Data-based benchmarks for private equity sponsors seeking to establish effective incentive equity plans.

Vesting terms for incentive equity arrangements of private equity (PE) backed portfolio companies can come in many shapes and sizes. While many PE sponsors have their own preferred vesting terms, deal practitioners should have a clear understanding of market trends and competing incentives. This allows them to properly guide sponsors and their portfolio companies to competitive incentive equity plans that will accomplish the sponsors’ objectives of retaining and incentivizing management.

In this article, we evaluate information sourced from Goodwin’s Private Equity Deal Database to identify common vesting criteria for incentive equity arrangements, general market trends, and what deal practitioners should consider when advising PE clients on typical vesting terms.

We find that almost all incentive equity plans of PE-backed middle-market companies include time-based vesting criteria, but the most effective approach for aligning the interests of sponsors and management teams lies in the hybrid approach of blending time-based and performance-based vesting.

Why PE Sponsors Use Incentive Equity

PE sponsors use incentive equity plans as a significant component of compensation packages for executives and other senior employees of portfolio companies. A competitive incentive equity package serves as a valuable tool for PE sponsors to retain portfolio company management teams post-acquisition and to ensure strategic alignment between sponsors and management during the PE sponsors’ holding period. Incentive equity plans can take a variety of forms, often driven by tax and structuring considerations. The contours of each plan — including the size of the incentive equity pool; the type of security subject to the plan (e.g., profits interests, options, restricted stock, phantom equity, etc.); and the vesting, forfeiture, and acceleration terms — are typically ironed out between a sponsor and a target’s management team during the acquisition process prior to the execution of definitive deal documents.

Typical Vesting Constructs

Virtually all incentive equity grants are subject to vesting conditions that must be satisfied for a management employee to realize value on such grants. A principal objective of PE sponsors is to establish vesting terms that properly incentivize management to remain employed with the portfolio company on a long-term basis while growing the business. Management, on the other hand, is typically focused on securing vesting conditions that are tangible, achievable, and shorter in duration. As a result of these potentially conflicting objectives, there is a natural tension between PE sponsors and management teams when advocating for preferred vesting terms.

Generally, incentive equity is subject to time-based vesting (in which vesting of the incentive equity corresponds to an employee’s continued employment over a specified period of time), performance-based vesting (in which vesting is tied to a target company’s or a PE sponsor’s satisfaction of certain financial targets), or a combination of both. PE sponsors typically seek to tie incentive equity grants to performance-based vesting criteria, which permit management to participate only if the sponsor or its portfolio company achieves specified financial benchmarks that are intended to be representative of the success of the sponsor’s investment. Unsurprisingly, management teams usually advocate for time-based vesting criteria, which they perceive as a more concrete and attainable vesting metric.

As shown in Goodwin’s Private Equity Deal Database, 62% of the incentive equity plans established in connection with middle-market and lower-middle-market deals in the past 18 months feature a combination of both time-based and performance-based vesting criteria. Of such “blended” incentive equity plans, most allocate one-half to two-thirds of incentive equity grants to performance-based criteria, with the balance allocated to time-vested conditions. Given the competing vesting preferences of PE sponsors and management, the prevalence of blended vesting criteria appears to be a logical compromise designed to accommodate the stakeholders’ differing objectives.

Although blended vesting is the predominant formulation, Goodwin’s Private Equity Deal Database reflects that 32% of incentive equity plans are subject exclusively to time-based vesting, while only 5% of plans are exclusively performance-based. It is noteworthy that exclusive time-based vesting is slightly more prevalent in lower-middle-market deals, which is perhaps a practical function of the greater difficulty in forecasting reliable performance thresholds for smaller, earlier-stage or growth companies.

Time-Based Vesting Criteria

As summarized above, most incentive equity plans include time-based vesting conditions, whether exclusively or as a component of a blended vesting construct. In either case, the specific characteristics of time-based vesting can vary from one incentive equity plan to another. According to Goodwin’s Private Equity Deal Database, slightly more than half of the relevant plans feature “cliff” vesting pursuant to which an initial percentage of the time-based grant vests on the one-year anniversary of the grant date, with the remainder vesting in equal monthly or quarterly installments over a period of three or four years thereafter. Most of the remaining plans implement “ratable” vesting pursuant to which the time-based grant vests in equal installments — usually annually — over a period of four or five years. In designing competitive incentive equity plans, PE sponsors can’t go wrong with either a cliff or a ratable time-vesting schedule.

Performance-Based Vesting Criteria

Goodwin’s Private Equity Deal Database also offers some useful trends on the formulation of incentive equity plans that feature performance-based vesting conditions, which can vary greatly. Performance-based vesting criteria are usually tied to a PE sponsor’s achievement of specified multiple on invested capital (MOIC) and/or internal rate of return (IRR)¹ hurdles, measured at the time of the sponsor’s exit. Of such plans, nearly two-thirds are conditioned on satisfaction of MOIC thresholds alone, approximately one-quarter are conditioned on satisfaction of IRR thresholds only, and the remaining plans include a combination of MOIC and IRR conditions. In many cases, performance-based vesting terms include “tiered” thresholds pursuant to which the vested portion of the performance-based grant increases as the MOIC and/or IRR hurdles increase. Of course, the most impactful decision for PE sponsors in constructing performance-based vesting criteria is establishing the actual hurdles. Those hurdles are likely to vary from one portfolio company to another depending on a number of factors, including the sponsor’s investment thesis and anticipated holding period, as well as the industry in which the portfolio company operates, and PE sponsors would be well served to establish thresholds that management considers to be realistic and within reach rather than purely aspirational.

Deal Practitioner Considerations

A blended time-based and performance-based vesting formulation presents an attractive alternative for both sponsors and management by accommodating PE sponsors’ goal of tying incentive equity to the financial performance of their investments and by appealing to management’s desire for concrete criteria that management perceives to be within its control. Additionally, market trends suggest that PE sponsors have a fair amount of flexibility to tailor specific time-based and performance-based vesting criteria on a case-by-case basis to match their investment expectations on each deal. For example, the use of a single performance-based hurdle with a MOIC of two may be appropriate for mature portfolio companies with a moderate growth outlook, while tiered performance-based metrics can allow sponsors to award exceptional financial performance in portfolio companies with a potentially significant growth trajectory. In any case, practitioners armed with market data on vesting trends will be well positioned to advise PE sponsors on common vesting formulations of their peers.

Finally, vesting conditions are only one of several key components of a constructive incentive equity plan for PE sponsors, and deal lawyers should have expertise with all such components to effectively advise PE clients. Among others, some additional criteria to consider while negotiating the vesting criteria include whether the unvested time-based incentive equity should accelerate upon an exit transaction and under what circumstances a management employee should forfeit incentive equity.

^[1] PE sponsors use MOIC to measure investment performance by comparing proceeds returned to a sponsor upon exit with the total amount of capital invested by the sponsor. They use IRR to estimate the growth of a particular investment.

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