Management participation: What is it?

The most important facts in brief:

• Management participations serve the purpose of Alignment of interests between management and owners of a company.
• The Granting of sharesThe issue of options and debt participations are the usual forms of management participation.
• The participation of management must be carefully contractually structured so that the goal of giving managers a share in the value created can be achieved.

What is a management participation?

A management participation gives managers a stake in the company. Management participation is intended to help ensure that the interests of the management and the owners of a company are aligned. Management participation thus solves the so-called "Principal-agent problem", according to which the management may pursue interests other than those of the owner (e.g. excessive use of resources, short-term rather than sustainable growth). Management participations are widespread. In particular, private equity funds, start-ups and listed stock corporations almost always involve managers in the company, case of Private equity typically in the operating portfolio company.

What options are there for management participation?

The Granting of shares, the issue of options and debt participations represent the usual forms of management involvement. There is no general answer as to which form of participation is advisable in a specific case.

• SharesPrivate equity funds in particular enable key executives to acquire shares in the company directly. In this way, managers participate in both increases and decreases in value. Only a few selected managers usually have the opportunity to acquire shares. This is because the participation of managers in the company leads to a reduction in the share of the private equity fund; this dilution is only accepted by a small number of people. If the shares are given to the managers as a gift or sold at a discount, the "gifted" portion constitutes wages that must be taxed.
• OptionsAnother form of management participation is that the managers Options receive. With an option, there is the possibility of being able to purchase shares at a fixed price at a later date. Even if the value of the shares rises, the managers can buy the shares at the lower price set in advance. Example: Based on the option, 1,000 shares can be purchased for a total of € 50,000. If the share price at the time of exercise is € 100 per share, the shares can be bought for € 50,000 and sold again directly for € 100,000. Options have the advantage that no initial financial investment is required. A precise agreement is important with options. The agreement of the exercise price and the exercise period are particularly important. It is also possible to structure options in accordance with the law of obligations. The managers cannot then acquire shares, but receive a payment claim in the amount of the profit they would have made with a corresponding option.
• "Participation" under the law of obligationsInstead of allowing them to participate in the company, the management can also participate in the development of the company they manage at contractual basis The management can participate in the performance of the company, for example by participating in the profit of the company and/or the performance of the company via a bonus. The management can participate in the performance of the company, for example, via a bonus that is due when the company is sold and the amount of which is based on the sale price.
• Further investmentsSilent participations or convertible loans are conceivable in principle, but rarely encountered in practice.

What needs to be considered when structuring management participation?

The involvement of management must be contractually regulated. The following points should be taken into account, depending on the individual interests and form of participation:

• ControlManagement participation is intended to allow managers to participate in the performance of the company they manage. Nevertheless, the main shareholder(s) would like to remain free to decide on a possible sale of the company. For this reason, the participation agreements often contain co-sale rights and obligations (so-called drag-along and tag-along clauses).
• Leaver clausesManagement should only have a stake in the company for as long as it works for the company. Therefore, in so-called Leaver clauses to regulate how participation is affected when service or employment contracts end. In most cases, these clauses differentiate according to the reason for termination. For example, if a manager is terminated without notice for good cause due to his or her own breach of duty, different rules apply than if the manager resigns due to a breach of duty by the company.
• Dilution protectionIt should be prevented that the managers' shareholding can be diluted. At the same time, the company should continue to be able to react flexibly to changes, so that granting subscription rights, for example, is one way of ensuring flexibility while protecting managers from a dilution of their shareholding.
• Own investmentPrivate equity funds in particular prefer managers to invest their own money, albeit on a small scale (so-called "skin in the game"). In the case of start-ups, own investments by the management are rather rare. Private equity funds often grant loans to managers to finance the acquisition of shares. In the case of such loans, attention must be paid to the arm's length nature. Information obligations may exist in this regard.
• Revenue distributionPrivate equity funds want to ensure that they get their invested money back safely. Therefore, they try to be favored in the distribution of proceeds. Managers need to be aware that they will be treated subordinate to the private equity fund, which increases the risk of losing their own investment.
• TaxesManagement participations should be structured in such a way that taxes only have to be paid if the beneficiary managers themselves generate income. Otherwise there is a risk of so-called "dry income". This means that the participating managers have to pay taxes without earning any money.
• PoolingIn order to simplify investment structures, the shareholdings of managers are often bundled in a management investment company. Private equity funds also prefer such models in order to be able to control the influence of management at shareholder level.

Interests in employee shareholdings

Employee shareholdings generally pursue the goal of aligning the interests of management and owners. The interests of the owners often depend on the type of company:

• Listed AG & family businessIn the case of listed stock corporations and family businesses, the owners are regularly interested in positioning the company for long-term success. The management should therefore be encouraged to ensure that the company develops sustainably - usually over decades.
• Start-upsStart-ups should generally be sold very successfully within a few years, either to a larger company or by means of an IPO. Accordingly, the management should also be incentivized to build up the company in such a way that a purchase in a few years is attractive and realistic for buyers.
• Private equityPrivate equity funds usually buy companies for 5 to 10 years and then sell them again. The aim is to maximize the value of the company during this period. The basis for determining a sales price is usually the company's profit, which is multiplied by a factor (so-called multiples valuation). Accordingly, the management is also encouraged to maximize the profit and thus the value of the company.