Optima Thoughts: Equity Compensation Series, continued

Equity #3 - how it works in privately held companies and in private equity

This is the third Optima Thoughts newsletter explaining how equity is used as a form of employee compensation. Here we’ll examine privately held companies - those with no publicly traded stock - and private equity firms.

Privately held companies have several ways to share value creation with founders, investors and employees using both real and phantom equity structures. Let’s start with an overview of key terms:

Founders' equity applies to company founders. Real equity is sometimes extended to early advisors and key early hires.

Phantom Stock tracks the value of company shares and pays out cash or stock equivalent rewards upon a liquidity event ( a time when shareholders cash out) at which time your gain will be taxed as ordinary income. This is often used in privately held companies to mimic the value of actual equity without transferring ownership.

Profit Interest Units are used in small and mid-sized LLCs and represent a share of profits after a certain threshold. They are generally structured to provide capital gains treatment, so they offer a tax advantage.

Performance Stock/Equity vests upon achieving specific milestones or performance metrics, such as revenue or EBITDA targets or at an IPO event.

Long-Term Incentive Plans (LTIPs) or Management Incentive Plans (MIPs) are used to align key employees with long-term value creation and may include cash, equity awards or profit sharing.

Over time the pool for employee grants may grow, but is likely capped at 20%. As the company raises new funding rounds, its valuation increases, and the percentage of equity offered to new hires is reduced. However, the absolute value of the equity may increase due to the higher company valuation. Each funding round introduces new investors, which dilutes existing equity holders; equity amounts get smaller, but the pie gets bigger. You may have heard of Series A, B, C - this refers to successive funding rounds and typically, valuations increase with each round.

As companies grow, their approach to funding employee equity may change. First, understand the successive stages of raising capital: at the start-up stage, founders raise money from “family, friends and fools.” They then may raise additional capital from angel investors. At the next stage, venture capital investors buy out the angels to take about 30% ownership. Private Equity folks often aim to acquire a controlling stake – over 50% - but in growth deals they may take less.

At each stage, equity may be reconsidered. New equity awards or ‘refresh grants’ might be awarded to maintain competitiveness and offset dilution from new funding rounds. These may occur at key milestones, e.g., after Series B funding. Performance-linked equity may be introduced with grants tied to individual or company milestones, e.g., achieving revenue targets or hitting product launch deadlines.

Equity grants vary across industries due to differences in business models, growth trajectories, risk profiles, visibility and competition. In business-to-consumer (B2C), the focus will be on brand, marketing and customer acquisition so equity might be given to creative and marketing talent. In business-to-business (B2B), growth is steadier and less volatile – they require more time to be acquired or go public than fast scaling B2C companies - so equity grants tend to be smaller in percentage terms. The exception would be in high growth tech start-ups where they often offer substantial equity especially in early stage and share equity more broadly.

If you join a privately held company that offers some form of equity, be sure to start by asking these four questions:

· How is the value determined, and what factors influence payouts?

· When and under what conditions will you receive a payout—does it require a liquidity event, continued employment, or performance milestones?

· How does dilution impact your award if the company raises additional funding?

· What happens to your equity if you leave the company before a payout occurs?

Understanding the details of any equity at a privately held company will help you assess the potential upside and risks of your compensation package.

You may be curious about how equity works in Private Equity. Here’s a snapshot:

PE firms have a unique structure to align with the funds they manage and the ‘carry’ structure of the firm. Carried interest, or “carry,” is the portion of the fund's profits (typically 20%) that is distributed to the firm’s investment professionals after the fund returns committed capital and a preferred return to the limited partners. Carry percentages may increase with tenure and they are subject to claw backs if the fund underperforms or fails to meet its hurdle rate.

In addition, there are co-investment opportunities where a partner might invest 1-5% of their compensation annually into the fund. Junior professionals may have an opportunity to contribute smaller amounts. Some PE firms offer ‘phantom equity’ or profit sharing. Senior partners may also own equity in the management company or in portfolio companies and earn income from management fees, typically 1-2% of assets under management (AUM) and carried interest.

I hope this information will help you better navigate your compensation conversations!