Management deals for restaurant management teams

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

This article was first published in M&C Report in March 2014.

One of the consequences of the growth in the size of restaurant groups following the early success of concepts like Pizza Express, Wagamama and Cafe Rouge for instance was that the casual dining sector registered on the radar of the private equity ("PE") industry and the rest is history.

This has led to the growth in incentivised, PE backed management teams whose job it is to roll out concepts on behalf of their PE lords and masters to enable the PE house to exit in due course at a healthy multiple, delivering significant capital growth to all involved.

The positive thing for restaurant management teams is that the PE industry is very good at incentivizing management - after all, the houses (particularly the larger ones) are typically generalists with no specialist restaurant operational expertise, meaning that they rely critically on management for delivering the business plan and the bacon.

There are effectively two deals that management need to be aware of when a PE house comes a knocking.

The first relates to their "roll over". Most management teams in larger operators are already incentivized to a certain degree in their existing concept and many are already PE backed. These members may have shares, they may have share options, they may have loan notes which bear interest and they may even have a ratchet mechanic which delivers them additional value depending on the sale price they ultimately achieve.

These packages deliver rewards to the management team on an "exit" which leads to a conundrum for a PE purchaser (a "PE Buyer") who wants a management team that is motivated, hungry and willing to push the business forward. A team that have all become overnight millionaires does not necessarily fit the bill.

Thus, whilst a PE Buyer will be happy to permit the team to take some cash off the table, they will insist that key management "roll over" and invest a percentage of their cash into the new purchasing vehicle that acquires the concept ("Newco").

Thus, management will often ask each other in a coffee break, "Just how much did you have to roll over?". In some cases, management "roll over" or reinvest all of their cash proceeds in return for being "reloaded" by the PE Buyer.

Thus, in practice, the management team (through their adviser) will generally have to negotiate several different deals with the PE Buyer as the team may have, for instance, a founder that is no longer key to the growth of the concept who is looking to cash out entirely or, alternatively, a founder that is prepared to work another stretch and then exit.

This second founder will roll over a large percentage of their shares whilst the first will probably not be interested in any rollover. Thus, every management deal is different.
In addition, the team may have operational or finance team members who have only recently joined the business who may not yet hold a significant equity stake but who will be critical for delivering the new growth plan. These members of the team may be allowed to cash out all of their value (which will not be a life changing amount but might make a fair dent in their mortgage) as a gesture and be handsomely incentivized in their new package with the PE Buyer.

Thus, in a sense, its everyman and everywoman for themselves at this first stage of the deal and it's generally up to the corporate finance adviser and lawyer acting for the management team to negotiate these deals with the PE Buyer and represent the management's interest.

Critical to the negotiations is, of course, the second part of the equation which is what incentive package is the PE Buyer offering the management team.

At this point, it's important for management to understand how the investment by a PE buyer is structured.

The PE Buyer has to inject cash into Newco to enable it to pay the purchase price and also to fund the new business plan. This is typically funded in part by cash from the PE Buyer but a larger portion comes from a third party bank, which takes security over the assets of the target group.

The cash from the PE Buyer is used to subscribe for what is known as the "Institutional Strip". The "Institutional Strip" will include shares and interest bearing loan notes issued by Newco but could extend to preference shares as well.

Where management has previously "paid for" or "earned" the equity they agree to "roll over", they may well be able to roll these shares into the "Institutional Strip" which generally enjoy the most preferential terms. Further, if a member of the team wants to invest further capital, again, they may subscribe alongside the "Institutional Strip". If management do not all have shares, or if some, not large holdings, the PE Buyer will often set aside an additional pot of equity known as "Sweet Equity" which can consist of "free" shares issued to the management team at par value (as opposed to fair value) which are allocated amongst the management team. Thus some members of the team participate in the "Institutional Strip" whilst others participate in the "Sweet Equity".

Part of the value that the management team "rolls over" is also used to subscribe for loan notes in Newco. These notes should, in a perfect world, rank alongside the loan notes given to the PE Buyer in the "Institutional Strip" in all respects, but sometimes they are subordinated.

Depending upon the terms of issue of the loan notes, these can provide the management with additional income during the course of the investment or could be repayable only on a subsequent sale. There are some specific tax rules regulating such matters.

Loan notes (or preference shares) typically eat into the equity value of the business so any management team that does a deal that sees the management receive only shares in Newco whilst the PE Buyer invests largely by loan notes will find their equity value erode over the life of the investment, so beware.

Given that there is sometimes a difference between the management's view of the value of the business and the PE's view, there can be a valuation gap. This can be bridged in part by the use of a performance based ratchet. A management performance ratchet can be extremely valuable and operates as follows.

The rights attaching to one class of the management's shares (as often there are several classes of management rollover shares to cater for the individual deals done for each member) will have built into them a right that operates to deliver value to that class of shares if, but only if, the sale proceeds achieved on an exit exceed a nominated threshold, for instance, if the PE Buyer achieves a 30% IRR.

Thus, readers will now understand that management have to negotiate their "roll-over" deal plus their new deal. In doing so, there are a number of related key tax and legal issues to be considered, far beyond the scope of this article.

On the tax side, it is important to ensure that when the management roll over their shares into shares in Newco, this is not treated as a disposal for capital gains tax purposes. Relief should be available. It is also critical to ensure, wherever possible, that each member of the management team (and potentially new members) is able to qualify for entrepreneur's relief ("ER"). This delivers a favorable tax treatment and is available to employees who own shares that are at least equal to 5% of the nominal capital of the company and control at least 5% of the votes at a general meeting. If a team member qualifies for ER, they should benefit from a 10% capital gains tax treatment on a subsequent sale (subject to various conditions). There are a number of structures open to procure that management can satisfy these tests.

There are other rather emotive issues that need to be addressed by the management team, nonetheless of which is to what extent their roll over shares should be taken away from them if they leave the business before the next exit. The concept of "Good Leaver/Bad Leaver" is very relevant here and could occupy an entire edition of M&C Report but the rule of thumb is that if a team member leaves (i.e. is dismissed or resigns) they should expect to have to hand back their "Sweet Equity" but if they have previously earned their roll over shares or paid for them, they should fall outside the "Good Leaver/Bad Leaver" regime (meaning they can keep their shares) or, if they have to be forfeited, the manager must get "Fair Value" for such shares with no minority discount (i.e. be a Good Leaver, as opposed to being a Bad Leaver who gets nil value for their shares.

Clearly, the management deal involves a complex set of inter-related issues that can really test the strength of the management team's resolve as the negotiations are carried out in the midst of the sale of the group. Many of the concepts in this article have been deliberately simplified but at least now readers will understand what an "Institutional Strip" is and perhaps avoid embarrassment over the negotiation table.