Searchers’ economic rights and equity vesting

By Edgar Preixens, Principal Associate at Cuatrecasas

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The primary incentive for searchers is not their salary as managers but the opportunity to lead a company as CEO and the vesting of their equity holdings in the search fund and economic rights, based on the milestones detailed below.

If all goes as planned, searchers will hold a maximum of 25% of the search fund’s common equity in the case of a solo searcher, or a maximum of 30% in the case of a partnership (each holding 15% of the company’s common equity)[1].

Traditional Vesting Structure

Traditionally, searchers’ economic rights (known as carry) vest in three even tranches: 

1^st tranche (1/3): vests upon acquisition of the target company.

2^nd tranche (1/3): linked to the searchers’ management of the acquired company, typically over a period of 4 to 5 years. The shares in this tranche vest over monthly, quarterly, or annual periods.

Accelerated vesting of this 2^nd tranche could occur if a sale of the target company happens before all of a searchers’ time-based shares have vested.

3^rd tranche (1/3): linked to the investors’ IRR (the calculation of the IRR will include the search capital step-up and the vested common shares):

• IRR less than 20% (hurdle rate): searchers receive zero common shares or economic rights in this tranche.
• IRR between 20% and 35%: searchers are entitled to a proportional part, the performance shares vesting on a sliding scale along the vesting range. For instance, if the IRR is 27.5%, they will vest half of the shares or economic rights of this tranche.
• IRR equal to or greater than 35%: searchers obtain the full third of the shares or economic rights in this tranche.

During both the management phase and the exit phase, any distribution of funds should adhere to the following waterfall structure:

• repayment of search capital and step-up to initial investors;
• repayment of acquisition capital to investors;
• payment of the preferred return;
• searchers’ catch-up, if any; and
• any remaining funds should be distributed among the shareholders on a pro rata basis, according to their stake in the search fund or their vested economic rights.

Before delving into the next section, it is important to note that the traditional vesting structure remains the general rule and is currently accepted as the standard. At Cuatrecasas, we do not promote one structure over another but aim to inform on the ongoing discussions within the ecosystem.

Modifications to the Incentive Structure

In recent years, modifications to the incentive structure have been proposed in the ecosystem.

Some of these proposals aim to better align the interests of searchers and investors, and also try to give more legal certainty to some of the tax issues arising in the ecosystem.

50/50 Split

One proposal involves a 50/50 split in the vesting of the searchers’ economic rights[2], structured as follows:

• 1^st tranche (1/2): vests upon acquisition of the target company.
• 2^nd tranche (1/2): linked to the investors’ IRR, in the same metrics outlined in the traditional vesting structure.

Reverse vesting

Another variation to the traditional vesting structure is reverse vesting. In this model, economic rights vest as follows:

1^st tranche (2/3): vests upon acquisition of the target company. However, within the initial 2/3, one-third (1/3) is contingent upon the searchers not leaving the project, subject to the terms of a good leaver/bad leaver agreement. Investors and the company are given a call option to buy back any unvested portions of equity.

The shareholders’ agreement should address certain side effects of this structure, including the denominator problem and governance issues. This will require enhanced shareholder majorities (indirectly ensuring that decisions can only be taken by searchers along with a majority of investors) or requiring investor majority approvals for significant decisions.

2^nd tranche (1/3): linked to the investors’ IRR, in the same metrics outlined in the traditional vesting structure.

Two important considerations in relation to the modifications to the incentive structure:

• The search fund model has consistently proven to be effective for both searchers and investors. One of the greatest risks to the success of search funds is making changes to the model. It remains uncertain whether these trends will eventually consolidate as the standard in the search fund community.
• Each search fund structure should consider the tax issues involved, both for searchers and investors, given the significant impact on the economics of the search fund incentives. Tax experts should always be involved in defining the search fund structure.

Financial Criteria for Vesting Economic Rights

Using IRR as a financial criterion for vesting economic rights could incentivize searchers to seek an early exit. This would contrast with the long-term hold approach, which has been one of the pillars of the traditional model.

For this reason, some shareholders’ agreements provide for the possibility of agreeing on other financial parameters, such as the multiple on invested capital (MOIC), starting from a certain year of the investment—subject to a reinforced majority of investors.

Unlike IRR, which measures the annualized return on investment, MOIC measures the absolute growth of the investment. A 2.0x MOIC in 3 years is equivalent to a 26% IRR, while the same MOIC in 5 years is equivalent to a 15% IRR.

However, using MOIC as the financial criterion for vesting economic rights could achieve the opposite effect, causing searchers to delay their exit by eliminating the annualized effect of the investment return criterion. Some experts in the search fund community actually recommend against it[3].

Tom Matlack, a serial entrepreneur and investor in the US, proposed in 2017 a combination of IRR/MOIC ladder to calculate search fund performance equity and incentives[4].

This approach has been seen by some investors as a framework to better align incentives between searchers and investors.

In any case, if a long-term hold approach is eventually chosen, liquidity windows should be provided to investors willing to exit.

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[1] All the references below to fractions of economic rights shall be understood as referring to these percentages of equity vesting (25% or 30%).

[2] A paper published by IESE in July 2017 (ST-452-E) outlined this alternative incentive structure and suggested some changes to improve alignment between searchers and investors, such as changing the structure and vesting of searchers’ rights or waiving investors’ preferred return.

[3] Wassertein, A.J.; Rilling, Jürgen; Webster, Simon; Bransden, Peter. A Reference Guide on European Search Funds, p. 9.

[4] https://www.linkedin.com/pulse/new-idea-how-calculate-search-fund-performance-equity-tom-matlack