Thinking Outside the Buyout: Four Factors Management Teams Need to Get Right

Management teams of companies acquired by private equity (PE) firms often find themselves in a unique position. For a time, they are both selling owners and operators who will continue to run the business after the sale. Unlike other stakeholders who may exit completely, management teams must consider how their ongoing role will be structured while also maximizing value in the transaction. This dual imperative creates challenges that require careful navigation.

Management teams that understand these dynamics can significantly improve deal outcomes. This article examines four critical areas that require focused attention in any buyout transaction:

• Equity rollovers
• Incentive compensation arrangements
• New employment agreements
• Restrictive covenants

Rollover Equity and Governance Documents

A common feature of buyout transactions is that management teams are typically required to reinvest (roll over) a portion of their existing equity in the target business, rather than receiving full cash proceeds from the sale of their stake. According to Goodwin’s internal rollover survey, most PE-backed buyers require some form of rollover, with founders often rolling 10–50% of their equity and other management members rolling smaller amounts. This maintains management’s financial stake in the company’s future success by aligning its economic interests with the new owners while also allowing management to realize partial liquidity from the sale.

Rollover equity is often structured to enable tax deferral benefits, making it attractive despite the lack of immediate liquidity. Retaining equity may also preserve Qualified Small Business Stock (QSBS) status, potentially allowing for capital gains tax exclusions. However, qualifying for these and other tax benefits requires careful evaluation on a case-by-case basis.

Beyond tax considerations, management must assess key rights and obligations tied to their rollover equity. These terms are typically outlined in the governing documents of the entity through which they and the new owners will hold their stake post-closing. The terms include:

• Economic terms (e.g., management’s priority in the distribution waterfall)
• Transfer restrictions (i.e., limitations on selling or transferring equity)
• Drag-along rights (i.e., allowing the sponsor and/or other majority owners to require minority holders to participate in a future liquidity event)
• Information rights (e.g., access to periodic financial reports and annual budgets)
• Governance or control rights (e.g., board representation or veto rights over key decisions)
• Liquidity rights and obligations (e.g., call and put rights over management’s equity stake)

Incentive Compensation Arrangements

Another tool in a sponsor’s toolkit for ensuring the continuity of key personnel post-closing is the establishment of incentive compensation plans. Incentive compensation plans are typically structured to grant management a share of the upside realized when the sponsor exits, thus providing management with an incentive to create value. Incentive compensation can take different forms, but the most common types are outlined below. Each of these has significant legal and tax implications, and the decision of which one to adopt for a target company should be carefully considered alongside expert legal and tax advice.

• Stock options: the right to acquire equity in the sponsor-led entity at a set exercise price after a vesting period
• Profits interests: a right to share in future profits and appreciation of the issuing entity without an immediate ownership stake or tax liability at issuance
• Restricted stock units (RSUs): a promise to issue equity interests of the issuing entity once vesting and other predefined conditions are met
• Phantom equity: a contractual right to receive cash compensation tied to equity value without actual ownership in the issuing entity
• Cash bonuses: cash payments based on predefined criteria, such as individual performance, company profitability, or other key metrics

Most incentive compensation structures are subject to vesting conditions, typically divided into (a) time-based vesting (i.e., vesting conditioned on the employee remaining employed for a minimum period), and (b) performance-based vesting (i.e., vesting tied to overall value creation in the target company since the grant date or the plan’s establishment).

Some plans allow full or partial vesting acceleration upon predefined events, most commonly a change of control, though many grant boards or compensation committees discretion over acceleration decisions. Meanwhile, virtually all sponsor-backed incentive plans require automatic forfeiture of unvested compensation upon departure. While departing employees often retain vested awards, exceptions exist for those terminated for cause or otherwise classified as “bad leavers.” Departures may also trigger a target company’s repurchase right, typically at fair market value or another (lower) predefined price if the departure is related to, for example, a bad leaver situation.

New Employment Agreements

As an outcome of the buyout transaction, management members may also be required to sign new employment agreements with the acquired company or another entity within the buyer group. These agreements often introduce changes to compensation, roles, and responsibilities to better align with the vision of the new owner. Key provisions of an employment agreement typically include:

• A description of the employee’s title, responsibilities, and reporting structure
• Details on base salary, potential bonuses, payment schedule, and entitlement to benefits
• Employment term and termination provisions, including definitions of “for cause” termination and “good reason” resignation
• Intellectual property assignment provisions
• Predefined dispute resolution mechanics

In certain cases, employees may successfully negotiate severance packages at the outset of the relationship, providing compensation if the employment relationship ends under specific conditions while the parties remain on good terms. Severance is often triggered by termination due to a change of control (a “single trigger”) or if termination occurs within a defined period post-change of control (a “double trigger”). Certain key executive employment agreements may include garden leave (a required transition period before departure) and cooperation clauses (requiring former employees to assist with company matters post-employment). Many sponsors also provide director and officer (D&O) indemnification and insurance policies to protect management from legal liabilities.

Restrictive Covenants

The last category of issues that are prevalent in many sponsor-backed buyout transactions are management restrictive covenants. Restrictive covenants aim to protect business goodwill, confidential information, trade secrets, and key customer, supplier, and employment relationships. In buyout transactions, they help ensure the buyer fully realizes the value of the acquisition without immediate disruption from former employees or sellers. Post-closing, these covenants also align employee and equityholder incentives and mitigate conflicts of interest. Restrictive covenants generally fall into three categories:

• Seller-related covenants imposed on management members who were preclosing owners of the target company
• Employment-related covenants contained in employment agreements for continuing employees
• Equityholder-related covenants tied to management’s post-closing interest in the business (through rollover, incentive compensation, etc.)

Common types of restrictive covenants include:

• Confidentiality clauses, which are imposed to protect sensitive business information from unauthorized disclosure or misuse
• Non-compete clauses that prevent individuals from engaging in competitive activities that could undermine the acquired business
• Non-solicitation and no-hire clauses, which prevent individuals from poaching employees, contractors, and/or business partners
• Non-disparagement clauses that protect a company’s reputation by prohibiting negative statements about the protected company or its leadership or business practices

Key negotiated elements of restrictive covenants include: (a) the scope of the restricted activities, (b) the duration of the restricted period (which usually ranges from two to five years post-sale and/or for the duration of employment or post-closing ownership plus another one to two years post-employment or ownership, as applicable), and (c) the geographic scope of the restriction.

Of importance to note is that, in recent years, legislative and regulatory efforts have sought to ban or limit certain restrictive covenants, particularly non-competes. Several states, including California, North Dakota, Oklahoma, and Minnesota, have outright bans on post-employment non-competes in employment agreements. In 2024, the Federal Trade Commission (FTC) attempted to issue a nationwide ban on post-employment non-competes, but a federal judge in Texas ruled against enforcement of the rule. Despite these trends, state-imposed non-compete bans generally do not apply to sale transactions.

Conclusion

Given the significant financial and professional implications facing management teams in a buyout transaction, management must proactively review and negotiate their rights and obligations throughout the sale process. Engaging separate legal representation can help ensure that the unique interests of management members are adequately protected and aligned with their short- and long-term goals. Successfully navigating the challenges outlined in this article will not only facilitate a smoother transaction for all parties but also help position the newly acquired business for long-term growth under its new ownership, alongside active management participation.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.