Existing executive compensation arrangements can trigger material and practical issues for a private equity sponsor acquiring a target company and can make performing a comprehensive analysis of those arrangements within an often-compressed diligence timeline challenging.

Solid legal analysis early on prevents both parties from unwittingly assuming liabilities, and when done properly, it can incentivize the target company’s senior management and help with retention. It is important to recognize the legal roadblocks that repeat themselves in these sorts of deals, and to come up with innovative solutions that work under labor and employment law.

This article lists five areas relating to executive compensation that an acquiring private equity sponsor should review during its diligence process.

Evaluate existing equity awards (if any)

In many private equity-backed businesses, senior management holds some form of incentive equity in the existing business (often at the parent or top-level holding company level). Understanding the types of incentive equity (such as stock options, restricted stock, profits interests, or even phantom equity), the tax characterization of such awards (for example, whether they are taxed as ordinary income or capital gains), and the quantum of payments all help identify potential flight risks and provide insight when planning how to incentivize, motivate, and retain senior management.  

Identify single- and double-trigger payments triggered by transactions

A change in control may trigger enhanced vesting and/or payout of certain existing rights in connection with a change in control. “Single-triggers” come into effect automatically by virtue of a consummation of a change in control (meaning, no further actions are necessary).

But “double-triggers” require both a change in control and a secondary event (such as a termination without cause occurring after the change in control). Counsel should identify any single- or double-trigger arrangements, quantify potential exposure (often with the help of an accounting team), and brief the client on resolving potential liabilities in connection with the transaction. For example, a buyer may be willing to accept the cost of potential liability for double-trigger events since the second trigger is often within its control, but it almost never will want to be liable for the cost of any single-trigger payments.

Evaluate whether Section 280G is in play, and assess remediation alternatives

If the target company is taxed as a C corporation, Section 280G (the Internal Revenue Code provision that imposes tax penalties on excessive “golden parachute” payments to executives in connection with a change in control) may apply. Violations of Sections 280G and 4999 can hit key executives with a 20% excise tax (in addition to ordinary income taxes) and invalidate the company’s tax deduction relating to such excess parachute payments. If the target business is privately held, it may be eligible for the cleansing vote process, under which shareholders would agree to approve these payments. Understanding what, if any, payments constitute potential parachute payments for Section 280G is critical in assessing risk for both management and the company.

Review arrangements to determine compliance with Section 409A rules on deferred compensation

Section 409A is a tax rule that governs nonqualified deferred compensation – a category that covers more arrangements and agreements than many clients realize. If an employee could earn compensation in one year but receives payment in a later year, Section 409A likely applies. Arrangements that violate Section 409A expose the employee to a 20% excise tax, plus interest and penalties, and there are very few ways to fix a non-compliant arrangement after the fact. This is a critical risk for buyers to understand: The acquiring sponsor often inherits the fallout when executives face unexpected tax bills.

Understand restrictive covenants and applicability post-closing

Members of senior management will typically be subject to post-employment restrictive covenants under their respective employment agreements and incentive equity agreements. These restrictive covenants may include non-competes, non-solicits, non-disclosures, and non-disparagements, among others. The enforceability of restrictive covenants is heavily contingent on state law; understanding the states in which senior management operates, the terms of any such restrictive covenants, and the payments being made to members of senior management in respect of agreeing to comply with such covenants all play into the analysis regarding the enforceability of such covenants.