Management Rollover vs. Management Option Pool in Leveraged Buyouts

Management Rollover vs. Management Option Pool Definition: In a leveraged buyout, rollovers and option pools are common incentive structures that allow management to retain some of their equity or get discounted equity upon exit if the deal performs well.

In a management rollover, the team already has shares in the company being acquired and retains some or all of them in the deal (e.g., there are 100 million shares outstanding, the managers have 10 million, and they keep all 10 million in the deal).

This structure results in the PE firm paying less upfront but also owning a lower percentage of the company, such as 90% rather than 100%.

When the exit takes place, the PE firm also receives only 90% of the Exit Equity Value rather than the full 100%, so it’s a proportional contribution and distribution.

With a management option pool, by contrast, the management team does not get any shares in the upfront deal, and the PE firm still owns 100% of the basic shares when the initial deal is executed.

It grants options to the team at this point, but these increase only the fully diluted share count and do not yet represent direct ownership.

When the exit takes place, if the common share price exceeds the exercise price of these options (typically set equal to the offer price per share in the initial deal), the managers can exercise their options and get new shares in exchange.

Effectively, this results in discounted equity for the management team.

For example, they might pay only $10.00 Exercise Price * 1 Million Options = $10 million, but if each share is worth $25.00 upon exit, they get shares worth $25 million.

This net amount of $15 million is deducted from the proceeds that go to the private equity firm.

Therefore, the returns are no longer proportional – the PE firm’s IRR falls, but the managers’ IRR increases, creating an effective incentive scheme.

Files & Resources:

• Simple LBO Model – Management Rollover vs. Management Option Pool (XL)
• Rollover vs. Option Pool in LBO Models – Slides (PDF)

Video Table of Contents:

• 0:00: Introduction
• 1:13: Part 1: The 3-Minute Summary
• 4:58: Part 2: Rollover vs. Option Pool IRR
• 6:42: Part 3: Share/Option Counts for These Structures
• 13:03: Part 4: Does the More Complex Method Matter?
• 14:10: Recap and Summary

Basic Math for the Management Rollover vs. Management Option Pool

To explain this concept in more detail, we’ll walk through two examples: One based on simple percentages, and one based on actual share and option counts.

In both cases, we will use an intentionally simple LBO model (linked to above) to keep the focus on these features rather than unnecessary details.

In Step 1 of the process, you decide on the rollover and option pool percentages, which are 20% and 10% in this simple example:

The “20%” here means that the management team will contribute 20% of the required equity in the deal, defined as Total Uses – New Debt Issued.

For this to make sense, the management team must already own shares worth $75 million when the deal closes; if they do not, you must reduce this rollover percentage.

The basic setup is shown below:

At this stage, you can also show the percentage ownership for the management vs. the sponsor (the PE firm), but it’s a bit pointless here since it’s a simple 80% / 20% split.

The management option pool does not affect direct ownership (yet), so it’s not shown in the Sources & Uses schedule. Yes, the team has this additional potential 10%, but it may or may not be a factor in the deal since it depends on the exit value.

Next, you need to model the exit based on an assumed EBITDA exit multiple and the Net Debt remaining at that time.

Once you have the Exit Equity Value, you can split up the proceeds based on the rollover and option pool.

There is a question over the “order of operations” here, but we prefer to start with the options calculations since they change the returns to each group.

The simplest method is to say that if the Exit Equity Proceeds exceeds the Total Equity in the beginning – Investor Equity + Management Rollover – the options are exercisable, and management pays 10% * Total Initial Equity to exercise them:

If these options are exercised, the managers get Exit Equity Proceeds * 10%:

The net effect is that the Equity Pool is reduced after these options are exercised and paid out to management, so less is available in the rollover and for distribution to the PE firm.

Once you have the “Exit Equity Value After Options Pool” number, you can distribute 20% of this to management as part of the rollover, with the remaining 80% going to the PE firm:

The IRR Effect of the Management Rollover vs. Management Option Pool

To understand the impact of these incentive structures, first, consider the deal without the option pool and just the rollover:

In this case, the overall project, the management team, and the PE firm all earn the same IRRs and money-on-money multiples in all exit years.

But now consider the deal with both the rollover and the option pool:

Since the option pool gives the management team “discounted equity” in the exit, it significantly boosts their IRRs and multiples while slightly reducing them for the PE firm.

It’s only a slight reduction because the PE firm owns 80% of the equity, and they retain over 70% when the exit takes place, despite this option pool.

This is why the management option pool can be a great incentive structure: The PE firm doesn’t give up that much, but even a small percentage grant can significantly improve the outcome for the managers, assuming the deal performs well.

Share Count Math for Management Rollover vs. Management Option Pool

In more advanced models, you’ll often look at LBOs in terms of share counts and share prices.

This is especially common for public companies that are acquired in leveraged buyouts because the price is always based on a premium to their share price (current or average historical price).

In these scenarios, it’s helpful to model the rollover and option pool in terms of share and option counts rather than just simple percentages.

Some of the formulas become more complex, and this method also introduces circular references into the model, which is not ideal in a quick LBO modeling test.

To set this up, you need an offer price per share in the initial deal.

If this company has 55 million shares, the per-share offer price is $550 million Purchase Equity Value / 55 million shares = $10.00:

This Offer Price per Share will also be the exercise price for the options granted to management, which is a standard assumption in deals.

The post-deal basic share count will be based on the $373 million of Total Equity contributed, divided by this $10.00 share price, so there are 37.3 million basic shares.

However, you need to “gross this up” to account for the 10% options pool, so the diluted share count equals 37.3 million / (1 – 10%) = 41.4 million:

You can then add up everything in the “Fully Diluted Ownership” area, which includes not just the rollover and PE firm’s shares, but also the potential shares from the option pool:

Moving to the exit area, the “Cash from Management Options” line is now based on the Offer Price * Management Options:

=IF(Share Price in Exit > Offer Price, Management Options * Offer Price, 0)

This creates a circular reference because the share price in the exit changes based on the share count in the exit – but the share count depends on the share price! This is because the options turn into shares based on this share price vs. the exercise price.

To handle this issue, you can check to see if circular references are enabled first.

If they are, you can calculate it this way, and if they are not, you can instead compare the Exit Equity Proceeds to the Total Equity, just like the simplified version:

The Equity to Management Options is still simple: If the options are exercisable, distribute Share Price in Exit * Option Count to management:

And the Management Rollover works based on the share count and share price now:

The Share Price in Exit equals the Exit Equity Proceeds + the Cash from the Management Options, divided by either the basic or diluted share count.

If the options are exercised, you use the diluted share count, and if they’re not, you use the basic share count.

If the options are exercised, the total “Equity Pool” increases based on the cash received from management exercising these options.

If the options aren’t exercised, the “Cash from Management Options” is $0, so it’s based on just the Exit Equity Proceeds in this case.

So, How Is This Different / Better?

The short answer is that this method is slightly more accurate but doesn’t make a huge difference.

The final numbers here are the same with both the simple and complex methods, but the complex method more accurately determines the option treatment in the exit because of the circular references.

So, this method is most helpful in “edge cases,” where the exercise price of the options and the share price in the exit are very close.

In reality, they’re rarely close in LBO models – the exit share price is much higher if the deal has performed well, or it is much lower if it has been a disaster.

This method based on the share counts also matches reality more closely because when the options are granted, the fully diluted share count does increase.

So, management will have to pay $41 million to exercise their options at the end rather than $37 million in the simplified version.

But the net effect is the same under either method, and so are the returns and multiples.

Therefore, this share-based method is not “mission-critical” in private equity case studies or modeling tests, but it could come up, especially if you are asked to analyze a public company LBO.