Management incentive plans for PE portfolio companies following an acquisition

May 2025  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

May 2025 Issue

This article outlines how management incentive plans are typically structured – from both a corporate and tax law standpoint – by private equity (PE) portfolio companies in Spain following an M&A transaction.

In leveraged buyouts (LBOs) and M&A transactions executed without external financing by a PE player, a crucial aspect of investment success is to ensure the goals and objectives of the target company’s senior management are aligned with those of the controlling shareholders, which typically include the PE firm in question and minority shareholders.

Achieving alignment is not always easy, and the specific mechanisms that PE firms may implement will vary depending on the jurisdiction, and the internal policies and practices of each firm.

Such mechanisms are quite similar in many Western jurisdictions. But when implementing any of them, or a combination of them, it is relevant to ensure that corporate and tax law aspects are suitable to serve the ultimate purpose.

The chosen management incentive plan should not complicate the corporate governance of the target company, nor pose an unnecessary burden on a future sale, as a smooth divestment process is necessary for sound PE investment structuring.

In addition, from a tax standpoint, it is important to ascertain whether the management incentive plan will qualify as employment income or capital gain, as the taxation on capital gains is generally much more attractive. From a manager’s perspective, this determination is the cornerstone of the tax analysis of any management incentive plan.

To put things into perspective, capital gains are taxed at rates of up to 30 percent of the gain whereas employment income tax can reach 45, 50 or even 54 percent, depending on the relevant Spanish region.

It is true that under certain circumstances, long-term incentive plans that qualify as employment income may enjoy a 30 percent reduction for tax purposes, which, in practice, significantly diminishes the gap between both sources of income.

However, not all plans can enjoy this benefit and, in any case, this reduction can only be applied over a maximum income of €300,000, so, as a general rule, treating tax as a capital gain is more favourable for managers.

The only (but quite relevant) exception to this general rule is carried interest for the managers of certain regulated entities (including investment companies and funds, long-term investment funds and other similar vehicles). In these cases, the carried interest might enjoy a 50 percent rebate despite being considered as employment income under certain conditions.

This, in practice, implies that the maximum tax rate for these incentives lies between 22.75 and 27 percent (depending on the relevant Spanish region), which is on par with, or even below, the taxation of comparable capital gains.

That said, it is worth analysing management incentive plans from a corporate and tax point of view. With this intention, we have classified plans that require an actual investment from managers versus plans that do not, plus a third ‘hybrid’ category, as we believe this to be the most obvious choice.

Management incentive plans

Management incentive plans give managers the opportunity to invest in a target company or special purposes vehicle (SPV) incorporated for that purpose. This investment is structured as a share capital increase, wherein managers subscribe newly issued shares and become shareholders, or a minority stake acquisition of the existing shares. These schemes are usually implemented upon closing of an M&A transaction or shortly thereafter.

The shares owned by managers can be ordinary shares (i.e., shares with economic and political rights) or non-voting shares. However, under Spanish law, non-voting shares have certain mandatory preferential economic rights, which make them unsuitable for a PE structure. Another reason for avoiding non-voting shares is the fact that, from a tax perspective, it is preferable for managers to invest pari passu with controlling shareholders.

In these type of schemes, it is also key to execute a shareholders’ agreement governing the rights and obligations of all shareholders, including those of the managers who become shareholders. Shareholders’ agreements in these cases typically include, at least, a drag-along right in favour of the majority shareholder and a call option for certain events, including so-called leaver and bad leaver scenarios.

As managers typically have a small minority stake, the focus of the shareholders’ agreement is to ensure that the existence of minority shareholders will not complicate the day to day governance and future sale of the company. It should always be borne in mind that the rationale for letting managers invest in the target is to align them financially and retain them, rather than allow them to have veto rights, a significant influence over governance or a key role in the context of divestment.

From a tax perspective, the only management incentive income that Spanish tax authorities would reliably qualify as a capital gain is where managers invest pari passu with other shareholders and are entitled to the same economic rights (in proportion to their number of shares). Other schemes where managers do not invest pari passu but are granted free shares or shares at a price below fair market value give rise (at least partially) to employment income.

Plans without manager investment

There are various types of plans without manager investment. Rather than listing them all, as a general overview, the income they generate typically qualifies, from a tax standpoint, as employment income (and may enjoy the aforementioned 30 percent reduction if certain conditions are met).

Equity-linked management incentive plan. This common management incentive plan consists of granting a potential credit right subject to the materialisation of certain events – typically a liquidity event which entails the sale of 100 percent of a target – provided that certain requirements are met. Most notably, that managers remain in position at the target, which will be carefully detailed in the plan.

This scheme is known by different names, but the key element is that it is a mere potential credit right that may end up accruing to the managers’ benefit. The plan is triggered when, upon the materialisation of a liquidity event, a certain return on investment for the majority shareholder is reached. This type of scheme is sometimes combined with equity participation programmes.

Salary-linked management incentive plans. Typically drafted as a bonus in employment agreements, these management plans aim to boost short-term performance and incentivise achievement of short-term goals. They are often combined with an equity-linked management incentive plan or equity participation programme.

Other incentive management investment plans

Certain mechanisms, two of which are outlined below, could be considered hybrid schemes, as they may or may not involve an investment by managers.

First is the delivery of free shares or shares at a value lower than their fair market value. Through these management incentive plans, managers become shareholders. From a tax standpoint, they give rise to employment income, as this is not regarded as a pari passu investment in the target. Tax accrues when managers receive shares (on the fair market value of those shares at that time, or on the difference between the price paid and the fair market value). When managers sell the shares at a later stage, the eventual gain should, in principle (and barring special situations where the managers are entitled to a special or preferential price when they sell), qualify as a capital gain.

Second is the granting of stock options. This kind of management incentive plan is uncommon in PE portfolio companies, as in Spain it is typically regarded as more suitable for listed groups and large industrial groups with a large number of beneficiaries, with the aim of ensuring long-term retention. From a tax standpoint, they also give rise to employment income. Here, the tax treatment differs depending on whether stock options are transferable. In the case of non-transferable stock options, employment income accrues when stock options are exercised between the strike price and the fair market value of the shares. Conversely, transferable stock options accrue employment income when they are granted (on the fair market value of the stock options at that moment).

Final remarks

The majority of the aforementioned management incentive plan schemes may be applicable, with appropriate adjustments, to industrial groups that are not owned or controlled by a PE house.

Rather than linking the accrual of the relevant incentives to a liquidity event and a certain return on investment, industrial groups may want to link them to a certain increase in earnings before interest, taxes, depreciation and amortisation. Such industrial groups, which usually have a long investment horizon, tend to offer additional long-term incentives to top management, such as retirement plans, which can be structured in various forms and entail certain tax efficiencies.

All in all, any management incentive plan should be tailored to the case at hand, with legal and tax advice provided by counsel specialised in PE transactions.

 

Bojan Radovanovic and David Navarro are partners at Cases & Lacambra. Mr Radovanovic can be contacted on +34 600 914 571 or by email: bojan.radovanovic@caseslacambra.com. Mr Navarro can be contacted on +34 664 64 98 08 or by email: david.navarro@caseslacambra.com.

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BY

Bojan Radovanovic and David Navarro

Cases & Lacambra

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