shown as 5% option pool / 1x strike, and the logic built in is that management only receives 5% of equity proceeds if the sponsor recoups initial investment (at least 1x return).
Do you have to layer in an additional layer of logic that options are only struck if the sponsor hits at least 1x returns, and then the strike price, etc. is all the same as above?
Edit to add: these models also don't show proceeds from management options adding to equity value - total equity value that's distributed to management and sponsor is just the TEV less net debt at exit. Is this conceptually a different idea or am I missing something?
Strike is not a "threshold", after which proceeds are split. When an option has a strike price, if a holder wants to exercise the option and become a shareholder, they must pay for the strike. So if I'm understanding your question correctly, yes, you need extra logic where option holders pay for strike, then receive the 95% / 5% splits.
In your model you are missing cash paid from exercise of management options.
The only logic you need is that if the fully diluted share price at exit is less than that at close (i.e. the strike price) then the options would be out of the money and not exercised. As it happens this is the case if the sponsor is looking at
Thanks so much. Thinking about it in terms of shares helps a lot. Assuming I also have a sub note with a 1% kicker, would the following calculation be correct?
Shares at Exit:
Sub Note: 1.053 (105.263 shares at exit / (1 / 1%))
Management: 5.263
Sponsor: 99.947 (105.263 - 1.053 - 5.263)
Equity Value at Exit
Sub Note: $2.04 (1.053 * $1.94)
Management: $10.21 (5.263 * $1.94)
Sponsor: $191.96 (98.947 * $1.94)
Sorry, not sure what a sub note with a 1% kicker is. You have a suboordinated debt instrument that converts to equity +1%?
Would you mind explaining into a bit more detail why the strike price of the management options is reduced when a dividend recap happens?
I am just struggling to understand, conceptually, why if a dividend is given to the sponsor before exit then there is less cash from management options.
Giving an extreme example, and using round numbers. Let's say management's 10% option pool is struck at $100M of equity value, so they get 10% of equity value above $100M. Let's say in year three post LBO, equity value = $150M, the sponsor takes a $100M dividend, remaining equity value = $50M. All of a sudden, due to the dividend, the option pool is out of the money, ie, worth nothing, whereas pre dividend, it would have been worth $5M ($50M of equity value above $100 x 10%). If you didn't adjust strike price for management, you'd have a revolution every time you did a dividend. So what most sponsors do is reduce strike price by the amount of the dividend taken, in this case $100M, such that strike is now $0. At $50M of post-dividend equity value, the option pool is once again worth $5M ($50M - $0 strike x 10%).
I've seen people calculate the management share as 5/105 of the post option payout equity price and now calculated this way - what is the difference and when do we do which? Sorry for the basic question
In most PE sales, what happens is a cashless option exercise. For management to exchange their options for shares (and therefore get proceeds), they need to pay for strike price, but in reality no one actually writes a check, people just do the math as if the cumulative option pool paid for strike price.
When calculating exit proceeds, people do the normal TEV to equity value bridge, but include "cash from option exercise", or the cumulative amount of # of options x strike price as additive to equity value. From there, you can count management as owning shares like any other shareholder, and divvy up proceeds. Just remember that management's proceeds get reduced by the amount paid for strike price after you've calc'd proceeds.
Doesn't thinks overlook the dilutive affect on our Price per share. Specifically, wouldn't our price per share decrease to below .8 because we are increasing the number of shares with the options?
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