Understanding Management Equity: What PE CEOs Should Know

0:00So are there like red flags or things that people should be listening for when they start to ask questions about their equity or their employment agreement? Like what would put your hackles up if you were asking questions? I just think it's about somebody hesitating to share information. I've heard people have been told we don't share the waterfall. But I don't know. I'd say, well, then let me talk to your boss in that situation. like because clearly I'm not talking to somebody who can make decisions here. It's not venture capital. It's private equity. It's the private equity funcast. Pour yourself a drink and have a seat.

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1:17NetSuite is customized for a wide range of industries, so it supports the way your business truly works. Whether your company earns millions or even hundreds of millions, it's time for NetSuite Next, where your business meets AI. For the first time ever, you can try NetSuite Next for free. Go to netsuite.ai slash funcast. Built for every industry, ready for every boardroom. netsuite.ai slash funcast. I'm Paul Stanzik from the Parker Gale Ops team. And I'm Ryan Milligan, a partner with Parker Gale. We get a lot of questions from friends of the firm and executives in our network about employment agreements, whether someone's thinking about joining a company as it's coming together in an investment for a private equity fund or joining a business that's mid-hold period.

2:01And these are anxious calls that we get because people don't necessarily know what to ask, especially when it comes to the equity components of their employment agreement. So Ryan's got some strong opinions on this. I think he also understands why this is so hard for people. Why is this such like an anxious, hard thing for people? People are trying to pull this all together. And there's a lot at stake. There's companies existing performance. There's an executive coming in that needs to change the performance. There's a lot of legal terms involved. There's a lot of structural terms involved. There's a lot of emotions involved and people are basically signing up for five years together.

2:35So we're going to try to break this down in a way that shows you how to structurally think this through what's allowed, what's not allowed, and the types of questions that you can get into and get the information you need to work together well for the next five years. Yeah. So whether you're a part of a management team that's headed into a deal or we get a lot of calls from friends that are thinking about taking new jobs, I think the thing we notice is people tend to focus on the headline cash compensation, the salary and the bonus, and they tend to speed past the equity part of that employment agreement.

3:08Like, why do you think that happens and why is that a mistake? Yeah, I think, I mean, why do you work in private equity in the first place, right? So when I think about this, what is one of the key benefits of being a management member of private equity is private equity businesses are bought to be run, improved, and sold. And the timeline for a sale for private equity is usually five years. That's a nice bite size for an executive to come in, make an impact, work alongside a private equity, and then sell. Well, why would you do that? Because there's a line incentives and compensation and a lot of wealth that can be generated both for the private equity firm and its investors and everybody else involved in that deal.

3:49Now, depending on the private equity firm that you're working with, there's some aligned incentives and there can be some misaligned incentives. Private equity, to some extent, wants to get somebody excited about taking a job and paying them enough but not too much when they're wildly successful together and generating great outcomes. So just the very nature of those incentives does insert some stress and just there's a lot of legal details and different structures that are used and things like that into the process. And because of that, there is an information gap and there's often timing that surrounds us as well.

4:28So that is really what kind of is the genesis of that problem. And that's something that we try to bring light to and transparency when we're explaining these things to people. So hopefully we can help others understand that better. And if you're not asking the right questions, I think there's a binary component to this too, which is kind of saying, oh, I'm getting equity. Great. That's good enough for me. But what does it actually mean if you're a part of the management equity pool? Yeah. And it's funny. There's kind of two types of people. There's people that treat the equity. They're like, oh, that's funny money.

4:57Like if it turns into something someday, like it's almost like a lottery ticket. And they'll be like, oh, that'd be cool if it happens. But they don't focus on it. But I think if done right and well, it really does set the tone and the clock and the expectations for the entire investment, meaning the management team member has understood from the private equity firm where the company's at, where it needs to go, what success for the private equity firm and its investors would mean, and what that means for the executive and all that. So that's why it matters. There's two types of people. There's people that kind of overanalyze it and stress about it.

5:34And there's people that underanalyze it as well. But I think there's a healthy balance that you really want to try to strike between private equity firm and manager to make this meaningful and do what it's supposed to do, which is help drive to an outcome. Yeah. And one of the first things you probably should ask about if you admit to yourself like, hey, I might be on that underanalyzing side of the spectrum is like, what is the actual structure of the pool? So like, what are the different structures that you typically see? and are there things that people should be asking or things that people should be getting curious about?

6:02Yeah. So yes, lots of different structures. I'll just kind of get into those. So the first term that I would want to educate you about is there's something called the waterfall. Yep. So what is the waterfall? Um, when you sell a business, it's going to be worth a certain amount. That's what somebody is going to call the enterprise value or the sale price. Okay. And then below that, there's kind of an order. The waterfall is what order do people get paid in? So the first thing that gets paid off is the debt. So there's, and surprise, surprise, private equity companies often have a lot of debt. Yep.

6:41Okay. So really the key here is ask for the waterfall. But here's how it works. There's enterprise value and then there's debt. Debt gets paid off first. Then there's probably preferred equity. That's what the private equity firm put into the business. Okay, so that gets paid off next. Then finally, there's common equity. That's likely what the manager is going to participate in alongside the private equity firm. So that's what you're really interested in. So what's probably going to happen is you're going to get quoted a percentage. it's going to be 0.25%, 1%, 2%, whatever that might be. That's going to be your share of that common part of the equity.

7:26And it does not mean you get half a percent of every dollar that comes back when you sell the business because of that progression or the word that gets thrown around a lot. You've seen our lingo episode is the stack, right? The debt is the top of the stack. The preferred is the next layer in the stack. And then it's the common equity. So it pays to understand that and to ask like what part of the stack am I in and what percentage am I getting of that part because that's what dictates what shows up in your bank account at the end of that five-year run is that right correct yeah yeah yeah so we'll get more into that and because there's a lot of um back and forth just around this waterfall on the model and things like that but we'll come back to that but there's going to be percentage and that's a part of the common equity but there's a lot of different structures yep so this is where it starts to get really complicated yeah so we're going to start with our own.

8:11So wherever possible, we use what are called profits, interests, profits, interests. Okay. What that means is you participate in the profits of the sale. So those are usually tied to what's called an LLC. Why do we use those? Those are the most tax advantaged situations for a manager. Getting profits, interests as part of an LLC structure is probably what you want. Yep. And that allows people to have better tax treatment. Basically, the long and short of it is that's going to allow you to get capital gains treatment faster than other structures. So if you are in that five-year run, you get credit for that as a long-term capital gain versus a short-term capital gains.

8:52We're not lawyers, obviously, but that's basically what we're talking about here. Yeah. Okay. There's also stock options. People hear a lot about stock options. Those are usually tied to corporate structures. the issue with stock options is it actually requires you so there'll be a strike price and you'll have to exercise your stock options a lot of times with stock options to take possession of the stock option to start what you call start the clock on capital gains treatment people actually have to write a check yep at some point to take possession of those stock options exercise them and maybe it's not a ton of money but it's some money it can be tens of thousands of dollars hundreds of thousands of dollars to then take possession and kind of start this clock and then um it's also at risk so yeah you have stock options you get a certain part of the upside but to really tax advantage yourself as they vest you have to basically purchase them or exercise them which means you're coming out of pocket for something that could end up not having value yep like there's there's a world where you exercise a stock option and then at the end you get zero and they'll be like oh but you get a tax write-off it's like okay when i have my next capital gains event, you know, and things like that.

9:59So, so in general, those are used kind of where necessary. We try to avoid those where we can. Those are probably the two most common. And then there's other, there's other options that are like restricted stock plans and phantom plans and things like that. You know, it becomes a longer list of things, but I think private equity has gotten pretty good at using profits interests. Um, when that happens, they're going to be talking about units instead of shares and things like that. So that's all usual and common just from a language perspective. But when we're talking structurally, that's what it really comes down to is when do I start to get paid?

10:37And what does this do for me from a tax perspective? And when it comes to stock options, am I going to have to write a check? Yep. And what else would you be asking? Let's say private equity fund, you're a CEO, puts a new employment agreement in front of and there's an equity component to that employment agreement. What else should you be asking? What else should you be poking into? What's on that punch list for people listening to this right now? Yeah. So I'd say the framework for somebody to really dig in on for that would be where's the company at? How's it doing? And where does the company need to go?

11:13That's where I would start. Because that's starting from a really productive place of alignment and understanding of really everything, right? Because you're probably taking this job because you want to go build something. But if you don't understand how it's doing and what needs to happen, you don't understand the extent of change. You know, a company's on a trajectory, right? There's a status quo trajectory of a company. Yep. You're probably being brought in to try to change that trajectory somehow. Or maybe not, but that would be a pretty easy job. Usually there's a lot of change that needs to happen.

11:48Right. So if you start from where is it at and where does it need to go, that's a great place to start. And I would add to that time horizon, too, because if you're in year one of the investment or as the deal is happening versus year five or six, like, yes, the trajectory matters and where it needs to go. But like, how much time do I have is kind of a question I would want to ask, too. Would you agree with that? Yeah, 100 percent. There's a CEO that I know well that I've that I've talked to about their deal before as well. They really appreciated the private equity environment because of that very part.

12:20There's a clock, right? So in years one, two, and three, so he was there five years. Years one, two, and three, you've got a long-term hat on, long enough term hat on where you're making some strategic changes and bets and things like that. Yep. When you start to get year four and five, your decisions are a little different, right? So are you going to take on something that's got a longer term run that needs to happen on the back end of it? If you're going to sell in 12 months, you know, is there a software rewrite you're going to start then? Or is there some big strategic project? Those are just really important things to understand.

12:56So that's why I do think if executives aren't staring long and hard at numbers just to start, you're not doing enough. Yeah. And that's like the entire frame for everything else that's in the weeds that we'll talk about. Then when I talk about waterfall and structure and things like that, everything else kind of like comes off of that because it's all one big outcome that you're driving the company toward that plays up. It's really, it comes down to the business where it's at and what it needs to do. Can I add something to that? Yes. if possible i think it's a good idea to ask that question to more than one person so if you're a ceo coming in you should ask it to multiple people on the deal team or multiple people on the board if you're a management team member ask the ceo and ask the investors because i think one if people are on the same page that's always a really good sign no matter if you're talking about comp or anything else and two if you are noticing differences you should know that going into it.

14:06Just like you should know what your compensation structure is and what the equity is and all that. But I think a mistake that people make is they actually ask the right questions, but they don't get enough perspective from different people. And that can tell you a lot. Yeah, very much so. We try to do that as much as we can when we're doing this. When we do talk to executives about this topic, one thing that I have heard happens is they start asking for numbers, is they start asking for expectations and the private equity person on the other end kind of clams up yep and they're just like we don't really go into that or that's not something we provide yep um there's a natural you know sometimes you're being hired because there's issues so people don't want to get too real about things i mean that is there's a natural friction there that just kind of exists because you want somebody to be excited about the role yeah you want to tell them enough be transparent about what's good and what's what's what's challenging um but if you're getting too much into the numbers then you might spook somebody away right so that does exist my strategy in that situation would be hey i'm coming into this assuming it's worse than you're telling me um the more that we look at this together and figure out what needs to happen the better off we're all going to be it's better to have this conversation this week than a week after I start.

15:28So taking that strategy is saying like, I get it. I'm not taking this job because it's easy. I'm taking this job because it's hard. But the hard part is where the value is created. And that's what we're going to try to do together. So like, let's get into that now. And by the way, that's going to help you assess my ability to meet those challenges and hit those goals. so i would push hard for as much transparency as you can get about the numbers and the trajectory and where it's going um and then we can also get into and then and then what's next yeah yeah i i love that and i think it's also just a a good way to sanity check how is it going to feel to work with the person on the other end of the table which is a super important thing to ask about if you're going to sign up for a five-year run.

16:15So let's say you're a CEO or you're a management team member and somebody shows you some version of what your equity could be worth. What should you ask next? We're going to get back to the waterfall now. Okay. Okay. So that's really what it comes down to. Yeah. So what you should see is a grid. In the columns are enterprise values, which is the sale price. if they're putting this in front of you it's probably pretty ambitious numbers yep so just know that but it's still a framework that you can have a conversation around most executives i think the way they kind of think is like if i do okay am i going to get something and if i do well how excited am i going to be so there's kind of like a base case and then there's a and if we really get this thing going together wow we're both really excited and you know that type of thing yep but there's a there should be some sort of sheet that's got columns with numbers and then there's this waterfall down below it yep so step one is okay what's it take to generate that i mean the biggest variable on the page is that enterprise value so what's the implied revenue multiple what's the implied EBITDA multiple how how much revenue and EBITDA needs to be generated to get to those outcomes is that reasonable is that rational right so just that's why i said like When I say start with the numbers, it all kind of comes back to that.

17:38And how different is that than the trajectory it's on right now? Is this just we keep going or is it like there's a meaningful inflection? Yeah, is there a hockey stick or not? Or do we have to fundamentally change something or change the cost structure or whatever it is? Yes, yes. That's going to tease all that out. And by the way, once you have that information, then call your investment banking friends, call other executives, call other private equity firms, and just kind of bounce it off them for a sanity check. But that's kind of step one is this first line, that's a row of enterprise value.

18:06Like what is that achievable? Is that reasonable? And make sure you get the good, better, best. Because if it's one case and this is what we're going to do, then it's like, okay, well, what if we don't do that? So just a little bit of sensitivity, I think, proves that the person has thought about it. And again, satisfies you as the management team member. So you can see the range of outcomes that might be possible in a, hey, we do okay and we do really great. I would want to know that. If I was signing up for something new. Yes. And so that's step one. Step two is then, okay, now the company's worth this.

18:41What happens from there? Okay. So we already talked about debt, preferred equity. Yep. Now I will say it's kind of, there's a lot of, there's a lot of debt and there's a lot of preferred equity and private equity deals, particularly from, I mean, it's been, it's not just a 2020, 2021 issue. issue that's 2019 to recent days i mean it's just something you should kind of get into for for all of these so just understanding what's ahead of you is really important because there's a world where somebody paid 10 times revenue for a business markets have changed maybe it's worth six or seven times revenue which is still a pretty good multiple yeah for a healthy business they bring you in give you an equity equity plan you go generate a ton of value from where it is today but you don't get you know the preferred equity is often growing at eight percent so there's a world where you go generate three four five hundred million dollars of value and you don't get to participate in that if you don't kind of understand how all this works yep Yep.

19:48That'd be the term for that would be like you're underwater. Yep. Right. So just really understanding all that, what you're doing there is just, is getting to the point of saying, now I understand what the possibilities are for common equity. That's what that's doing at the end of the day. Okay. Okay. So now you understand what the common equity could be worth. You've got an idea of what the company could be worth and what the common, how the common equity kind of comes out of the bottom. Yep. Now you're looking at your security that they're giving you units, options whatever it is and you're saying okay what's the vesting schedule there's usually time vesting and then there's some performance vesting okay for time vesting probably vests over four or five years that's kind of market is that yeah four to five years is market yeah um then people say like what are the cliffs or like what you know um usually market would be it vests annually or or quarterly or a mix of their, a lot of times it's a year and then quarterly thereafter, things like that.

20:48But that's kind of, if you leave in year three, your time vesting shares or units, you would get to keep. Yep. Okay. The key part for all of that though is does it accelerate on a sale or a change of control? So what that means is if you got five-year vesting, you sell in year three, everything accelerates. You get all of your time vesting units. You don't lose those last two. It's not like, oh, well, you did it faster. Congratulations. Now just continue on. You'll make it up with the next person. So that's kind of the time vesting side of things. On the performance side, there's hurdles. So what we often use is 25 % or three times our money.

21:32So again, that's just saying just being here and generating the outcome. There's a time vesting part. and then there is a certain expectation that we have for performance and you need to get above and beyond that. Now you're going to circle back to your original is like, okay, well, I just figured out how much the common equity is worth. Well, now I got to go figure out is that common worth enough for them to make their return and things like that. Just ask and ask for transparency and things like that. Yeah. But that's normal and that's kind of a general framework for how people lay these things out.

22:05And I think the sanity check there is if your investors do good, you should do good like we've all gotten the call from a friend or have had the experience personally i i had a job offer at a venture capital backed company a long time ago and i did very similar math and both looking at the revenue multiple test and just the the spread between how good the investors had to do versus when the equity started paying it just didn't make sense and i ended up turning down the job but there's probably a lot of people that wouldn't ask that question but that that to me feels good in that your investors do good and so you should do good and the way to check that is on the performance side of the vesting i think yeah yes yeah again i think if you're having this conversation about trajectory of the business and the overall expectations this should kind of come naturally at the end of the day one other one other point to make there's there's other structures out there just to make you aware of that I've seen.

23:05And to me, it kind of comes down to the maturity of the business. If you're in a more mature business, so a lot of larger firms, I think, use this structure is there's some firms that will walk a management team through an investment case before the deal closes and actually get them to sign up to performance hurdles for that business. So saying we expect x percent growth x you know this amount of ebitda each year and then kind of set parameters like a schedule almost yeah basically like this is where this is what on track is yep that that can happen in a business that has an inertia and a certain level of predictability and it's that's probably a business that they're paying more for that they have pretty tight underwriting on and they know what it would take to kind of get from A to B.

23:57Yep. Those structures can work and make sense. Now, for lower middle market private equity, we have an end state in mind. And I think the path to that end state is there's going to be some things that go better and some things that go worse, some things that go better. And so it's more of a jagged line and things like that. So for there, you're really kind of taking a big step back, looking at the overall space, competition,

24:28how much work needs to be done what needs to be changed how much white space is there and things like that you know so that's that's a little harder to do those types of structures yeah um so you really just it's it's kind of a take a step back make a big bet on we think we can go do this together we know it's not going to be a perfect straight line and we'll kind of get there and it's a little more of a gut feel than those those larger situations but i have been taking people through some negotiations there and that that does happen for bigger deals yeah so what what's negotiable like what can you ask for my opinion for negotiating comp is everything's technically negotiable yeah you know it's but then there's also like what's normal and what's acceptable so i think there's kind of two phases so if you're in an m a process and you're a ceo looking at a deal with somebody.

25:18There's probably a band of outcomes that the private equity firm kind of uses. But I think at that time, you can help shape how you want that program to look, what the key terms are. And there's not wild differences, but is it four-year versus five-year investing? Is it one-year versus quarterly or a mix of those two? What's the methodology for equity to the team. Venture capital gives out much more equity further down the org chart. Private equity keeps it a little tighter. But the CEO has a hand in that. Is this a tool that we're going to use to incent people or do we want to concentrate it at the top?

25:57I think those are all conversations that if you're part of the M &A process, you can have. And it's total fair game to get people deeper into that and help shape that. Because again, you want to be aligned with how you want to run your team and send people and things like that. So you keep using the word alignment. Do you have a story where there was like an alignment problem and you just couldn't figure it out? Well, I do. Luckily, it's not one that I was the first party to, but yeah, there's, you really want to not, we talked at some point about people kind of harboring things in their head and they're just like, ah, I should ask for this or something's, something's off.

26:34There was a CEO I was getting a drink with and we were early on. It was, we had a smaller business He had a larger business and we were thinking about selling him our business down the road. So this is just, we're kind of building our relationship. So he's getting more transparent with me. And he just kind of says at some point, he didn't feel like he had alignment with his board and particularly when it came to the incentive program and the deal. So he just said to me, he's just like in passing, Hey, I'm going to sell this business for$2 billion someday. There's going to come a point to where I, we get down the road and I'm just going to crush it for them.

27:03And then when we get to the end, I'm just, yeah, what I'm going to do is I'm going to say, okay, we're, it's kind of past the point where they're trying to get to a close. And he's going to say, uh, I need a$50 million sale bonus. And it'll be at the point of the deal where he's doing the math to say, like, it's kind of like having a real estate agent. It's like, they're looking at a billion and a half dollars maybe for their fund. And he's like, oh, they'll shave 50 million off the top. Right. That's only going to happen. Like that's, that's not a great look. And that's not how you want these things to go and negotiate.

27:34But really you just want these things to be understood and dealt with along the way. If not, then somebody is going to kind of say, all right, well, I'm not feeling good. So I'm going to just put that in my own political capital box and take it out at an opportune time and say, this is what I need. And they'll kind of play liar's poker to see who blinks first. Now, would he really blow up the deal over that? Or would he even really do this? Who knows? But like, that's, that's not the mindset that you want to have your, your management team in kind of sitting on these things. Hopefully they're sitting with you saying like we're all doing this together we all understand each other and we're trying to accomplish this goal if that happens goes through everybody's happy but there's a real moral hazard there if you're not if you're not taking care of people and having them understand this stuff and in that deal process like before you even get close to seeing an employment agreement i think it's it's fair game and it's a good idea to communicate with your investors like hey here's what i care about like i care more about cash comp i care more about the equity i care about the vesting i care about so just like communicating the design principles earlier in the process is a good thing because we don't like feeling like we don't know how someone's going to react when we put something in front of them and everything's negotiable and we iterate on these things all the time but i think tell me if you disagree it feels better knowing what that person values as ceo or management team member earlier versus later yeah that's why i teed up the way i do i say you should whatever's on your mind you should talk about now you only get one shot at this and when you're doing a deal in private equity it's like a marriage it's a five-year commitment um so what you don't want to do is not hear those things and then start hearing them two months in the first time something hard comes up you know and things like that so best to get those things on the table and work through them up front and have people feel like they were at least heard.

29:33Now, on the private equity side, there's only so much that they can do or will do. They might have methodologies and things like that. So you may hear back from somebody, I can do this and this. We don't do that. We've never done that. There's a realm of outcomes. You could have them talk to other, I mean, you could ask to talk to other CEOs in the portfolio. You could ask for references. You can ask for things like that. There's always some level of trust that comes into these situations. Cause I'll talk about like when things go wrong, like what some of the strategies can be there as well. And some things that people don't use enough in my opinion, but yeah, best to best to hear it all up front, get it on the table, work through it.

30:11Cause the second the deal's done, you want the management executive team focused and not thinking about, yeah, I should ask for this. Yeah. That's everything. Now, the only caveat is if it's an existing situation and there's a new CEO being brought in and there's a team of eight people that already have deals and it acts a certain way, the positioning may be more like this is kind of our program. I don't want everybody to have something different. So it kind of is what it is. So like read through it, understand it, ask why. But, you know, you don't like being in a situation where you're kind of like a take it or leave it.

30:47But that's when that happens. It's usually for that just for consistency and sanity and things like that. But in general, I think people should be open to the conversation and then just kind of work through it. And it's kind of understanding the why. Yeah. So let's start with what do people not do enough of or where do they not dig deep enough? I think it comes back to the earlier point of how's the business doing and where does it need to go? and what's it going to take to get it from A to B. This is part of why we interview the way we interview as well. A lot of this should come out of like we do panel interviews.

31:27Yep. And a lot of it is tell me about a time when you or let's put a hypothetical on the table and understand that. By the way, like what's happening in that business is directly tied to those questions. And we've selected those questions because of what's happening. Because of what needs to be changed. So I would take as many notes in your interviews as they are because that's what you can kind of come back to and use to say, hey, you asked a lot about this. So like tell me what's going on in DevOps or like why did we spend so much time on product? Is that what I'm really going to be digging in on to start?

32:03Or is it just the go to market products in good shape? You know, all those things. And we've even gravitated towards sharing a lot more real company data, whether it's board decks or diligence materials or both. And treating that as the homework assignment, which is like, hey, we'll just show you what's going on, which I think seeds what you're talking about. It's like we want you to have situational awareness of what you're stepping into. But then like kind of testing your instinctual take on that. It's like you have the context of what the company is trying to do, what seems important, and what would you do about it?

32:37You can have a three-hour conversation that tells you a lot based on that. And I think the side effect of that is the person understands a lot better what they're stepping into and whether they can be excited about that. Yep. So that's number one. And then number two is just understanding that waterfall, right? And I'll use this to kind of transition into backup plans for those situations. But, yeah, like what did you pay? you're going to be partnered with the private equity firm for five years so just be like where are we at like what did you pay too much like what's what's going on here yep like did you miss on this did you miss on that or is there something happening in the market like what is it i don't know just getting that on the table helps um but yeah understanding that because what you don't want to do is be in year two and it's taken longer to get going than than you thought and now Now you're in a situation where you are underwater and now you're just like, that just leads to a whole host of issues and people are like, well, what am I working for?

33:32Yep. So what do you do in that situation? It's, you know, people get so hung up on tax treatment and things like that. So why do you do these incentive plans in the first place? Why not just bonuses? Well, there's different. It's because of the disparity between capital gains and ordinary income. But to some extent, that just there's a point where that kind of drives everything. and there's probably a point in deals where like i've had people talking about their equity programs with me and i'm just like it's all underwater i was like why just do a sale bonus right like or do a structured sale bonus like you can you can actually do whatever you want to some extent right um maybe there's some stuff with debt or otherwise that you you have to make it subject to or maybe it has to be paid after the debt or things like that but like in those situations if it's like really hard to get your head around the equity and things like that you can write a contract that says there will be a sale bonus beyond this enterprise value and after the debt is repaid you're going to participate alongside this preferred equity or this common equity or things like that those can be written now are they tax advantaged no so is there some tax leakage that people will like point to there sure but they could do a true up but but it's way more motivating than yeah if the goal is alignment and transparency why not just get to it and do that if somebody did a deal that's a little sideways like they don't want to admit it if you start doing that stuff you're probably admitting it right so there's that's probably what leads to the the people not doing those types of things but if you're in that situation you're kind of in a loop that's something you could bring up just to even if they don't go that route you're at least signaling like i understand where this is at it seems like i'm going to be kind of like trying to claw my way up and get back to where we're actually like for every if i have two percent of the common like for every 100 million of value i create i get a million bucks you're kind of clawing your way back to that so if you're at least having that conversation you're saying hey i get where we're at we need to come up with something for scenarios where i am doing a good job but it just because of the structure in place this isn't really we're doing the things it's supposed to be doing and again that all starts with having the conversation that some people skip which is where are we today and where are we trying to get to because if you have that conversation it's like okay well you know if we got there what is it worth and does that make sense and i think the question is like would you be open to something a little bit more structurally creative like a sale bonus or something like that a lot of people don't know to ask that question right yeah and that's where references can matter and things like that i mean a lot of times in private equity deals there's like these structures are kind of weird and people get in at different times so somebody might get in early so their participation threshold is low and then somebody might come in later the participation threshold is higher yep and then you get to the sale and it's like well this person who came in higher did a great job the last 12 months and allowed us to get the transaction done but then you run the math and it's like so and so gets this much and then the person who really deserves a lot is ends up with very little just because it's like it's kind of razor thin there yeah at the margin so most firms in those situations kind of you kind of look at all the proceeds at closing and you say all right this is a little off this person should get more so you write them a sale bonus this person should get more they write they get a sale bonus so these things come into the fray closer to to the closing of a deal either way um but yeah it's they can be put in place earlier on as well yeah so are there like red flags or things that people should be listening for when they start to ask questions about their equity or their employment agreement like what would put your hackles up if you were asking question i just think it's about somebody hesitating to share information um if somebody i've i've heard people have been told we don't share the waterfall but that's i don't know i'd say well then let me talk to your boss in that situation like because i clearly i'm not talking to somebody who can make decisions here like yeah that that shouldn't be a thing and if it is it's somebody to, it's probably somebody who's coming up in their career and they're just saying like, well, my job is to get you in for as little as possible.

38:05And this is going to mess up my negotiation. And I don't want to share that with you because I don't want to go through it and you're going to press me and I'm going to have to tell the truth, you know, and things like that. So I think it really comes down to that the most. That's like number one red flag just around terms and conditions and just overall transparency around the waterfall or the model or things like that another one is just like if the hurdle seems really really ambitious if it's all performance vesting and the performance vesting is some crazy multiple on where they're at today like that would be like okay well that's not necessarily a walk away situation but it is a situation to ask the question like okay well let's talk about how we get there again and like how much of an inflection point you're trying to create here and how quickly I have to do that and how much room I have to maneuver and if it again if it gets cagey or they're like just sign the damn thing that's like yeah yeah and I think you can tease some of these out you can kind of create your own red flags a little bit so you so you get you could also ask I'm trying to think through what else I would ask I would say tell me about a time so you went through this behavioral interview yep and they did they had all this fun with tell tell me about a time when you it's like all right now it's my turn tell me about a time when you had a tougher deal and the team came in and did a good job and it didn't quite get to outcomes for the incentive equity but they were selling to another private equity firm in a strategic and they still got paid how did that work and just i mean it's either on the tip of their tongue or it's not and if they don't have that story that's like well i mean yeah they or if they're not willing to i mean it's just good information either way yeah but yeah they should have an answer that whether it's this time this happened and we did this be like well which company like i just asked for specifics what company was that you know things like that um and then or at least come up like maybe they're the greatest all right fine give them the benefit of the doubt they're the greatest investor of all time this never happened be like all right hypothetically speaking what will we do in that scenario.

40:11Just like see where they go with that, right? Because I mean, so that's one. The other one you could pull forward is on the sale where this also gets tense is private equity firm is selling and they wait too long toward the end to say, oh, by the way, another private equity firm is buying and they need you to roll 30%. So just get into that conversation upfront. Be like, hey, I know we can't nail this down now, but who do you think this is going to sell to? And is it likely another private equity firm? And in general, how have you handled rollover? Because there's some firms that are just like, you got to roll 40 % and they're kind of like, hey, take it or leave it.

40:57You know, like that type of thing. Or some private equity firms try to like precede that and go more to bat for management, like bring it up front to the LOI and be like, hey, this is the management team. This is where they're at in the careers. This is what they want to do. yeah it's like bid knowing that and they're going to roll 25 of post-tax dollars into the deal that's what they're willing to do so just like kind of help them out and pull that forward because it's an awkward conversation for a firm because you know it it's um there's a point in that deal later where the management team actually gains a lot of power because the buyer needs them to keep working but the buyer wants some incentive for them to keep working there's some skin in the game and things like that, right?

41:36So anyway, that's like stressful time number two, five years down the road. But if you pull some of that forward, that ends up being a really important time for your money, your equity is only as good as it's worth when somebody buys it, right? So if you can pull that conversation forward, even as a hypothetical, just kind of get that uncomfortableness on the table and talk through how does this work. I think the best firms work that out with their management teams up front. They go to bat forum to some extent, right? Find that middle ground where everybody's a little uncomfortable, but everybody's willing to say, yep, we're generating great outcome together.

42:11This is what's required. How does that go forward and stuff like that? So just like hopefully this all allows you the time to do this stuff. But it's not that hard. But on my side of the table, I know the answers to all these questions. I can do the math in my head. If I'm not willing to offer it up, it's because I'm trying not to, not because I can't. You know, there's a time element to it, but I think you got to just get into it and be as honest as you can be and go from there. A hundred percent. So if people have their three by five card of takeaways from this episode, what should be on the card?

42:47You only get one shot. So ask questions. You can ask about the company's current performance. You should ask about the company's expected performance and what good looks like. you should understand the waterfall you should understand the vesting terms and there should be a depth of conversation that you've had with your investor about what happens when this goes great and what happens when this goes sideways or wrong how do we work through those things that's those are the those are the main things that happen what it really comes down to is just like start being partners before your partners like just get into it and i think if you're doing that you're in good shape starting your partnership um but yeah i think it just comes down to being adults and getting into it yeah i think partnership's the word for the whole episode So that's awesome.

43:51Okay. I think that's a good place to leave it. All right. Thanks. Ciao for now. Technology issues, middle market, PE back companies. They bicker with each other and they don't take themselves too seriously. It's not venture capital. It's private equity. It's the private equity fun cast. Pour yourself a drink and have a seat.