Bet The Jockey

Joseph W. Bartlett – Special Counsel at McCarter & English LLP and Founder of VC Experts

The most successful venture capitalists carry one slogan around in their heads as they review new investment opportunities: "Bet the jockey and not the horse." This means that the quality of management is the key ingredient in a successful early stage investment strategy. This is not new news to anyone even casually familiar with private equity investing. In fact, it makes me curious about the avalanche of criticism in the media aimed at directors of public companies who award lush employment and option contracts to key managers. The fact is, the quality of management makes just as much difference in a public company as it does in a private, emerging growth firm…a make or break proposition. If the company has $1 billion in gross revenues and $100 million in margin in today's environment, it is likely to be headed in one of two directions…on the way up to $2 or $3 billion, with a consequent effect on shareholder value, or exactly in the opposite direction. As Dick Foster and Sarah Kaplan have pointed out, very few public companies are able to stand still these days. The gifted managers are continuously involved in the process of reinventing their firms. Intense global competition means today's good times, left unattended, are tomorrow's death spiral.

All this is background music to the point of this column, a comment on perhaps the most contentious issue in executive compensation generally.

The controversy has to do with the issue of vesting. Since management is so important, it is generally agreed that the "sweat equity" should be motivated by awards of restricted stock and options. When the directors, including the financial partners, acquiesce in an option/restricted stock plan, vesting is part of the equation. Usually, the maximum awards are awarded immediately, subject to recall at the holder's cost (meaning nothing) if employment terminates prior to the expiration of the vesting period. A typical vesting schedule would vest a percentage of the award periodically and pro rata, either annually, quarterly or monthly over a period of three years, for example. If a 'balloon' number of shares (a number of shares in excess in what would be the pro-rata number) is vested at the beginning of the vesting period or by virtue of the occurrence of some exogenous event, jargon in the trade refers to this contingency as 'cliff vesting,' meaning that the non-pro rata number of shares jumps off a cliff and becomes vested instantaneously. Thus, for example, if vesting of 100,000 shares is pro-rata vested over a five year period at 20,000 shares a year and the vesting is accelerated 100 percent upon the occurrence of a "change of control," the unvested shares are 'cliff vested' by virtue of the change.

The big argument has to do with the instance to which we have just referred. Is it appropriate to provide in the initial documents that the unvested shares will be 'cliff vested' if a change of control occurs ("change of control" being a term that typically means the company is sold)? On the assumption that a company sale is a happy event for the shareholders, the sweat equity recipients of the restricted stock and/or options argue that the 'cliff vesting' is only fair. The terminal value has been created in large part by the sweat equity; and it is unfair, when all the rest of the shareholders are taking their marbles and going home, to leave management (the "jockeys" on whom the VCs bet) with unvested shares which are either canceled or carried over as unvested shares or options to the acquiring company. The financial partners argue, however, that 'cliff vesting' is equitable. How would George Steinbrenner sell the New York Yankees if all the long term contracts of the Yankees star players were 'cliff vested' (i.e., cancelled) and the new owner of the Yankees had to negotiate from scratch with Derek Jeter, Bernie Williams, Joe Torre, Roger Clemens, etc.?

The notion that unvested equity represents value to the acquiring company (and, therefore, value that the acquiring company will pay to the sellers of the target) is supported by FASB interpretation No. 44, which requires that a portion of the acquisition costs in a merger under the new purchase accounting rules be allocated not to goodwill but to an intangible styled as "unearned compensation." According to a recent report, the amount to be allocated to the intangible is:

"equal to the portion of the intrinsic value of a target's unvested options that is allocable to the remaining vesting period of such options. The amount assigned to the unearned compensation account, which would otherwise be allocated to non-amortizable goodwill, must be amortized over the remaining vesting period of the options." [1]

The FASB interpretation lends credence to the idea that the intrinsic value of unvested options is a valuable intangible. It also, on the other hand, supports the argument of the sweat equity, that all the unvested options and restricted stock should 'cliff vest' on a change of control. If vesting accelerates and the purchase price remains the same (an assumption which is open to question), then the acquiring company need not worry about an intangible being created on the books which is amortized over a relatively short period of time- i.e., the remaining unvested portion of the awards.

This is a little bit of 'inside baseball' concededly; but the arguments about 'cliff vesting' on changes of control are significant (they involve personal outcomes) and there is no right answer.

[1] As most financial engineers are aware, new M&A rules provide that goodwill no longer need be amortized unless impaired. The game of allocating the purchase price in an M&A transaction has, accordingly, taken a 180-egree turn. Nowadays, the planners are anxious to allocate as much of the purchase price as possible to good will and therefore, as little to tangible and intangible assets. The idea is that goodwill will remain unimpaired and, therefore, that portion of the purchase price will never be, through amortization deductions, a charge against publicly reported earnings.

Joseph W. Bartlett, Special Counsel,

Joseph W. Bartlett is special counsel in the Corporate, Securities and Financial Institutions practice. A recognized pioneer of the national private equity and venture capital bar, Mr. Bartlett contributed to the original models for private equity and fund of fund partnerships. His experience extends to alternative investments, venture capital, emerging companies, corporate restructurings, private equity and buyouts. Mr. Bartlett's practice includes serving as counsel to asset managers, including those of major public and private equity funds, with a focus on technology companies, and he has also served as trustee of a series of public mutual funds and chair of a public REIT. His venture fund work began with the first Greylock fund, and he has drafted documents for several of the largest and most successful LBO funds.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Joseph W. Bartlett. This work reflects the law at the time of writing.